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Investing in Tech Stocks

Updated: July 27, 2021, 4:37 p.m.

The technology sector is vast, comprising gadget makers, software developers, wireless providers, streaming services, semiconductor companies, and cloud computing providers, to name a few. Any company that sells a product or service heavily infused with technology likely belongs to the tech sector. Below is a quick breakdown of the differences.

Hardware Companies

These design and build devices such as:

  • Personal computers
  • Smartphones
  • Fitness trackers
  • Smart speakers
  • Enterprise equipment like servers and networking gear

Software Companies

These design the software that runs on hardware, such as:

  • Operating systems
  • Databases
  • Cybersecurity software
  • Productivity software

Software companies are increasingly moving to a software-as-a-service model where customers buy a subscription to a program instead of a one-time license. This generates recurring revenue for the software company.

Powering all that hardware are semiconductor chips. Semiconductor companies design and/or manufacture central processing units, graphics processing units, memory chips, and a wide variety of other chips that find their way into today’s devices.

Telecom companies that provide wireless services are part of the tech sector. So are the video streaming companies that provide easy access to high-quality content, and so are the cloud computing providers that power those streaming services.

The best tech stocks

Many of the most valuable companies in the world are technology companies. These are some of the most dominant and impressive tech stocks:

  • (NASDAQ:AMZN) is the leading online retailer and the leading provider of cloud computing infrastructure. Founder and CEO Jeff Bezos will step down as chief executive later this year, opening up a new chapter for the company.
  • Microsoft (NASDAQ:MSFT) is a dominant software company known for its Windows PC operating system and Office productivity software. Microsoft is also the second-largest provider of cloud infrastructure behind Amazon.
  • Apple (NASDAQ:AAPL) makes the iPhone, the iPad, and Mac computers. Intense customer loyalty ensures plenty of repeat customers, and a growing array of services makes Apple’s ecosystem sticky.
  • Intel (NASDAQ:INTC) is one of the largest semiconductor companies in the world. Intel designs and manufactures CPUs for PCs and servers, as well as specialty chips for uses such as artificial intelligence.
  • Cisco Systems (NASDAQ:CSCO) is the dominant provider of the enterprise networking hardware that forms the backbone of the internet.
  • Netflix (NASDAQ:NFLX) is the top dog in the video streaming industry, spending billions of dollars each year on content to keep its ever-growing subscriber base hooked.
  • Facebook (NASDAQ:FB) is the largest social media company, with more than 2 billion daily active users across Facebook, Instagram, Messenger, and WhatsApp.
  • Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL) is the parent company of online search giant Google and the popular Android operating system for smartphones.

Facebook, Amazon, Apple, Netflix, and Alphabet (Google) are sometimes grouped together as the FAANG stocks. These companies dominate their industries, and their stocks have produced impressive returns over the past few years.

The impact of COVID on tech stocks

The pandemic meant that Americans had a whole new world of tech needs. Many tech companies stepped up to meet those challenges, so the pandemic time frame has netted mostly positive results for the tech industry.

Amazon has thrived as consumers shifted hard toward e-commerce, even as rivals like Walmart (NYSE:WMT) and Target (NYSE:TGT) stepped up their e-commerce games. Amazon expanded total sales by 44% in the first quarter of 2021 to $108.5 billion, an incredible feat for such a large company.

Microsoft has also done well, buoyed by demand for collaboration software, devices, gaming, and cloud computing services as people spend more time at home. Sales of PCs remained extremely strong at the start of 2021, helping Microsoft on multiple fronts. Microsoft’s revenue jumped 19% in its most recent quarter, and net income soared 44%.

While it was unclear early in the pandemic how sales of Apple’s pricey gadgets would fare, consumers are now snapping up Apple products. Sales of everything the company makes were up considerably in its latest quarter, with the core iPhone business posting 66% growth. Sales of Macs soared as well, helped by the launch of M1-powered MacBooks featuring Apple’s first home-grown chip.

High demand for devices has helped Intel as well, with sales of laptops surging as people work from home, although a global semiconductor shortage is complicating the situation. Intel saw strong demand for its server chips in 2020 from cloud customers, but those customers have pulled back this year. Intel reported a 20% decline in data center chips in its first quarter.

Intel rival Advanced Micro Devices (NASDAQ:AMD) has also been thriving. AMD’s latest Ryzen 5000 PC chips outclass comparable chips from Intel across nearly every metric, which will almost certainly lead to more market share losses for Intel.

Cisco hasn’t been so lucky. While the company’s videoconferencing business is booming, the core networking hardware business has suffered as customers pull back on spending. While the pandemic has hurt Cisco in the short term, the shifts toward e-commerce and working from home could ultimately boost demand for networking equipment in the long run. The Internet of Things should also be a long-term growth driver for Cisco as an increasing number of objects and devices are connected to the internet.

Netflix saw its user base rapidly grow during the pandemic as people stayed home. The company had to temporarily pause production of all shows, but that didn’t stop people from signing up for its service. While growth was strong for Netflix in 2020, 2021 is looking like a different story. Netflix expects subscriber growth to slow dramatically this year.

Other streaming services are growing fast, including Disney’s (NYSE:DIS) Disney+. Another major competitor will emerge next year after a mega-deal between HBO-owner AT&T (NYSE:T) and Discovery (NASDAQ:DISC.A) is complete. And AT&T’s WarnerMedia will merge with Discovery to create a streaming giant that could cause Netflix some trouble.

Both Facebook and Alphabet depend on advertising sales, so the steep decline in advertising from hard-hit industries like travel early in the pandemic hurt both of those companies. They’re both doing just fine now -- Facebook reported 48% revenue growth for the first quarter, and Alphabet saw sales jump 34%.

Antitrust action could be one thing that eventually derails these advertising giants. The U.S. Justice Department, along with 11 state attorneys general, sued Alphabet’s Google in October 2020, accusing the company of anticompetitive behavior related to its search advertising business.

Both the Federal Trade Commission and 46 state attorneys general sued Facebook in December 2020. The suits allege the social media giant used acquisitions to eliminate competitive threats. The FTC is looking to force Facebook to divest Instagram and WhatsApp.

Only time will tell how the long-term trajectories of these major tech companies have been altered by the pandemic and by increasing antitrust scrutiny from the U.S. government.

How to analyze tech stocks

For mature tech companies that produce profits, the price-to-earnings ratio is a useful metric. Divide stock price by per-share earnings and you get a multiple that tells you how highly the market values the company’s current earnings. The higher the multiple, the more value the market is placing on future earnings growth.

Many tech companies aren’t profitable, so the price-to-earnings ratio can’t evaluate them. Revenue growth matters more for these younger companies -- if you’re investing in something unproven, you want to make sure it has solid growth prospects.

For unprofitable tech companies, it’s also important that the bottom line be moving from losses toward profits. As a company grows, it should become more efficient, especially when it comes to the sales and marketing spending necessary to close deals. If it’s not, or if spending is growing as a percentage of revenue, that could indicate something is wrong.

Ultimately, a good tech stock is one that trades at a reasonable valuation given its growth prospects. Accurately figuring out those growth prospects is the hard part. If you expect earnings to skyrocket in the coming years, paying a premium for the stock can make sense. But if you’re wrong about those growth prospects, your investment may not work out.

Investing in an exchange-traded fund that focuses on tech stocks is one way to avoid making mistakes. The ARK Innovation ETF (NYSEMKT:ARKK) is one option, although the fund’s bets on high-flying tech stocks may ultimately prove riskier than investing in the tech giants listed above.

Investing in tech stocks can be risky, but you can reduce your risk by investing only when you feel confident their growth prospects justify their valuations.

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