There’s nothing more fun in investing than technology stocks. Sadly, few sectors are as dangerous. The trouble with techs and biotechs isn’t just that many hot new companies never make money; it’s that even the ones that do often don’t create any value over the long term.
If you’re a computer buff, you may remember 3dfx Interactive, a dominant graphics-card maker in the 1990s. It went bankrupt, however, in 2002. It’s very hard to stay abreast of an industry that’s always changing, but some solid overall rules can help you.
The first rule is simple: If something looks too good to be true, it probably is. One good example: Research In Motion. RIM dominated the early years of the smart-phone market with its BlackBerry, which had some proprietary technology but wasn’t unique enough to keep out competitors.
One number to watch is return on equity (ROE). Companies that make a lot of money on each dollar they invest attract competitors. RIM’s ROE was a lofty 40% for its fiscal year ended last Feb. 28. But unless a competitive advantage is durable, a leader’s product often becomes commoditized, and its profit margins and ROE suffer.
That competitive advantage may not be a patent. It may be better to have a user base for your product or service that has little need to change providers (like Google‘s) or that can’t switch, because of the high cost of changing (like Microsoft‘s). Google and Microsoft may not survive forever, but they have a better shot at it than RIM.
A second rule is to look for profits and what’s done with them. A lot of tech companies can’t pay earnings back to their shareholders as dividends because they have to constantly reinvest so they won’t fall behind their competitors.
Take Open Text Corp.: In its past three fiscal years, the company has made about $130 million (U.S.) in profits, but it hasn’t paid any dividends or bought back stock. In fact, it has sold new shares to finance part of the more than $625 million (U.S.) of investments. The result? Not that impressive: Annual sales are up about $190 million (U.S.). If companies are reinvesting heavily with little to show for it, beware, even if the bottom line looks good.
Research and development is the basis of the third rule: Spend, spend, spend, but spend wisely. Look at total R&D spending as a percentage of revenues. It should stay somewhat constant, and it should produce results. Nortel spent $11 billion on R&D over the six years before it filed for bankruptcy protection last January, yet its revenues fell.
Finally, watch out for compression of share price multiples. Often when a tech company takes off, both its share price and its multiple climb–if its earnings, say, double, its price-earnings ratio may quadruple as growth investors bet on continued profit increases.
Unfortunately, the process can work in reverse. Edmonton’s CV Technologies (now Afexa Life Sciences) burst onto the scene with its Cold-fX remedy in 2003, and profits climbed to $10 million in 2005. Then competitors started making similar ginseng-based products that were inferior, but much cheaper. The company’s profits skidded to $640,000 in 2006, and a loss in 2007. As earnings fell, the price investors were willing to pay for each dollar of earnings also declined, and Afexa’s share price bottomed at 23 cents in December, 2008. That’s the kind of excitement you want to avoid.
Source thompson datastream
15.3 Recent price-earnings ratio (trailing 12 months)
- Aastra Technologies Ltd. Aastra makes olde schoole telephony gear, digital voice-network products, Internet protocol gear and the like for businesses. But there’s nothing tired about its profits. Cash flow from operations should swell to $87 million in 2010 from $77 million last year, says a National Bank Financial analysis. There’s even a chance it will exceed $100 million. The company’s recently announced quarterly dividend of 15 cents a share requires just $8 million in cash flow. Guess they could dial that up quickly.
15.2% Growth in rental revenue, first nine months of fiscal 2009 versus 2008
Calgary-based Mainstreet entered the recession with $8.5 million in cash.
It now has about $25 million. That’s a handsome war chest for an acquisitive residential rental real estate concern, especially when competitors are sucking wind, if they’re getting any air at all. Put that cash to use and, in time, profits will move up, dragging the share price with them.