What To Look For in Tech Stocks

11/23/2011 7:30 am EST

Focus: STOCKS

Patrick McKeough

Editor, Successful Investor

Everyone wants to get in on the ground floor of a big tech stock but there are real challenges and sometimes it takes patience and planning, Pat McKeough of TSI Network.

Broadly speaking, there are some time-tested qualities to a good tech stock, and I’ve been discussing the risks and rewards investors can expect with tech stocks in general. Fast-changing technology offers huge opportunities in these stocks. However, fast change can also bring danger.

Below you will see four risk factors you face when investing in tech stocks. Further on, we look at four ways you can minimize these risks—and increase your profits…

  • Marketing is as hard as inventing. Even a great new product or computer program may fail to overcome the skepticism of retailers and consumers.
  • A tech stock’s acquisitions can bring “time-bomb” risk: Companies sometimes grow quickly by buying other companies. But those selling the companies may simply want to bail out of a losing situation.
  • Major tech stocks also make mistakes: Junior technology stocks often trumpet their deals with major firms, such as Apple (AAPL) or IBM (IBM). And it’s true that Apple and IBM have vastly more knowledge and bargaining clout than any individual investor. But they still invest in products that fail.
  • High-tech shams are common: It’s easier to set up a company and sell stock to investors than to perfect a technological breakthrough. Be especially wary when junior technology stocks splurge on elaborate Web sites and glossy investor brochures.

And now, the four ways to reduce risk and increase rewards with tech stocks:

  • Diversify: The high-tech sector has more than its share of winners and duds. So invest carefully and buy five to ten technology stocks instead of just one. Gains on your winners should overwhelm any losses you have.
  • Focus on up-and-coming technologies: For this, you need to know how technology is changing. For instance, the immense popularity of wireless devices, like the iPhone and iPad, is increasing demand for faster, more reliable wireless networks.
  • Buy multi-product companies: Technological advances come in spurts, and leapfrog each other. Focus on technology stocks that have a number of existing or soon-to-be-released products, and avoid one-hit wonders.
  • Look for earnings: A perpetual money loser will eventually go broke, no matter how impressive its technology. But if it makes even a little money, it can stay in business and perhaps reap the bonanza of a new product.

NEXT: Good Tech in the Flesh

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Good Tech in the Flesh
Recently, I talked about Cisco Systems (CSCO) and the challenges technology stocks face in a highly competitive industry.

Briefly put, Cisco is a leading maker of hardware and software that links and manages computer networks. The company’s hardware includes routers, local-area network (LAN) and asynchronous transfer mode (ATM) switches, and dial-up access servers.

Cisco’s Internet Operating System (IOS) software ties these products together, delivers network services (which interconnect and move information between networks) and lets programs run across networks. Cisco gets about 46% of its revenue from overseas customers.

The company also sells home routers and networking products to consumers under the Linksys brand. Consumer products account for less than 5% of Cisco’s sales.

Cisco recently announced a major restructuring plan that includes closing its Flip camcorder operations and other underperforming businesses. In addition, Cisco will cut 9% of its workforce.

If you exclude one-time items, such as severance costs, Cisco’s earnings fell 4.3%, to $9 billion, in its 2011 fiscal year, which ended July 30. Revenue rose 7.9%, to $43.2 billion from $40 billion.

It’s a good example of a successful long-term tech company, because its strong balance sheet will let it continue to spend heavily on product development and share buybacks. The company holds cash of $44.6 billion, or $8.20 a share. This technology stock’s $16.2 billion of long-term debt is just 15.9% of its market cap, or 1.6 times its annual cash flow of roughly $10.2 billion.

Earlier this year, Cisco started paying a quarterly dividend of 6 cents a share. The annual rate of 24 cents yields 1.3%.

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