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How To Size Up Tech Stocks

Technology stocks are hot again--and with good reason. These are companies that typically hoard lots of cash and carry little or no debt, two desirable attributes in an unstable economy.

But before you start scooping up tech shares like it’s 1999, hoping to power drive your returns after a dreadful year and a half, consider these tips on investing wisely in the sector.

Smarter Evaluations

Cell phone tower, telcom, telecom
Cell phone tower, telcom, telecom

Investors look to tech stocks to find companies primed for growth, but the technology landscape has been littered with one-hit wonders. To avoid that trap, Rob Cihra, technology analyst at Caris & Company, recommends looking for companies with unique product cycles.

“You want to focus on a company with definable, hopefully unique, product cycles that are going to drive their growth,” says Cihra.

Cihra points to the smart phone market as one with strong organic growth, and Apple as a company, whose product cycles can help it weather tough market conditions.

“Apple is showing that while it’s certainly not immune to weaker consumer spending, it can still grow within a market that’s otherwise shrinking,” he says.

Along the same lines, close examination of the competitive nature of a particular sector within technology can help identify stocks with staying power. For John Bright, director of technology research at Avondale Partners, that means looking at sectors with high barriers to entry.

“Competition is very high within technology investing, and if you don’t have some core competency that creates a barrier to entry, then you’re likely to experience additional competition, which often leads to price competition, which is never a positive thing for equity investors,” says Bright.

Enterprise-level software and services typically have high barriers to entry, notes Bright, as is less the case with consumer products.

“Companies that have patents and/or licensing models would have strong barriers to entry,” he says, citing Neutral Tandem and Akamai Technologies as good examples.

Eliminate False Assumptions

Tech companies that hit it big with one great product are often rewarded with a rich valuation. But if those companies can’t maintain a competitive advantage, that high-flying stock price quickly falls back to earth. That’s why analysts believe market valuation is an overrated measure of a tech stock’s worth.

“If you have something that’s working, you’re going to attract competitors,” says Toan Tran, technology analyst at Morningstar. “You’re starting to see that with a company like VMware . They were the first company to come out with virtualization software, and for a couple of years they pretty much owned that field. The stock had a tremendous run, but the stock has come back a lot because you’re seeing competition in this space. Microsoft is getting in this space, and it’s only a matter of time before VMware gets commodified.”

Bright says a company’s terminal value—the value of a business at the end of an income projection period—is a good way to evaluate its longer-term growth prospects.

“You need to take a more holistic look at tech companies to see whether or not it’s just a one-trick pony or a company that has iterations of performance,” Bright says. “Oftentimes investors exclude [terminal value] from their investing. They may just look at the growth characteristics near term and turn a blind eye to that potential competitive entry and/or technology risk.”

For Tran, enterprise value carries more weight than market valuation because it takes into account a company’s cash and debt holdings.

“Apple has $29 billion in cash right now and no debt,” he says. “You should subtract that from their market cap to get an enterprise value of the company. I think it gets more to the heart of the valuation for a tech company.”

Cihra adds investors should beware of falling into a value trap, wherein a mature tech stock has a low valuation, giving the appearance of being a bargain stock poised for an inevitable spike.

“The problem is if their other markets aren’t growing, there’s no reason to think the stock’s going to do anything but stay cheap,” he says.

There are relatively safe bets in technology. IBM [IBM] and Hewlett-Packard [HPQ], provide stability because they’re diversified, large-cap companies that have recurring revenue streams from their services divisions. But for the most part, the tech market is cyclical, which means investors have to do more homework to make informed decisions.

That also means investors can be well served by taking a contrarian stance, says Cihra.

“Often things aren’t as bad as they sometimes seem, but often aren’t as good as they sometimes seem, either,” he says. “When everyone loves tech is not the time to own it. When everyone hates tech is the time to own it.”