Investing in tech stocks

Technology stocks have dominated the investment landscape for much of the last decade, here's a guide to investing in the sector.
Investing in tech stocks
Updated
April 5, 2022

Table of contents

Technology stocks have dominated the investment landscape for much of the last decade.  When the pandemic got going, some seemed to think they were the only companies worth bothering with.

Covid-19 pulled us all online more than ever before, and it forced companies to beef up their digital capabilities in double-quick time.


“We’ve seen two years’ worth of digital transformation in two months” Satya Nadella, Microsoft CEO. 

According to McKinsey, the percentage of the US population shopping online jumped from just over 15% before the pandemic to nearly 35% by the end of Q1 2020. Some shopping will revert back to the physical world, but it is likely a decent amount of our online habits will endure.

All told, technology makes up roughly 23% of the MSCI World index (a global equity index) and 30% of the S&P 500 (an index of large US companies).

And this doesn’t include Meta, Alphabet or Amazon, which sit in consumer sectors. Add those names into the mix and technology is close to 40% of the S&P 500.


S&P 500 Index Sector Breakdown 


Source: S&P Global 


For comparison, at the height of the tech bubble in 2000, the tech sector made up around a third of the S&P 500. Similar to today’s level but lower adjusting for Meta, Amazon and Alphabet.  

We should point out that this is a bit of a US phenomenon. In Europe, the sector is much smaller, and it’s practically non-existent in the UK (for public companies that is - it's a different story for the UK’s rapidly growing private tech market).

But as the US makes up more than half of the world's global company capitalisation, technology is still important for investors on this side of the pond.


What are tech stocks?

The most commonly used industry classification scheme is the Global Industry Classification Standard (GICS) which is jointly owned by MSCI and S&P Global, both US companies.

Classification schemes like GICS are calculated using market capitalisation (market cap) weightings. In other words, by size. Market cap is calculated by multiplying all of a company’s share count by its share price. So, because of their market cap, large companies like Apple carry high weightings in the indices they are members of.

Under GICS, technology has seven subsectors covering a wide range of companies including handset manufacturers, software developers, communications equipment manufacturers, data processors and IT consulting firms.

Technology sector
First level subsector Second level subsector
Software and services
IT consulting and other services
Data processing and outsourced services
internet services and infrastructure
Application software
Systems software
Technology hardware and equipment
Communications equipment
Technology hardware, storage and peripherals
Electronic equipment and instruments
Electronic components
Electronic manufacturing services
Technology distributors
Semiconductors and semiconductor equipment
Semiconductor equipment
Semiconductors


Source: MSCI Global.


For our deep dive into technology, we focus mainly on the three high-level subsectors; software and services, hardware and equipment, and semiconductors and semiconductor equipment.


What do the different technology industries do?

For investors less familiar with the differences between the subsectors of technology it might be helpful to personify them.  

We’re not biologists, so stay with us.

If software and services are the brain, hardware and equipment would be the bones, muscles and nerves, and semiconductors/semiconductor equipment the cells or electrical components that provide the power. 

Thinking about the different areas of technology in this order helps contextualise what each of the industry players do, and the role they play in the supply chain.

Imagine the brain as the software industry. It’s where computing power exists and is at the centre of a lot of the industry’s invention and progress.

It’s the least commoditised part, meaning the capabilities and products of software companies are very different from each other. The brain is responsible for our personalities, intellect, even sense of humour (or lack thereof). In short, everything that makes us unique.  

Hardware companies make the physical infrastructure or the bones, muscles and nerves. 

There are nuances in physical form that make us different heights, weights, slower or faster runners etc. But physically we have more commonalities than differences. 

So relative to software, hardware companies tend to be more commoditised.

Lastly, semiconductor companies make the electrical components that power the whole system. Semiconductors (semis) are highly complex and difficult to make but the reality is they’re all pretty similar. A semi made by Intel, for example, performs the same functions as one made by TSMC.

The lack of differentiation means semiconductors are basically commodities. The value lies in the production process, and the most successful semi companies are those with the most efficient and advanced manufacturing capabilities.

Having personified the technology industry, let’s hop onto the operating table and dissect it a little further.

Software and services

Home to the second-largest company in the world, Microsoft, software and services has been one of the hottest sectors in investing over the last 10 years. 

In 2011 legendary venture capitalist Marc Andreessen wrote that “software is eating the world”. What he meant was that software programmes are enabling and automating tasks that used to require physical labour and hard assets. 

For example, collecting, filing and maintaining information on customers once required people, pens, and paper. Customer relationship management (CRM) software, from companies like Oracle, was a death knell for that particular filing cabinet. 

Cloud computing has picked up a lot of software tasks (like collecting, storing and analysing customer data) and moved them away from individual offices and on-premise data centres into massive off-premise data centres run by cloud service providers. 

Salesforce.com was the pioneer of cloud-based CRM solutions and its products have displaced many of the old on-premise CRM software solutions. 

Software business models

Before cloud computing, software was predominantly sold as a perpetual licence. Customers bought the software upfront and acquired a licence to use it forever. In the enterprise world, larger customers (businesses with usually 1,000+ employees) also bought a maintenance contract, effectively insurance against the risk of any breakdowns. 

Maintenance agreements would last multiple years and be highly profitable for software vendors, mainly because breakdowns were reasonably rare and cheap to mend when they did happen. 

Although in theory a customer could buy a perpetual licence and run the software forever, vendors would try to release new and improved versions every few years to try and create an entirely new sale.

This revenue model was highly profitable, but it had the problem of being a bit unpredictable for a few reasons. 

First, it was never guaranteed that customers would upgrade to the latest release. Sometimes the old version did the job well enough, which led to version skipping or only buying new software every other release or so. 

Second, customers could let their maintenance contracts expire without renewing, opting to run the risk of breakage. 

This is where the cloud stepped in and fundamentally changed the revenue model for most software companies. Workloads shifted to the cloud and software vendors changed the way they billed their customers.

Instead of customers being asked to pay for an upgrade every few years, involving an army of people installing new versions onto on-premise servers (the more complicated the software the more challenging the implementation), software vendors could now sell software as a service (SaaS). 

This granted customers access to centrally-managed servers in exchange for a subscription payment. 

All customers needed was a good internet connection and to trust their SaaS provider would keep their data safe. 

The cloud transition has transformed the software industry in other ways too. For sellers, it opened up a new market of smaller businesses previously unable to afford expensive upfront software. And, in some cases, it increased the amount of money software companies could earn from customers over the relationship’s lifetime.

For example, a three-year subscription at £833 a month (£30,000 total) is more affordable for some companies than a £25,000 upfront payment every three years, even though clearly it is £5,000 more in total. Customers often don’t have the cash lying around to pay upfront.

For vendors, the subscription model means there’s significantly less friction when releasing newer versions. No major installations are required, saving the customer integration costs in both money and time.

On top of the possible increase in customer lifetime value, subscription revenues tend to get renewed at high rates, solving the problem of version skipping that plagued the old perpetual licence model. 

For investors, anything recurring and predictable is a good thing.

As well as their attractive revenue profiles, software companies can be very profitable. Outside of wages (which admittedly can be very high for software engineers) and research and development, there are few other costs associated with running a successful software business.

Software and services operating profit margins
Company Operating margins %
Microsoft 42%
Oracle 39%
Adobe 37%
Alphabet 31%
Intuit 26%
SAP 19%
IBM 10%
ServiceNow 4%
Salesforce.com 4%


Source: Koyfin 2022. FY2021 reported EBIT margins.


Software companies also generally require limited capital investment to sustain growth. This means they usually earn a high return on capital. 

The combination of a predictable recurring revenue stream, fat profit margins and high return on capital is an attractive recipe for investors. 

It is perhaps unsurprising, then, that some of the best investments over the last 10 years have come from the software and services sector.


Software valuations

Due to the many attractive features of software businesses, their shares can command rich valuations, especially for companies experiencing rapid growth.

It’s not unusual to see multiples like price to earnings (P/E) or price to cash flow (P/CF) in the 30s or even 40s. Multiples like the P/E represent the price of one share (P) divided by the earnings per share (E) that the holder of the share is entitled to.

High valuation multiples are usually the result of either a rapid rate of forecast sales growth or a high degree of predictability. With software, investors can often achieve both.


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Technology hardware & equipment

Hardware companies manufacture the physical infrastructure that software needs to run. 

Outside of Apple, which is technically a hardware company and arguably the greatest success story of the last 20 years, the importance of hardware has diminished over the years as software advances.

The sector is a diversified mix of companies ranging from handset manufacturers like Apple to communications equipment companies such as Cisco and server/PC makers like Dell or Hewlett Packard Enterprises. 


Hardware business model 

Unlike the software industry, hardware companies generally do not benefit from recurring subscription revenue streams. Instead, they rely on constant innovation and new iterations of products. 

Successful hardware companies able to stay ahead of the competition through continuous innovation can win customer loyalty and a large market share. Although technically they don’t receive recurring revenues, loyal customers will purchase their latest product release and form a pattern of repeat purchasing that feels subscription-like.

However, the industry is fiercely competitive and innovation happens at a rapid pace. Products can become obsolete and today’s winners can be tomorrow's losers. 

It might seem inconceivable that Apple could crumble, but readers with more investing tenure will remember Nokia. The Finish company enjoyed an Apple-like market share in the early 2000s until Apple and Samsung out-innovated them in the smartphone arena.

This fate can befall software companies too, but because software tends to become embedded in our work practices more than hardware, it is more difficult to rip out and replace. A phone is a phone or a server is a server at the end of the day.

Hardware companies are also usually less profitable than their software peers. 

On top of the cost of raw materials like semiconductors to make the physical products, hardware sales require a distribution network. And whether done internally or via a third-party network, distribution costs eat up a slice of the profit pie. 


Hardware valuations

For all the reasons outlined, hardware companies tend to trade on lower valuations than software businesses. 

There are no hard and fast rules though. Growth is an important determinant of valuation and a rapidly growing hardware business could command a higher valuation than a mature software business, for example.


Semiconductors & semiconductor equipment

Semiconductors are embedded in the circuitry of almost anything electrical. While the production of semis is at the leading edge of technology, the products themselves are commoditised.

In 1965 Gordon Moore said that the number of transistors (semiconductors) that fit on an integrated circuit board (ICB) will double every year. And the industry’s evolution has followed Moore’s law. 

Because the scientists that design semis have yet to break the laws of physics, Moore’s law means semis become smaller and smaller over time.

The leading producers in the world are currently operating at a production size of seven nanometers. One nanometer is one-billionth of a metre. The industry jargon for that is ‘really tiny’.

Cramming ever-more semis onto ICBs has allowed an exponential increase in computing power. But the production process itself has become increasingly complex, elevating the importance of the role semiconductor manufacturing equipment (SME) companies play.

SMEs manufacture the machines used in the production of semis and are exposed to all of the same industry dynamics that semi companies are.


Semiconductor industry business model 

The semiconductor industry is famed for its cyclicality. A cyclical industry is one that suffers from swings in demand and supply that are often difficult to predict. It is the unpredictable nature of the swings that are more challenging than the swings themselves.

Consider a new iPhone launch.

Apple management will forecast how many phones they think they’ll sell and instruct their contract manufacturer, Foxconn, to make a certain amount, usually with an added buffer in case the phone sells better than their forecast. 

Foxconn will place orders for parts (including semiconductors), building in another buffer to ensure that they’re not scrambling for parts if demand is strong. They want to make sure they can meet Apple’s order.

At the end of the supply chain, semiconductor companies end up with orders that could be meaningfully different to actual end demand. The problem is they have very limited visibility (their customers don’t tell them they are deliberately over-ordering) and the end demand for phones is difficult to predict. 

Imagine we all get a bit sick of iPhones or hang onto our current models for longer instead of buying the new one. This could cause a sales shortfall for Apple that would cascade all the way down the supply chain. Apple would need to cancel orders from Foxconn. Foxconn would have a mountain of semiconductor inventory to work through, and orders for new semis would dry up. 

The cyclicality works like a lever, with small changes in end demand for iPhones amplified down the supply chain, leaving semiconductor and equipment manufacturing companies experiencing the worst of the cycle.  

There are differences in the level of cyclicality depending on the type of semiconductor, the end market exposure (smartphones/industrial products to name a few) and the level of secular growth in end demand. But for most semiconductor companies, supply cycles are unavoidable.

Profit margins for semi companies are more volatile than revenue. The main reason is that semiconductor companies, like all companies, have some costs that are fixed, and can’t be scaled up or down in line with revenue. See the chart below which shows operating profit for Micron, a leading producer of memory semiconductors.


Micron Technology Operating Profit 2003-2022 $m


Source: Koyfin 2022.


The good news though, as the chart of growing profits for Micron suggests, is that the industry as a whole should continue to enjoy some level of secular long-term growth. The rate of growth will differ depending on end demand, but it is widely accepted that the world is becoming more dependent on technology. 

It is highly likely that products in the future will be fitted with more semiconductors rather than fewer, and for investors willing to look through the cycles, the industry could still be attractive.

Long-term demand drivers include themes like artificial intelligence (AI), the metaverse, the internet of things, electric vehicles and even climate change. For investors wanting exposure, the semiconductor industry, as suppliers to all companies exposed to those themes, might be a good option.


Semiconductor valuations

Semiconductors, like all cyclical stocks, are difficult to value. If investors are prepared to buy and hold, cyclicality is less of a concern. But it’s important to know that professional investors sometimes try to time the cycles. 

Timing is very challenging and not recommended for anyone that isn’t specialised but the idea is to buy the stocks at or near the bottom of an earnings cycle like the one we described above. 

From a valuation perspective, this can mean share prices are often considered attractive when their multiples are high, which is the exact opposite of convention.

Using a price to earnings (P/E) multiple to demonstrate, investors are trying to buy shares when profits are depressed hoping they are about to improve. This could drive the price higher, leading to an elevated P/E. However, this might be the best time to buy the shares if a healthy profit cycle ensues.

The exact opposite is true near the peak of an earnings cycle. If profits are riding high, the elevated E would compress the P/E and lead to attractive looking multiples. But this might be the wrong time to buy if the company is about to enter a down cycle and the E is poised to decline or simply not climb.  


How have tech stocks performed?


Long-term performance of tech stocks

Over the last 10 years the performance of tech stocks, represented in the chart below by the Technology Select Sector SPDR Trust ETF (the blue line), has been strong. We have included the S&P 500 for comparison, as well as the two largest tech stocks (Apple and Microsoft) on the same chart as their huge returns have contributed a lot to the overall sector’s performance.

The sector had been doing well for most of the last decade, but the pandemic further boosted the share prices of a number of technology companies.


Long-term performance of the technology sector, S&P 500, Apple and Microsoft


Source: Koyfin 2022.


Technology tends to advance in waves. In the 1990s and early 2000s, the internet tsunami hit, clearing the path for the aftershock waves to follow. Those being the smartphone, which came in the mid-to-late 2000s, and cloud computing, towards the end of the 2000s.

AI and the metaverse will be next and while their impact is yet to be determined, it is likely to be meaningful.  

The tech companies that performed the best over the long term invested early, positioning themselves to catch the incoming technology waves. 

So going forward, it might be worth keeping a close eye on the companies that are investing heavily in AI and the metaverse if you believe those will be vital trends in the future.


Past performance is not a reliable indicator of future returns

Discrete calendar year performance
Investment 2017-18 2018-19 2019-20 2020-21 2021-22
Technology select sector SPDR ETF -4.6% 31.2% 18.3% 28.7% -8%
S&P 500 -6.2% 28.8% 16.4% 26.9% -8.1%
Apple -5.4% 89% 82.3% 34.7% -5.7%
Microsoft 20.8% 57.6% 42.5% 52.5% -14.2%


Source: Koyfin, as at 18 Feb 2022. Basis: bid-bid in local currency terms with income reinvested


Short-term performance of tech stocks

Despite the impressive long-term performance of the overall sector, technology stocks have sailed into choppier waters in recent weeks.

The Nasdaq 100, a technology-heavy US equity index, is down nearly 15% this year and some of the initial pandemic winners like Twilio, Docusign, Zoom and Shopify have fallen sharply, reversing a lot of their pandemic gains.

So what’s going on?

A couple of things are behind the sell-off of the once high flying pandemic winners. 

First is valuation. 

Investors got too caught up in the post-pandemic new paradigm narrative. Some companies saw their sales growth explode almost overnight and the market assumed that new level of growth would continue indefinitely. 

This led to sky-high valuations somewhat disconnected from reality. In hindsight, which of course is always 20-20, a pullback was inevitable.

However, just like we can say now that it was obvious not all tech stocks could sustain the rates of growth they experienced immediately after the pandemic, the current indiscriminate selling might now present some very good opportunities.

It’s difficult to know exactly which stocks will ultimately emerge as the long-term winners from this round of selling, and perhaps there is more downside to come.

One useful exercise for investors is to consider stocks with valuations that round-tripped the pandemic. Meaning that their multiples, like the ones we discussed earlier such as P/E or P/CF, are now lower than pre-pandemic levels. 

For some of the larger cap tech stocks like Microsoft, Alphabet and Meta this is now the case and if their futures are to be brighter than their pasts, perhaps thanks to pandemic led themes, then their stocks could be at attractive levels.

The other explanation for recent tech stock weakness has to do with inflation and interest rates.

Past performance is not a reliable indicator of future returns

Discrete calendar year performance
Investment 2017-18 2018-19 2019-20 2020-21 2021-22
Nasdaq 100 Index -1.0% 37.9% 47.7% 26.6% -14.2%
Twilio 278.4% 10.0% 244.4% -22.2% -39.9%
Docusign N/A 85.0% 200.0% -31.5% -27.6%
Zoom N/A N/A 385.7% -45.5% -31.0%
Shopify 20.8% 187.2% 184.7% 21.7% -52.3%


Source: Koyfin, as at 18 Feb 2022. Basis: bid-bid in local currency terms with income reinvested


Technology stocks and inflation

Inflation is currently running hot across the world and the primary tool used by central banks to combat inflation is interest rates. The reason this is seen as bad for tech stocks is mostly theoretical in nature and is related to a valuation method known as intrinsic value.

In theory, the price of any stock is the present value of all future profits or cash flow that will ever be produced by the company. If we knew all future profits and converted them into a value today we would have a fair price known as intrinsic value.

Converting future profits into a value today is done by a calculation called discounting. To discount any value in the future back to today we divide by a discount rate.  

A large component of that discount rate is the prevailing interest rate. So as interest rates go higher, the amount that we need to divide future values by increases. Dividing anything by a higher value produces a lower result.

So as rates go up when we discount (divide) future profits by a higher number the present value of the company and its share price declines. 

This is the theory behind what is currently happening in the technology sector.

Tech stocks, because they are considered growth stocks, have more of their profits coming from the future. That makes sense because growth companies are generally in spending mode to grow sales at the expense (sometimes) of profit, which they hope will come down the line.

When doing a discounting calculation to value a company and its stock price, the further in the future the number you are discounting, the lower that number is today. So for a growth stock like technology, when interest rates go up it's a double whammy because we have to discount future profits by a higher rate and that future is further out than for non-growth stocks.

But, and this is key, this is all theory. A higher discount rate might lower a stock’s valuation on a spreadsheet but it has nothing to do with the actual profits that a company will produce, and in any area of investing, the best stocks are those that produce the highest level of future profits relative to what is currently priced in. 

In fact, the only direct relationship between interest rates and potential profits is related to the rate that a company might have to pay to borrow. Higher rates might be bad news for companies that rely on debt, but technology stocks, which are cash generative, generally don’t.

So any inflation-led sell-off in growth stocks could present a good opportunity for long term investors. 

What are the most popular tech stocks?

Most popular US tech stocks

Now that we’ve got a sense of some of the biggest subsectors and themes in the industry, let’s take a look at the five largest US technology companies.


1. Apple: market cap. $2.7tn

Apple manufactures smartphones, laptops, PCs, tablets and wearables. The company also has an attractive and growing services business including the app store, cloud storage plans and Apple music.

Apple has been an incredible success story over the last 20 years and has continued to grow at rates that seem gravity-defying given the size of the company.

While the iPhone is the company’s marquee product, commanding a large market share, its share of the PC and laptop market is still surprisingly small at less than 10%. 

Add to this the company’s attractive services business which is growing rapidly, and the future for Apple still looks bright. 

It may not be able to repeat the last 20 years, however, and its stock price valuation has expanded over the last 10 years in line with its success. 


2. Microsoft: market cap. $2.2tn

Microsoft has undergone a transformation over the last 10 years which saw the once assumed slow-growth tech dinosaur emerge as one of the fastest-growing large-cap tech companies in the world. Its successful transition to the cloud is largely responsible for the company’s renaissance around the middle of the 2010s.

Today, Microsoft sells its suite of software solutions almost exclusively in the cloud via subscription. It offers a range of tools to support these software solutions and also boasts a leading cloud hosting service called Azure. Azure has been an enormous success and is responsible for a large part of the company’s growth over the last few years. 

As an undisputed leader in cloud solutions, Microsoft should continue to benefit from this solid theme.


3. Alphabet: market cap. $1.7tn

Alphabet, the parent of Google, is still a search business at its core. Search (increasingly dominating on mobile vs desktop) is still enjoying impressive growth despite the company commanding a monopoly-like market share. YouTube also enjoyed rapid growth as streaming of short-form video has become increasingly popular.

Alphabet operates the third largest public cloud business behind Amazon and Microsoft and is believed to be at the vanguard of artificial intelligence technologies.

Breaking down Alphabet into its key business segments unveils the attractiveness of the company.


4. Amazon: market cap. $1.5tn

Amazon evolved from an online first-party seller of a wide range of goods to the largest third-party marketplace in the world. 

Third-party sales, where Amazon takes a small percentage of the price, is an attractive business for Amazon because it’s highly profitable and has few costs attached. For a fee, Amazon will also manage the fulfilment of orders for third-party sellers.

Amazon blazed the cloud trail when it recognised the huge server farms it constructed to service its own business had terabytes of spare capacity, and that capacity could be rented out to others. Amazon Web Services  was born and has been responsible for much of Amazon’s growth over the last 10 years or so.


5. Tesla: market cap. $849bn

Tesla is primarily a maker of electric vehicles (EVs) but its lofty stock price valuation suggests that it might be much more than only a car manufacturer in the future. The company has aspirations to become a closed-loop solar power company, meaning our house could be covered in head-to-toe Tesla, powered entirely by the sun. 

The company’s enigmatic leader has other sci-fi-like ambitions, but for now, its near-term future will mostly depend on the continued rapid adoption of EVs.


Most popular European tech stocks

1. ASML: market cap. €220.6bn

ASML is a leading provider of technologically-advanced machines used in the production of semiconductors. ASML specialises in lithography, a critical part of the semi production process.

The semiconductor manufacturing equipment (SME) space is reasonably consolidated with a handful of leading producers, of which ASML is one. 

As the presence of semiconductors in products of all types from electric cars to fridges has increased over the years, the fortunes of the SME industry has prospered and ASML’s share price has performed well.

SME stocks can be held hostage to the cycles that we’v discussed, but ASML is an example of where a long-term view can pay off. 

The future looks bright for leading players such as ASML, but investors need to weigh up near-term challenges (such as valuation and elevated cyclical risk) against longer-term prospects.  


2. SAP: market cap €123.5bn

SAP falls into the category of legacy technology companies slow to adapt to technology changes, in their case the shift to the cloud.

Its core product is enterprise resource planning (ERP) software. ERP systems are far-reaching inside an organisation and help a business plan and operate across almost all functions. 

Because ERP software tentacles go deep into organisations, installation can be challenging, and for companies that opt to run SAP across their entire business, it can take years to complete.

It is perhaps understandable, then, that SAP couldn’t face telling its customers to rip out on-premise software that took years to implement and replace it with a cloud operated me-too version.

Unfortunately, though, this led to SAP losing share and its stock has lagged the broader software sector.

SAP has now fully embraced cloud and offers all its ERP systems either on-premise, off-premise or as a hybrid. The company has some work to gain back all that lost ground but its stock is relatively less expensive as a result. 

3. Infineon technologies: market cap €36.8bn

Infineon is a diversified semiconductor company. Its largest segment is automotive, where it sells products that should benefit from some key themes in the auto industry: electrification, enhanced safety, and rich infotainment. 

The shares have lagged behind the industry and its American peers, however, due to a perceived lack of growth in its end markets, and the company’s lack of scale.


4. Adyen: market cap €49.0bn

Adyen is a relatively new company operating in the increasingly competitive payments industry. Adyen offers end-to-end solutions for electronic payments including terminals, online gateways, data and financial management, all in a single solution. 

The company counts some leading brands as its customers, including McDonald's, Uber, eBay and Spotify.


5. Capgemini: market cap €30.4bn

Capgemini is a technology consulting business, servicing clients that require third-party expertise to help with their technology spending plans. 

Its share price had become stale, but the pandemic has given it a boost as companies across the globe are rethinking their technology strategies.


Why invest in tech stocks?

The technology sector houses a number of profitable and growing companies. From a business model perspective, technology companies tick a lot of boxes and for long-term investors, the sector should be a happy hunting ground. 

But as always, there are risks. Here’s a summary of the main advantages and risks of investing in tech stocks.


Advantages of investing in tech stocks

Technology stocks come in different shapes and sizes with different risks and opportunities. The common advantage that exists across the sectors is growth. 

Technological innovation facilitates change, and successful technologies that provide either people or companies with a better or cheaper way of doing things are likely to be widely adopted. The inventors of successful technologies will inevitably experience rapid growth. 

Technology stocks also give investors the chance to participate in a future that is tough to forecast. Good tech companies are ahead of the curve, recognise emerging themes and invest heavily in order to capitalise. 

Early investors in Amazon, for example, saw the benefits and convenience of e-commerce for things like books and DVDs. It’s unlikely they foresaw Amazon as the world’s largest provider of cloud computing solutions, the world's largest third-party marketplace and with a huge advertising business to boot. It is these themes that have been responsible for Amazon’s success over the last five years. 

From this perspective, investors in technology companies can ideally get exposure to management teams and cultures that embrace change. This exists elsewhere, but it is probably most prevalent in technology. 


Risks of investing in tech stocks

The strengths of good technology companies are also the weaknesses of bad ones. The rapidly changing nature of the sector means today's successful businesses can quickly become tomorrow's failures. Tech companies that aren't nimble enough to adapt to change will probably be left behind. 

This is particularly challenging for investors with a long-term approach as they need to be able to recognise when a company is failing. Pick the right tech stocks and the returns can be exceptional, pick the wrong ones, and the results will be uninspiring. See IBM.

IBM Share price 2002 - 2022


Past performance is not a reliable indicator of future returns


Source: Koyfin 2022.


Past performance is not a reliable in dictator of future returns

Discrete calendar year performance
Investment 2017-18 2018-19 2019-20 2020-21 2021-22
IBM -22.6% 23.6% -1.2% 16.8% -5.8%


Source: Koyfin, as at 18 Feb 2022. Basis: bid-bid in local currency terms with income reinvested

Perhaps the biggest risk with tech stocks, though, is valuation. There are two aspects to investing. Identifying a sustainably successful company, and assessing the degree to which the stock price is already baking in this success. 

This can be especially challenging for investors attracted by seemingly cheap valuations. In technology, the most successful companies continuously deliver financial performance much better than expectations. Our Amazon example above is perhaps the best of the last 20 years.

Amazon’s share price might have appeared expensive throughout its history, but the market has continuously underestimated the company’s success. Its high valuation put many investors off, but ultimately its share price has proven to be good value for much of the last 20 years.

The exact opposite is also true. Apparently cheap technology stocks have floundered and stayed cheap for a long time, delivering unimpressive returns for shareholders, like IBM above.

Technology investing can be exciting. Some of the best future returns could come from the sector, but there will be a lot of failures too. We advise investors to keep an open mind and continuously revisit their investment thesis. 

Technology can change rapidly. But investors who pick the right companies that know how to adapt, and then hold on for a long time, will probably enjoy above-average returns. 


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Important information

This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice.

When you invest, your capital is at risk. The value of your portfolio, and any income you get from them, can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.

Freetrade is a trading name of Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).



Important information

This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice.

When you invest, your capital is at risk. The value of your portfolio, and any income you receive, can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.

Eligibility to invest into an ISA and the value of tax savings both depend on personal circumstances and all tax rules may change.

Freetrade is a trading name of Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).

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Simple pricing plans

£0.00/mo

Accounts

GIA pink
General investment account

Benefits

  • Commission-free trades (other charges may apply. See full pricing table.)
  • Fractional US Shares
  • Access to more than 1,500 stocks, including the most popular shares and ETFs
£4.99/mo

Accounts

GIA white
General investment account
ISA
Stocks and shares ISA

Benefits
Everything in Basic, plus:

  • Full range of over 6,000 US, UK and EU stocks and ETFs
  • Automated order types
  • Advanced stock fundamentals
  • 1% on uninvested cash, up to a maximum of £2,000
NEW
£9.99/mo

Accounts

GIA white
General investment account
ISA
Stocks and shares ISA
SIPP white
Self-invested personal pension (SIPP)

Benefits
Everything in Standard, plus:

  • 3% on uninvested cash, up to a maximum of £4,000
  • Priority customer service
  • Freetrade Web beta

Download the app to start investing now



When you invest your capital is at risk.