What Every Investor Should Know about High-tech

By Bobby Chen
Analyst, mPower

In This Story What the Web Offers An Investment Point of View It's Difficult to Value Companies without Track Records The Risks of Tech Stocks Looking Ahead

Investing in technology companies is riskier than ever, despite high growth in the sector. Just as today's cutting-edge technology may become obsolete tomorrow, today's billion-dollar company could be out of business in a year.

Investors who buy stock in individual companies must judge each company on its merits, and not on the performance of the entire sector. This article, the second in our series on tech investing, lays out some of the important factors that investors should consider.

minute: read this article at a glance.

There is a bevy of new technology companies looking to capitalize on the continued growth of the Internet, thus spawning new industries that are providing fertile ground for investors.

Other Articles in This Series Technology Stocks and Your Portfolio

However, it's important to independently assess individual companies, and not get caught up in general high-tech hype. If history is any indication, many of these new Internet-related companies will just be a flash in the pan.

What the Web Offers

Who are these red-hot companies serving up the latest dose of tech fever? Let's run across the chain.

Internet Service Providers (ISPs), like AOL, are raking in money by connecting people to the Net. In addition to AOL's own portal, there are a myriad of portal sites on the Web (like Yahoo!, for example) that organize information into neat categories for your browsing pleasure. Equipped with search engines, these sites allow you to find just about anything you want.

Online advertising firms such as DoubleClick and Engage are helping to steer customers to Web sites. Information about customers is constantly being collected and stored in Web-based databases. Data-mining software applications profile potential customers for targeted advertising. The massive amount of data is backed up onto dedicated Storage Area Networks (SANs). EMC and Veritas Software have become multi-billion dollar companies by specializing in this area.

New breeds of software applications are now built specifically for e-business and cover everything from setting up online storefronts to managing back-end operations. eCRM (electronic Customer Relationship Management) applications from vendors such as Siebel Systems, enable automation of many of the sales processes.

VeriSign and Entrust are among a group of companies focused on Internet security solutions that will ease the minds of those wary of entering their credit card numbers online. Companies like Akamai and Digital Island are working on content distribution solutions that will speed up page downloads — a much welcome relief.

New companies are built to challenge traditional business models. Application Service Providers (ASPs) that deliver software applications over the Internet for a rental fee, instead of the heftier up-front purchase fee, will have a profound impact on the software industry.

These are all new industries born from the Internet Age, and this list is nowhere near exhaustive. The point is that companies everywhere are working on technologies that will lead to a more connected world.

An Investment Point of View

As exciting as these developments are, the Internet itself is still very much a work in progress, with a nascent infrastructure. Technologies involved with the Internet are often young and unproven. That said, one of the biggest risks investors face today is that stock prices of many of these companies are largely driven by market momentum. They rise and fall dramatically based more on investor perceptions than business fundamentals, and are particularly vulnerable to any negative news.

The incredible volatility of technology stocks in general is best reflected by the performance of the tech-laden NASDAQ over the last 12-month period. (The NASDAQ Composite Index is generally thought of as a general proxy for technology stocks.)

It wasn't long ago that investors were practically throwing money at every dot-com company that came to market. Shares of Internet content and service providers were bid through the roof only to come crashing down as investors soon realized the lack of barriers to entry means no real competitive advantage. Ad-based business models were discarded largely because top sites like Yahoo! were getting virtually all of the advertising dollars.

Spiral-marketing pioneer Hotmail, which gives users a free e-mail service in exchange for putting an advertising link at the bottom of every e-mail message sent, leveraged its first-mover advantage into a billion-dollar enterprise that eventually became part of Microsoft. Now spiral marketing is just another tool that companies use, not a real competitive advantage.

Then came the B2B (business-to-business) buzz, which sent the stock price of those companies skyrocketing. Investors were salivating over the potential size of that segment, which by all accounts will be in the trillions in the coming decades. That figure is not in dispute, what is in dispute is who's going to make money from those transactions, and how?

Just like the B2B segment, wireless technologies were supposed to be the next big thing. A Lehman Brothers analyst went so far as to slap a preadjusted price target of $1,000-a-share on Qualcomm, one of the hottest stocks in 1999. Qualcomm is now down more than 60 percent from the time he made his recommendation. (As of August 24, 2000, Qualcomm stock closed at roughly $60 per share, down significantly from its 52-week high of $200 per share.) So much for expert advice.

Difficult to Value Companies without Track Records

Without momentum, how are these companies valued? The Internet is brand-new territory, so the metrics used to place a value on "new economy" stocks are also unproven. Wall Street analysts often set price targets based on things like relative market multiples, which compare the company's valuation to that of its peers or the market. But, relative measures will contract or expand depending on market conditions, which means a stock's value will be higher when the market goes up and lower when the market goes down — not exactly a definitive opinion on the value of a business.

The Internet is brand-new territory, so the metrics used to place a value on "new economy" stocks are also unproven.

Of course, it's hard to judge the value of many young technology companies, given their usual characteristics:

• Unproven technology
• Short and unproven operating history
• Nondiversified revenue base
• Massive losses, or volatile earnings streams

The Risks of Tech Stocks

Competition is fierce and technology product cycles are much shorter than in other industries. Just as today's cutting-edge technology may become obsolete tomorrow, today's billion-dollar company could be out of business in a year. Investors who focus on growth should bear in mind that it is much easier to "grow" a small revenue base. A sales increase from $2 million to $10 million is a fivefold increase, but in absolute terms it's still a drop in the bucket when compared to stalwarts like Microsoft.

We are still in the land-grabbing stage, and many companies have taken on huge debt to stake their claim in the market. This could potentially be fatal because if a company is running negative cash flows, it isn't well equipped to endure market downturns and could be out of business if additional sources of capital dry out. Here are some other areas of focus when assessing the value of young technology companies:

• Business model
• Technology (you can't sell what you don't have)
• Potential market size
• Competition
• Barriers to entry (legal or technological)

We are still in the land-grabbing stage, and many companies have taken on huge debt to stake their claim in the market.

Additionally, companies used to go through four or five stages of growth and financing before they went public, but many are now rushing to the market at record pace, some as short as a year after inception. Investing in such companies effectively makes you a source of venture capital — venture as in "you can lose all your money." If you are going to roll the dice, you'd better know what you are buying.

As technology continues to develop and evolve, there is little doubt that technology companies will shape the competitive landscape for many years to come.

Triple-digit gains like those of 1999 are not the norm and will not be sustained in future periods. If you feel compelled to invest in technology stocks or funds, you should use only speculative capital (that is, money you can afford to lose).

Judging from the latest tech debacle, the risk we speak of is very real. Investors must realize that though the Internet is creating some big waves, the peaks and troughs are much more extreme — and the roller-coaster ride will continue.

The next article in our high-tech series will take a look at optical networking stocks, which have remained fairly strong in the face of recent high-tech turmoil. The article will be published on September 11.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

What Every Investor Should Know about High-tech

By Bobby Chen
Analyst, mPower

In This Story What the Web Offers An Investment Point of View It's Difficult to Value Companies without Track Records The Risks of Tech Stocks Looking Ahead

Investing in technology companies is riskier than ever, despite high growth in the sector. Just as today's cutting-edge technology may become obsolete tomorrow, today's billion-dollar company could be out of business in a year.

Investors who buy stock in individual companies must judge each company on its merits, and not on the performance of the entire sector. This article, the second in our series on tech investing, lays out some of the important factors that investors should consider.

minute: read this article at a glance.

There is a bevy of new technology companies looking to capitalize on the continued growth of the Internet, thus spawning new industries that are providing fertile ground for investors.

Other Articles in This Series Technology Stocks and Your Portfolio

However, it's important to independently assess individual companies, and not get caught up in general high-tech hype. If history is any indication, many of these new Internet-related companies will just be a flash in the pan.

What the Web Offers

Who are these red-hot companies serving up the latest dose of tech fever? Let's run across the chain.

Internet Service Providers (ISPs), like AOL, are raking in money by connecting people to the Net. In addition to AOL's own portal, there are a myriad of portal sites on the Web (like Yahoo!, for example) that organize information into neat categories for your browsing pleasure. Equipped with search engines, these sites allow you to find just about anything you want.

Online advertising firms such as DoubleClick and Engage are helping to steer customers to Web sites. Information about customers is constantly being collected and stored in Web-based databases. Data-mining software applications profile potential customers for targeted advertising. The massive amount of data is backed up onto dedicated Storage Area Networks (SANs). EMC and Veritas Software have become multi-billion dollar companies by specializing in this area.

New breeds of software applications are now built specifically for e-business and cover everything from setting up online storefronts to managing back-end operations. eCRM (electronic Customer Relationship Management) applications from vendors such as Siebel Systems, enable automation of many of the sales processes.

VeriSign and Entrust are among a group of companies focused on Internet security solutions that will ease the minds of those wary of entering their credit card numbers online. Companies like Akamai and Digital Island are working on content distribution solutions that will speed up page downloads — a much welcome relief.

New companies are built to challenge traditional business models. Application Service Providers (ASPs) that deliver software applications over the Internet for a rental fee, instead of the heftier up-front purchase fee, will have a profound impact on the software industry.

These are all new industries born from the Internet Age, and this list is nowhere near exhaustive. The point is that companies everywhere are working on technologies that will lead to a more connected world.

An Investment Point of View

As exciting as these developments are, the Internet itself is still very much a work in progress, with a nascent infrastructure. Technologies involved with the Internet are often young and unproven. That said, one of the biggest risks investors face today is that stock prices of many of these companies are largely driven by market momentum. They rise and fall dramatically based more on investor perceptions than business fundamentals, and are particularly vulnerable to any negative news.

The incredible volatility of technology stocks in general is best reflected by the performance of the tech-laden NASDAQ over the last 12-month period. (The NASDAQ Composite Index is generally thought of as a general proxy for technology stocks.)

It wasn't long ago that investors were practically throwing money at every dot-com company that came to market. Shares of Internet content and service providers were bid through the roof only to come crashing down as investors soon realized the lack of barriers to entry means no real competitive advantage. Ad-based business models were discarded largely because top sites like Yahoo! were getting virtually all of the advertising dollars.

Spiral-marketing pioneer Hotmail, which gives users a free e-mail service in exchange for putting an advertising link at the bottom of every e-mail message sent, leveraged its first-mover advantage into a billion-dollar enterprise that eventually became part of Microsoft. Now spiral marketing is just another tool that companies use, not a real competitive advantage.

Then came the B2B (business-to-business) buzz, which sent the stock price of those companies skyrocketing. Investors were salivating over the potential size of that segment, which by all accounts will be in the trillions in the coming decades. That figure is not in dispute, what is in dispute is who's going to make money from those transactions, and how?

Just like the B2B segment, wireless technologies were supposed to be the next big thing. A Lehman Brothers analyst went so far as to slap a preadjusted price target of $1,000-a-share on Qualcomm, one of the hottest stocks in 1999. Qualcomm is now down more than 60 percent from the time he made his recommendation. (As of August 24, 2000, Qualcomm stock closed at roughly $60 per share, down significantly from its 52-week high of $200 per share.) So much for expert advice.

Difficult to Value Companies without Track Records

Without momentum, how are these companies valued? The Internet is brand-new territory, so the metrics used to place a value on "new economy" stocks are also unproven. Wall Street analysts often set price targets based on things like relative market multiples, which compare the company's valuation to that of its peers or the market. But, relative measures will contract or expand depending on market conditions, which means a stock's value will be higher when the market goes up and lower when the market goes down — not exactly a definitive opinion on the value of a business.

The Internet is brand-new territory, so the metrics used to place a value on "new economy" stocks are also unproven.

Of course, it's hard to judge the value of many young technology companies, given their usual characteristics:

• Unproven technology
• Short and unproven operating history
• Nondiversified revenue base
• Massive losses, or volatile earnings streams

The Risks of Tech Stocks

Competition is fierce and technology product cycles are much shorter than in other industries. Just as today's cutting-edge technology may become obsolete tomorrow, today's billion-dollar company could be out of business in a year. Investors who focus on growth should bear in mind that it is much easier to "grow" a small revenue base. A sales increase from $2 million to $10 million is a fivefold increase, but in absolute terms it's still a drop in the bucket when compared to stalwarts like Microsoft.

We are still in the land-grabbing stage, and many companies have taken on huge debt to stake their claim in the market. This could potentially be fatal because if a company is running negative cash flows, it isn't well equipped to endure market downturns and could be out of business if additional sources of capital dry out. Here are some other areas of focus when assessing the value of young technology companies:

• Business model
• Technology (you can't sell what you don't have)
• Potential market size
• Competition
• Barriers to entry (legal or technological)

We are still in the land-grabbing stage, and many companies have taken on huge debt to stake their claim in the market.

Additionally, companies used to go through four or five stages of growth and financing before they went public, but many are now rushing to the market at record pace, some as short as a year after inception. Investing in such companies effectively makes you a source of venture capital — venture as in "you can lose all your money." If you are going to roll the dice, you'd better know what you are buying.

As technology continues to develop and evolve, there is little doubt that technology companies will shape the competitive landscape for many years to come.

Triple-digit gains like those of 1999 are not the norm and will not be sustained in future periods. If you feel compelled to invest in technology stocks or funds, you should use only speculative capital (that is, money you can afford to lose).

Judging from the latest tech debacle, the risk we speak of is very real. Investors must realize that though the Internet is creating some big waves, the peaks and troughs are much more extreme — and the roller-coaster ride will continue.

The next article in our high-tech series will take a look at optical networking stocks, which have remained fairly strong in the face of recent high-tech turmoil. The article will be published on September 11.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.