Investing in Tech Stocks

The technology sector is vast, comprising gadget makers, software developers, wireless providers, streaming services, semiconductor companies, and cloud computing providers, to name just a few. Any company that sells a product or service heavily infused with technology likely belongs to the tech sector.

Software companies are increasingly moving to a software-as-a-service model where customers buy a subscription to a program instead of a one-time license. This generates recurring revenue for the software company.

Powering all that hardware are semiconductor chips. Semiconductor companies design and/or manufacture central processing units, graphics processing units, memory chips, and a wide variety of other chips that help to run today’s devices.

Telecom companies that provide wireless services are part of the tech sector. So are the video streaming companies that provide easy access to high-quality content, and so are the cloud computing providers that power those streaming services.

The best tech stocks

Many of the most valuable companies in the world are technology companies. These are some of the most dominant and impressive tech stocks that investors should consider in the fourth quarter:

• Amazon.com (NASDAQ:AMZN) is the leading online retailer and the leading provider of cloud computing infrastructure. Founder Jeff Bezos stepped down in July, opening a new chapter for the dominant tech company.
• Microsoft (NASDAQ:MSFT) is a dominant software company known for its Windows PC operating system and Office productivity software. Microsoft is also the second-largest provider of cloud infrastructure behind Amazon.
• Apple (NASDAQ:AAPL) makes the iPhone, the iPad, and Mac computers. Intense customer loyalty ensures plenty of repeat customers, and a growing array of services makes Apple’s ecosystem sticky.
• Intel (NASDAQ:INTC) is one of the largest semiconductor companies in the world. Intel designs and manufactures central processing units (CPUs) for PCs and servers, as well as specialty chips for uses such as artificial intelligence. The company is betting big on manufacturing, with plans to make chips for other companies.
• Cisco Systems (NASDAQ:CSCO) is the dominant provider of the enterprise networking hardware that forms the backbone of the internet.
• Netflix (NASDAQ:NFLX) is the top dog in the video streaming industry, spending billions of dollars each year on content to keep its ever-growing subscriber base hooked.
• Facebook (NASDAQ:FB) is the largest social media company, with more than 2 billion daily active users across Facebook, Instagram, Messenger, and WhatsApp. The company sees virtual reality as its future.
• Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) is the parent company of online search giant Google and the popular Android operating system for smartphones.

Facebook, Amazon, Apple, Netflix, and Alphabet (Google) are sometimes grouped together as the FAANG stocks. These companies dominate their industries, and their stocks have produced impressive returns over the past few years.

The impact of COVID on tech stocks

The pandemic has been mostly positive for the tech industry. Amazon has thrived as consumers shifted hard toward e-commerce, even as rivals such as Walmart (NYSE:WMT) and Target (NYSE:TGT) stepped up their e-commerce game. Amazon expanded total sales by 27% in the second quarter of 2021 to $113.5 billion, an incredible feat for such a large company. Growth is starting to slow, although the delta variant surge may drive consumers away from stores once again.

Microsoft has also done well, buoyed by demand for collaboration software, devices, gaming, and cloud computing services as people spend more time at home. Sales of PCs remained extremely strong at the start of 2021, helping the company on multiple fronts. Microsoft’s revenue jumped 21% in its most recent quarter, and net income soared 47%. The upcoming launch of Windows 11 comes as PC sales remain elevated due to the pandemic.

While it was unclear early in the pandemic how sales of Apple’s pricey gadgets would fare, consumers have been snapping up Apple products. Sales of everything the company makes were up considerably in its latest quarter, with the core iPhone business posting 50% growth. Apple will try to keep the momentum going with its latest batch of iPhones, which are expected to launch sometime in September.

High demand for devices has helped Intel as well. Laptop sales have surged as people work from home, although a global semiconductor shortage and supply chain issues are complicating the situation. Intel is aiming to become a major player in the foundry business by investing heavily in manufacturing. The company has the advantage of being a U.S.-based manufacturer at a time when relations are tense between the U.S. and China.

Intel rival Advanced Micro Devices (NASDAQ:AMD) has also been thriving. AMD’s latest Ryzen 5000 PC chips outclass comparable chips from Intel across nearly every metric, which will almost certainly lead to more market share losses for Intel.

While Cisco suffered during the pandemic as its customers paused spending on upgrades, the company has now recovered. Revenue jumped 8% in Cisco’s latest quarter, and the company’s guidance points to a strong year ahead. Cisco has grown into a major software provider, with $15 billion in software revenue last year. The pandemic-driven growth of WebEx, Cisco’s video conferencing solution, helped the cause.

Netflix saw its user base rapidly grow during the pandemic as people stayed home. Growth in 2021 has been much slower, and the company has started to shed users in its core North American market. Comparisons will be tough for Netflix in the post-pandemic period.

Other streaming services have also been growing fast, including Disney’s (NYSE:DIS) Disney+. Disney+ now has 116 million subscribers, more than twice as many as one year ago. Another major competitor will emerge next year after a mega-deal between HBO-owner AT&T (NYSE:T) and Discovery (NASDAQ:DISC.A) is complete.

Both Facebook and Alphabet depend on advertising sales, so the steep decline in advertising from hard-hit industries such as travel early in the pandemic hurt both of those companies. They’re both doing just fine now -- Facebook reported 56% revenue growth for the second quarter, and Alphabet saw sales jump 62%.

However, antitrust action could be one thing that eventually derails these advertising giants. The U.S. Justice Department, along with 11 state attorneys general, sued Alphabet’s Google in October 2020, accusing the company of anticompetitive behavior related to its search advertising business.

Both the Federal Trade Commission and 46 state attorneys general sued Facebook in December 2020. The suits allege the social media giant used acquisitions to eliminate competitive threats. The FTC is looking to force Facebook to divest Instagram and WhatsApp. The original FTC lawsuit was tossed out by a judge in June, but the FTC refiled in August.

Only time will tell how the long-term trajectories of these major tech companies have been altered by the pandemic and by increasing antitrust scrutiny from the U.S. government.

How to analyze tech stocks

For mature tech companies that produce profits, the price-to-earnings ratio is a useful metric. Divide stock price by per-share earnings and you get a multiple that tells you how highly the market values the company’s current earnings. The higher the multiple, the more value the market is placing on future earnings growth.

Many tech companies aren’t profitable, so the price-to-earnings ratio can’t evaluate them. Revenue growth matters more for these younger companies. If you’re investing in something unproven, you want to make sure it has solid growth prospects.

For unprofitable tech companies, it’s also important that the bottom line be moving from losses toward profits. As a company grows, it should become more efficient, especially when it comes to the sales and marketing spending necessary to close deals. If it’s not, or if spending is growing as a percentage of revenue, that could indicate something is wrong.

Ultimately, a good tech stock is one that trades at a reasonable valuation given its growth prospects. Accurately figuring out those growth prospects is the hard part. If you expect earnings to skyrocket in the coming years, paying a premium for the stock can make sense. But if you’re wrong about those growth prospects, your investment may not work out.

Investing in an exchange-traded fund (ETF) that focuses on tech stocks is one way to avoid making mistakes. The ARK Innovation ETF (NYSEMKT:ARKK) is one option, although the fund’s bets on high-flying tech stocks may ultimately prove riskier than investing in the tech giants listed above.

Investing in tech stocks can be risky, but you can reduce your risk by investing only when you feel confident their growth prospects justify their valuations.https://www.fool.com/investing/how-to-invest/stocks/price-to-earnings-ratio/