Tech Stocks Not Worth the Risk

We're Dueling over tech stocks this week on Fool.com. In this article, Fool contributor Richard Gibbons says investors should beware of the tech sector. But Tim Beyers thinks tech stocks should be a part of everyone's portfolio. Read them both and then vote for your favorite.

Warren Buffett, CEO of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), does not invest in the technology sector, a position for which he took a lot of flak at the height of the tech bubble. Buffett's simple answer has always been that he does not understand technology. But I think this really is just a way to summarize a raft of problems with investing in technology.

Technology is tricky
The straightforward interpretation of Buffett's answer, that technology is hard to understand, deserves mention, even if it seems overly obvious. One important rule of investing is that you should understand how the company makes money -- a rule I violated in my deep, dark, pre-Fool days. Alas, I learned then that buying companies whose business I didn't fully grasp was not exactly a path to wealth.

Thus, anyone who owns Cisco (NASDAQ:CSCO) should spend the time to learn how the Internet works, what the difference is between a router and a switch, and how these technologies are changing. Meanwhile, a potential McDonald's (NYSE:MCD) investor can spend a few hours thinking about the 10-K -- and maybe grab a Quarter Pounder -- and have a pretty good idea of how that company makes money.

So, maybe this just means that tech is a great place to be, because you're not a lazy investor and are willing to spend the time to understand the technology. That brings us to the next problem in the tech sector, neatly summed up by the title of Intel (NASDAQ:INTC) Chairman Andrew Grove's book, Only the Paranoid Survive.

The problem stems from the high rate of change in technology relative to almost any other sector. Tech bulls tend to focus on potential high growth that such change can bring, but investors should be aware of the negative consequences as well. For example, it is difficult to sustain a competitive advantage in technology because of the fast rate of both evolutionary change and disruptive change.

Evolve or die
Evolutionary change happens when technology improves incrementally, such as the speed of computer processors increasing each year. It requires companies to constantly expend resources simply so they don't fall behind.

You see this effect with most hardware manufacturers. For instance, Intel and Advanced Micro Devices (NYSE:AMD) are constantly burning cash trying to improve the performance of their processors just to remain competitive. Compare this with Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP), whose core products can remain unchanged for decades, leaving piles of free cash flow to be distributed to shareholders or invested in opportunities that will actually increase revenue.

Disruptive change is even worse than evolutionary change. Disruptive technologies offer a completely different value proposition than existing technology, and may underperform the existing technology in the near term. However, a disruptive technology that initially only seems to address a niche can take over the market. For example, digital photography is a disruptive technology for traditional film photography, resulting in Eastman Kodak's (NYSE:EK) recent dismal performance. Similarly, TiVo (NASDAQ:TIVO), a pick by David Gardner in Motley Fool Stock Advisor, is a disruptive technology for the VCR.

Disruptive change can happen in non-technology businesses, but technology companies are particularly vulnerable. And disruptive change can demolish companies that seem to have huge competitive advantages. WordPerfect once had a leading position in word processing, but faded when Microsoft (NASDAQ:MSFT) was faster at creating a decent word processor for Windows. Similarly, Digital Equipment Corporation (DEC), once a dominant company with piles of cash, a strong brand, and good technology, is now a memory after its mini-computers were displaced by PCs. Even IBM (NYSE:IBM) has been hit. Its dominance in mainframes 25 years ago means little now. According to IDC, IBM's mainframe sales in 2003 were about $4.2 billion, less than 5% of its revenue, and negligible compared with the $178.1 billion PC market.

The implications of change
Thus, technology is extremely difficult to predict, even in the short term. As a speculator looking for a lottery ticket, that isn't a concern. But as an investor, it's a huge negative. Ideally, the company you invest in will grow and prosper over time. That's particularly challenging in an industry where only the paranoid survive, where a single mistake can lead to the death of the company. It's much more preferable to invest in simple industries with a strong, sustainable advantage, where management can make huge mistakes, trip over its own feet, walk into walls, and the company can come out the other end still profitable for shareholders.

Investors should consider this when they value stocks using the discounted value of their future free cash flow. This method uses earnings of future periods to derive the present value of an investment. According to this valuation method, a dollar a year from now is worth less than a dollar now, because if you had a dollar now, you could put it in a bond, and get back more than a dollar in a year's time. In addition, if you're talking about a company's earnings, there is some risk that something could go wrong and the company might not earn that dollar in a year. Thus, that future dollar of earnings has to be discounted to get its present value.

When we look at technology, the constant change means increased risk, which implies that the discount for the future earnings of technology stocks deserves to be greater than stocks with more predictable earnings. Consequently, all else being equal, the valuations for tech stocks should be lower. However, this hasn't been true for much of the last decade. Speculation and excitement over potential new technologies have resulted in tech stocks commanding a premium, a sign that investors should be wary.

Weighing the options
So, after all this, suppose you end up picking a tech company that is able to prosper over the long term. You'll then be able to see how, through the magic of stock options, the company's insiders devour a large portion of your profits. Stock options, an expense that technology executives have fought hard to avoid accounting for, are not exclusive to technology. But their use in the tech sector is notorious.

Options are generally issued yearly to employees, and give them the right to acquire shares at some fixed price some time over the next decade. They don't currently show up on the income statement, and you have to delve deep into company 10-Ks to find what the effect on income would be if they were expensed.

The numbers are ugly if you compare the reported income with the pro forma income the company would have had if it had expensed options at fair-market value. From recent 10-Ks:

Thus, even in the best cases, earnings are significantly overstated. In the worst, it seems like shareholders just receive management's leftovers.

Summary
Investors have a choice. They can go for the excitement of expensive tech companies with unpredictable earnings diluted constantly by management options. Or, they can buy cheap companies with strong long-term competitive advantages that will reliably print cash for investors for decades. I'm going with the cash.

Next: Read the bullish take on tech stocks.

Fool contributor Richard Gibbons is biding his time in Vancouver, contemplating irony. He does not own any of the securities mentioned in this report, but welcomes your thoughts at [email protected].