Investors may have noticed that the technology sector has been resilient in the face of extreme economic volatility due to the pandemic.
However, for a non-technical person, understanding jargon like artificial intelligence (AI), big data and cloud computing may seem daunting.
The task gets harder with the rapid pace of change in the technology sector.
It is no wonder that some investors are reluctant to invest in the sector, despite its highly attractive growth prospects and potential to generate outsized returns.
But it doesn’t have to be hard.
Today, we will walk through a simple framework for you to pick the right tech stocks for your portfolio.
Tech titans and “FAANG” stocks
First time tech investors may want to start with larger, mature businesses with proven track records.
These businesses are typically entrenched with deep economic moats that fortify their ability to maintain their competitive advantages, hence making them safer investments in the context of growth.
They include leaders in software and cloud-computing such as Adobe Inc. (NASDAQ: ADBE) and Microsoft Corporation (NASDAQ: MSFT), both of which have recorded a 1,479% and 715% increase in share price respectively over the past ten years.
Meanwhile, the technology hardware sector, which has a reputation for being cyclical and economically sensitive, has also sported gems such as NVIDIA Corporation (NASDAQ: NVDA).
In the early 2000s, NVIDIA emerged as the leader in graphics processing units (GPUs) and continues to maintain its lead today, particularly in key growth segments such as video games and data centre processing.
Over the past ten years, its share price has risen by a staggering 3,960%.
And of course, there are “FAANG” stocks that feature prominently in the tech sector and are well known for dominating their respective fields.
These five tech giants – Facebook (NASDAQ: FB), Amazon (NASDAQ: AMZN), Apple (NASDAQ: AAPL), Netflix (NASDAQ: NFLX), and Alphabet (NASDAQ: GOOG) make up a sizable portion of the S&P 500 Index and have consistently outperformed the benchmark index.
Emerging market leaders in strong, secular trends
Larger businesses provide safety. But they are built to be workhorses rather than fast growth.
To identify stocks with the potential to be multibaggers (stocks that have a return of more than 100%; for example, a five-bagger stock is one with a 400% return), investors will need to look at smaller companies that are likely to become the next generation of “FAANG” stocks.
Typically, these businesses have a market capitalization under $10 billion and are just at the beginning phase of their life cycle.
Another characteristic of a potential multibagger is a business that is leading and benefiting from megatrends.
Similar to how e-commerce propelled Amazon’s massive growth, such transformational trends redefine the way we work, learn, live and play while creating significant value over time.
For example, Fastly (NYSE: FSLY), a cloud-based content delivery network (CDN) provider, is well-positioned to benefit from powerful trends such as e-commerce, telecommuting and digital entertainment.
With a market capitalization of around US$9 billion, Fastly has demonstrated explosive growth as evidenced by the impressive 288% increase in its share price since the beginning of this year.
The metrics you should watch
Mature tech companies can be valued using traditional techniques.
A useful metric is the price-to-earnings (P/E) ratio, which is obtained by dividing the stock price by per-share earnings. It indicates how much the market is willing to pay for a stock based on its past or future earnings.
As a reference, the S&P 500 has a P/E ratio of 28 based on its latest reported earnings and current market price.
Tech stocks however, tend to have higher P/E ratios due to their higher growth potential.
For younger tech companies that are not yet profitable, it is crucial to consider revenue growth. Therefore, metrics such as price-to-sales (P/S) ratio and dollar-based net-expansion (DBNE) rate are more relevant.
DBNE measures how much more existing customers spend in the current quarter compared to what they did a year ago. A DNBE rate of 150%, for example, means that the same customers spent 50% more in the current quarter compared to a year ago.
Another area to watch is whether companies display an ability to grow their free cash flow over time as this would allow them to continue to innovate and pursue new expansion opportunities.
Get smart: Invest in the right US tech stocks
While the tech sector may seem daunting for some investors, it is hard to ignore the stellar returns it has generated and its prospects of outperforming in the long-term.
Even Warren Buffett, who is famous for his value investing philosophy and once shunned tech businesses, is now on board. Buffet’s Berkshire Hathaway portfolio now comprises more than US$91 billion in Apple shares, or over 40% of the conglomerate’s entire stock portfolio.
To get started, you may consider using the framework above to value potential tech stocks. Depending on your short-term and long-term goals, hopefully it will help you narrow down the tech stocks that are suitable for your portfolio.
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Charlotte owns shares in Adobe, Microsoft, NVIDIA, Facebook, Amazon, Apple Alphabet and Fastly.