How to Pick Growth Stocks in the Tech Sector
August 02, 2019
“What makes a solid tech stock?” may be one of the most important questions an investor can answer. Over the last decade, tech companies started to penetrate the top ten list of global companies by market cap. Today, tech dominates this list with Apple, Microsoft, Google, Facebook and Alibaba.
Not all tech stocks are winners, of course, with IBM and Yahoo flatlining over the past decade and Cisco unable to reclaim its valuation from nearly twenty years ago. This is why it is important to follow guidelines for individual tech stocks regardless of a broader bear or bull market.
Basic Definition of Growth Stocks:
“Growth stocks tend to react faster to market swings, so you need to examine the risk of every investment you make.”
— Nick Giorgi, Investment Strategist in the Chief Investment Office at Bank of America Merrill Lynch
Growth stocks are commonly characterized as stocks with 20% revenue growth for a minimum of three years. Many growth stocks today have much higher revenue growth yet lack profitability. These stocks garner higher valuations and price-to-earnings ratios as the future growth of the company is priced into the stock. This creates more volatility for growth stocks than the broader market, although the risk comes with a greater potential for rewards as growth stocks are expected to double their market capitalization in five years.
Investors in growth stocks are chiefly concerned about the competitive moat, as any business model reporting solid growth will likely be copied by rivals. This is especially a concern if the stock is in the small-cap or mid-cap category as the rivals are likely to be larger than the disruptive company.
Key characteristics of a growth stock include:
- Higher price-to-earnings ratio than the broader market
- High earnings growth record
- More volatile than broader market
- Typically, doesn’t pay dividends to shareholders
In general, the financial industry tends to look for a few common traits:
- Revenue growth of at least 20% over each of the past three years compared to a typical S&P company showing 7% growth.
- An identifiable moat that will protect the business.
- A valuation above the market’s average.
- A reasonable chance to double in market capitalization in five years.
With that said, the basic definition of growth can deter investors from winning tech stocks as the definitions discussed above do not fit within the trajectories that tech companies follow.
3 Challenges to the Traditional Definition of Growth Stocks
The finance industry needs to see proof that products or services are becoming more and more popular every day. Typically, in the finance industry, there is hyper-focus on revenue growth for earnings reports, while net income and free cash flow are given broad leniency when evaluating the technology sector. This is a mistake that causes Wall Street investors to suffer losses.
On the other hand, venture capitalists who specialize in high-risk tech investments believe revenue growth is important but product-market fit is critical. Income is one way to determine product-market fit, however, the best markets for growth potential are often too nascent to show up on the income statement on the first day of listing as a public company. Product-market fit requires further analysis into customer retention and churn to conclude if the revenue growth is sustainable.
1. Tech Growth is Not Linear
Tech growth is typically parabolic and rarely proportional along the x-axis. Hockey-stick growth is the most coveted graph pattern for startups and young tech companies which is not consistent with the 20% year-over-year guidelines. This is due to the evolution phase of early adopters (phase 1), virality (phase 2), to critical mass (phase 3). This is why tech products struggle to gain traction for many years and then suddenly appear to be an overnight success. The typical growth trajectory for tech stocks is more like -15%, 10%, 70% compared to the 20%-25%-30% the public markets want to see. For example, Twitter had negative revenue in 2017 before posting 30% growth in 2018. Nvidia has issued guidance for the second quarter at a decline of -18% year-over-year.
2. Competitors and Growth Trajectory in Constant Flux
“Build fast and break things” is an oft-quoted motto in Silicon Valley. Tech companies iterate at minimum quarterly, and sometimes monthly, to stay competitive. The ecosystem is constantly changing, which causes surprises in the stock market, especially because most financial analysts were trained to analyze changes in financial statements rather than learning how to track continuous R&D.
This goes hand-in-hand with growth companies investing heavily in R&D instead of paying dividends. How often do value stocks iterate, such as Hershey’s, Walgreens or Starbucks? Most value stocks have had the same product lines with little variation for many decades while a tech company can change monthly. A good example was when Facebook announced Audience Network in 2014 at their Developers Conference. This announcement signaled the beginning of third-party programmatic for Facebook, and marks the plot point on the x-axis that precedes the upward parabolic rise.
3. Revenue Too Simplistic for Growth Stocks
Revenue, operating income, net income and free cash flow are very important and should be included in every diligent analysis. Keep in mind, however, that financials don’t tell the story of what is driving the growth. Venture capitalists rely on up to fifty key metrics for each industry vertical to determine if a company will make a good investment. Across all industry verticals, the tech sector has hundreds of key metrics that help determine future growth. Generally speaking, you want to look for accelerating revenue and decelerating losses with a discernable path to profitability. For larger investments, you’ll need to rely on a tech analyst who works with key metrics or plan to spend time doing this research on your own.
Here is a sample of the key metrics venture capitalists use that are not available on the income statement, balance sheet or free cash flow statement.
- Uber Stock Had Disappointing Q1 Earnings: So Why Did the Price Go Up?
- Pinterest Stock: Price-to-Sales Risky
- How Investors Use Artificial Intelligence in the Stock Market
- Facebook Stock: Too Good to Be True
To summarize, you can forget how the finance industry defines a solid growth investment when analyzing technology. Tech companies change frequently and post sudden growth. Financials do not tell the whole story and key metrics help fill in the missing pieces. There are hundreds of key metrics when looking at the tech industry, averaging fifty or so key metrics for each industry vertical. In the following post, I will discuss 7 do’s and don’ts for evaluating tech investments.
Beth’s research services provide an edge in finding opportunities and identifying risk in the leading growth sector. She has analyzed thousands of companies in the private and public markets and has an impeccable track record. Learn more here and access 12-month history of her calls.
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