How to Invest in Tech Stocks -- a Beginner's Guide

The dot-com bubble of 2000 might have been the worst thing that happened to an entire generation of investors. The carnage was twofold: First, those investing in the NASDAQ Composite Index -- a technology-focused listing -- lost 75% between early 2000 and late 2002. Then, scarred by those losses, many stayed away from technology stocks. That's too bad, because between September 2002 and April 2019, the index has almost octupled. In other words, a $10,000 investment made in 2002 is worth nearly $80,000 today.

Technology stocks can be scary, especially for those who feel they don't understand how the latest gizmos actually work. Below, I'll try and simplify the sector, help you feel more comfortable investing in it, and offer up three ideal technology stocks for beginning investors to start with:

1. Microsoft (MSFT -1.92%): the company behind Microsoft Office 365 (read: Outlook email, Word, Excel, and PowerPoint) and Azure cloud services
2. Alphabet (GOOG -1.07%) (GOOGL -0.92%): better known by the name of one of its subsidiaries: Google.
3. Verizon (VZ -0.88%): the market leader in wireless subscriptions, Internet connectivity, and 5G networks in the United States

Image source: Getty Images.

What is the technology industry?

Technology stocks represent companies that research, develop, or manufacture products and/or services that make use of technology. With each passing year, every business -- regardless of what it does -- has become more reliant on technology. In 2019, for instance, McDonald's announced that it was acquiring an artificial intelligence (AI) company to help improve the drive-thru experience at stores.

Does that make McDonald's a tech company? Not quite. It's important to look at the final product or service a company offers. Despite the amount of technology behind delivering them, Big Macs are still burgers -- not technology!

To get a better idea for the different types of technology companies -- and stocks -- in the world, we can look at broad subcategories.

1. Software providers: These companies write code that helps to run programs. Again, Microsoft is the biggest software provider in the industry.
2. Hardware providers: Instead of code, these companies produce physical pieces of technology that you can hold in your hands. Cisco, for example, makes modems, switches, and routers that help data flow through the Internet.
3. Semiconductors: Technically also hardware providers, these companies make the computer chips that make machines work. Intel is the largest semiconductor player today.
4. Internet information providers: These are the websites you'll visit to find information. They include many familiar names such as Google and Facebook. They largely rely on advertising for sales.
5. Telecommunications: Finally, we have the companies that help connect everyone -- either by providing direct internet connectivity or via wireless mobile plans on smartphones. Verizon and AT&T are the leaders here.

What's driving the technology industry?

The technology industry is driven by...you guessed it...technological innovation. That might seem obvious, but its worth noting that the pace of technological innovation is only accelerating as time goes on.

It's obvious that things are changing -- but less obvious that things are changing at a faster pace. Let's imagine a Rip Van Winkle-type scenario to illustrate. Someone who fell asleep in 1300 could have woken up 200 years later and -- more or less -- felt at home in the environment they woke up in.

Now imagine someone in 1900 falling asleep and waking up in 1950. The world would simultaneously seem like a wonderland (flying across the country in a matter of hours?) and a horror show (the atomic bomb can do what?).

Here's the mind bender. Someone who fell asleep as recently as 1994 could wake up today and have difficulty adjusting to the immediate surroundings. Just look at how Today Show co-host Bryant Gumbel reacted to an Internet address back then.

So what drives the technology sector? In the end, it's the intersection of problems that need to be solved, and technology workers -- coders, tinkerers, builders, and entrepreneurs -- that are working to solve those problems for a profit. It really is as simple as that.

What's driving change in each part of the tech industry?

1. Software providers: By far the biggest thing happening here is the massive transition to software as a service (SaaS). Here, companies sell subscriptions to software that's hosted on the cloud. This makes up-front costs lower for customers and lifetime value higher for the providers.
2. Hardware providers: In essence, companies need to have the best mix of product performance and cost. Sometimes there are high switching costs that lock customers in, like servers relying on Cisco switches, but these advantages can erode over time.
3. Semiconductors: Like hardware providers, companies that make computer chips are constantly called upon to come up with the best possible chip for the lowest possible price. This can lead rapidly to commoditization, which is great for customers and not-so-great for companies.
4. Information providers: The companies here started out focusing on one thing but have rapidly expanded their products. For instance, Google initially focused on search but now has eight different products with more than 1 billion active users. The key factor: Information providers have access to unprecedented amounts of data. That data is primarily sold in the form of advertisement placement, but other uses could develop over time.
5. Telecommunications: Like semiconductor and hardware providers, there's a delicate balance between value provided and cost. However, because of enormous up-front infrastructure costs, the barriers to entry have narrowed this field to a few key providers. The biggest new driver of growth is coming from 5G technology.

What risks are involved with tech stocks?

As with any investment, there are plenty of risks to be aware of. While we can't build out an exhaustive list of every possible risk, there are a few big ones to take note of.

Unpredictability and disruption

Technology can be completely unpredictable. Sure, it's great that you invested in a company that makes Widget X, which is far better than all the other Widgets that were available before it. But unbeknownst to you, a little known company in California is developing Widget Y, which will far outshine Widget X when it comes to market. When that happens, your investment gains will quickly disappear.

That's the biggest overarching risk with technology stocks. While disruptive technologies can make your investments skyrocket, the disruptor can quickly become the disruptee -- and it's very difficult to know if/when that may happen. This risk is particularly salient for hardware and semiconductor companies.

When high switching costs disappear

In the software realm, the biggest risk to be aware of has to do with switching costs. Generally, if a big enterprise customer is relying on a single software provider for all of its e-commerce needs (say, a company like Shopify), it is loath to switch. That's because doing so is time consuming and costly and runs the risk of losing key data.

But if a company were to come along that offered to pay for switching costs, guaranteed little to no downtime, and was so intuitive it wouldn't require massive employee training, those switching costs could slowly erode.

In a way, this is what happened in the telecom industry. AT&T and Verizon historically invoked high cancellation fees to lock their customers in via high switching costs. But then T-Mobile came along and offered to pay those fees, thus eliminating a key advantage almost overnight.

Valuation

Finally, it's worth noting that different areas of the technology sector can get very expensive. Right now, for instance, SaaS-based stocks are very expensive -- based on traditional metrics. And that's because they are reinvesting so much of their sales to grab long-term market share. If they capture that share and can defend it, things will turn out well for investors. But if they can't, their stocks could fall precipitously.

What metrics should I look for?

This underscores the importance of investigating the sustainable competitive advantages -- or moats -- of the tech stocks you invest in. Generally speaking, moats come in four different forms:

1. High switching costs: Once customers start using a product or service, it is difficult to switch to a competing provider. Think of how telecom companies used to lock subscribers into two-year contracts with high cancellation fees as an example.
2. Network effects: This happens when each additional user of a service makes the service more valuable. Nowhere is this more evident than with social media sites. What's the point of joining a social media platform if other people aren't joining, too?
3. Low-cost production: If a company can produce something of equal value for less money, it will continually win over customers. Today, this means not only physical goods but also virtual ones -- like data.
4. Intangible assets: This includes things like brand value, patents, and regulatory protection.

There's no standard metric that can measure the value of a company's moat. It's more of a holistic approach that uses both data and logic to arrive at a conclusion that makes sense to you.

It's also important to evaluate how the company would fare if a recession arose in the near future. The best way to do this is by evaluating:

• Cash on hand: This includes cash, short-term investments, and long-term investments.
• Long-term debt: Money that will be paid out over the coming years.
• Free cash flow: All of the cash provided by operations, minus capital expenditures.

Generally speaking, companies that have lots of cash on hand, little debt, and strong cash flows can not only survive a downturn but get stronger as a result. That's because they take advantage of lower prices. They can buy back their own shares at lower prices, acquire start-ups at a discount, or simply offer their goods for less than the competition.

That last technique might sound odd, but think about it: If I can afford to offer something at a loss -- because I have a big cash balance in the bank -- the competition won't be able to beat it. They'll eventually go out of business, and I'll grab market share. Later on, I can raise prices again, knowing there's less competition out there to deal with.

An important caveat to this has to do with telecom stocks. Because their infrastructure costs are so high, these companies almost always have much more debt than cash. In general, that's OK, because free cash flows are usually very strong. If they aren't, however, that's a red flag for investors.

What are the best tech stocks to invest in?

As you'll see, while all three of the technology companies listed below are exposed to the tornado of disruption that comes with the industry, they also have moats that make them worthy investments.

Microsoft

Microsoft started out with the raging success of the Windows operating system back in the 1990s. Since then, however, it has become a three-pronged behemoth that is a major force in the tech industry. Of the different niches within the tech industry, Microsoft is primarily a software provider -- though it still has operations in hardware as well.

Here's what those three lines of business look like:

• Productivity: Office 365 -- which includes Outlook, Word, Excel, and other tools -- is the primary driver of revenue in this division. It is augmented by LinkedIn revenue as well.
• Personal computing: The hardware division get sales primarily from Xbox systems and the Surface tablet, as well as from software solutions like Windows 10 and the company's search engine, Bing.com.
• The intelligent cloud: Like other huge tech players, Microsoft offers cloud solutions via its Azure division.

Revenue from the three segments broke down as follows during 2018.

Data source: SEC filings.

Generally speaking, Microsoft's intelligent cloud and productivity revenue is more important. These divisions typically have wider moats thanks to high switching costs. Once a company starts using Office 365 for business processes or Azure for cloud hosting, the financial and emotional costs of switching away and retraining entire staffs on a new system become onerous.

On top of that, both divisions also benefit from the network effect. LinkedIn's key advantage is that it already has hundreds of thousands of employees and employers signed onto the network. And Azure's artificial intelligence (AI) ambitions are fueled by data. The more companies using Azure, the more data the AI gets, and the better the service is for existing users.

The personal computing division, on the other hand, is more vulnerable to competition. There is a slew of video game console and tablet providers. Brand value is key, but it isn't that strong. When consumers need to upgrade these tools, they'll generally pick the best value for their money -- regardless of who makes it.

Perhaps it's heartening, then, to see the cloud and productivity divisions consistently chipping in the lion's share of operating income (though the personal computing division has fared well lately too).

Data source: SEC filings.

The real key to following Microsoft's progress will be the continued expansion of operating profit in the cloud and productivity divisions. As long as these are growing, we will know that three things are happening, likely in tandem: Microsoft is winning over more clients, those clients are sticking with the company, and Microsoft can maintain or increase pricing because it has a defensible moat.

Alphabet

As I said above, Alphabet is much better known by the name of its primary subsidiary: Google. The company doesn't really qualify as a software or hardware provider. Instead, it is an Internet information provider. That makes sense, because the company's mission statement from the start has been:

To organize the world's information and make it universally accessible and useful.

To that end, Google has created eight different products that today have more than 1 billion active users:

• Search: The company's bread and butter -- this is where you "Google" something on the company's homepage to answer a question you have.
• Gmail: The company's email solution.
• Maps: Google's maps have become the go-to source for navigation.
• YouTube: The video-sharing site is the second-most popular in the world...behind only Google.com!
• Chrome: An Internet browser.
• Android: An operating system for mobile devices.
• Google Play Store: A location for buying apps.
• Google Drive: A cloud solution that allows you to store and share documents.

With the exception of the Google Play Store, almost all of these offerings are free. That might lead you to wonder: "How does Google make money?"

Google collects more data from these free services than any other organization in the history of the world. Its services are ubiquitous. People are using them all the time. Google then turns around and sells advertising spots to companies, guaranteeing that the right ad will appear in front of the right eyes at the right time.

That's why Alphabet's real moat lies in low-cost production. Once each service or app is set up and running, it costs Alphabet comparatively little to maintain the likes of YouTube, Chrome, or Android. But the data it collects from its billions of users flows in at a rate that can't be beat.

The two key metrics to watch are cost per click (CPC) and paid clicks. The former represents the amount of money advertisers pay when someone clicks on their display. The latter is the total number of times Internet users click on a display ad featured by Google.

Over time, CPC has fallen -- especially with the transition to mobile, where getting a user to click is more difficult. This has been more than offset, however, by the rise in paid clicks.

Data source: SEC filings. Note that trends represent those at Google-owned properties and not Google Network sites.

While any investor would love to see cost per click rise (blue line), the transition to digital advertising has been massive, with total paid clicks (red line) not only outpacing CPC losses but accelerating over time. When those two forces are combined (yellow line), it's clear that Alphabet has impressive growth for a company already valued at more than $800 billion.

One additional item of note is Alphabet's commitment to moonshot projects -- or technologies that promise to provide enormous and immediate benefits to mankind. These projects include efforts at autonomous driving (Waymo), cybersecurity (Chronicle), remote-area Internet access (Loon), and several others. Even if most of these projects fail, the success of just one could make a huge difference not only for the public but for Alphabet's bottom line as well.

Combine these forces and it's easy to see why Alphabet is such a solid choice for beginning tech investors.

Verizon

Finally, we have the country's largest wireless subscription provider: Verizon. As you might suspect, this company qualifies as the only telecommunications specialist in our group of three.

Generally speaking, it is prohibitively expensive for telecom players to sprout up over night. As far as disruption goes, Verizon is actually more protected than most tech stocks. In fact, if we look at the market share for wireless subscriptions since 2011, the number of competitors has actually shrunk.

Data source: Statista. Percentages rounded to nearest whole number. Results come from Q4 of each year except for 2018, which is from Q3.

There are two things of note here. First, wireless carriers used to be protected by high switching costs. That moat, however, started to fade fast when T-Mobile came out with its unbundling strategy, which didn't require a long-term contract and offered to pay cancellation fees for those switching to its service.

That move accounts in large part for T-Mobile's gains over the past decade. But notice that almost none came at the expense of Verizon -- or AT&T. Despite the mobile landscape changing monumentally since 2011, Verizon has been able to maintain its supremacy in the industry. These wireless plans constitute roughly 70% of the company's sales

Not to be overlooked, Verizon also offers Internet connectivity via its FiOS service, referred to as Wireline in company reports.

Technically speaking, the moat is somewhat narrower around the company since switching costs have fallen. But because the infrastructure costs associated with building up such a service are so onerous, investors need only keep their eye on market share to know where the business is going. And the future already looks promising, as Verizon will be the first to offer the next generation of connectivity to American citizens: 5G technology.

One final consideration with Verizon is the fact that the company offers a substantial dividend. This payout typically hovers over a 4% yield. In 2018, Verizon brought in $17.7 billion in free cash flow. It only needed to use 55% of that amount to pay its dividend. That means the high payout both is relatively safe and has room to grow.

While not as exciting as other potential tech stocks, Verizon offers both stability and large dividend payouts to beginning investors.

A final word on investing in tech stocks

By no means do you have to stop with these three stocks. There are plenty of opportunities in the technology sector. As exciting as those opportunities can be, however, make sure to carefully consider what moats are protecting the company.

By doing that, you not only protect your hard-earned cash but also make sure you're investing in companies that will still be around decades from now, when you start pulling that money out in your golden years.