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High Marks for High-Tech Investing

Should you consider high-tech stocks as part of your investment portfolio?

As appeared in Wealth magazine

High Marks for High-Tech Investing

Should you consider high-tech stocks as part of your investment portfolio?

With memories of the dot-com bubble still lingering, several recent high-profile IPO disappointments and the falling stock prices of popular Internet companies have left many wondering if the high-tech investment sector has stalled.

But while negative press has cast a cloud of doubt on the entire segment, at least half a dozen IPOs in 2012 alone went far above the IPO price and performed quite well, says Deborah Koch, senior technology analyst and technology fund portfolio manager at Northern Trust.

As a result, investors should guard against painting the industry with too broad a brush, says Koch, who has been involved with technology investments since the 1980s. That’s because a shift in how the world computes occurs every 10 to 15 years – and with each shift comes new ideas, new products and new companies driving innovation. Currently, we appear to be in the early stages of the next major shift with the advent of cloud computing, social computing, mobile computing and analytics.

As with any investment, however, an informed strategy is critical to help minimize the risks and maximize the opportunities associated with high-tech investments. Consider these five tips:

1. Pay Attention to Valuation

“Tech stocks, more than any other sector, are really keyed into growth outlooks,” Koch says. In other words, a company’s valuations closely relate to anticipated growth; if that growth is different than what was anticipated, stock prices react accordingly.

In addition, people naturally become excited about new technology, which can drive up expectations and cause companies to be overvalued.

To mitigate the risk of overvaluing a high-tech company, Koch recommends identifying those with differentiated technology and which typically have higher profit margins than competitors. (Apple, for instance, has higher profit margins than many of its competitors because of its differentiated technology.) Whenever there’s a paradigm shift like the one we’re currently experiencing, these types of high-tech companies tend to emerge. “Older established companies in the tech sector often find it hard to cross the bridge into new business,” Koch says.

She predicts that as a result, newer, smaller companies with differentiated technology will be the main players in a healthy IPO market for the next several years.

2. Take Advantage of the Next Big Idea

While some investors in the public market may have taken a financial hit after the recent high-tech IPO letdowns, venture capitalists who invested in these companies years ago still saw plenty of return, says Bob Morgan, senior vice president and managing director of Northern Trust Alternatives Group.

That’s because venture capitalists seek “the next big thing.” “Most people today already know about social media, cloud computing and mobile tech, but what big idea comes after that? That’s what venture capital firms today are looking for,” he says. “Northern Trust invests in these firms before the public market even recognizes the value in their ideas.” Clients, in turn, can potentially reap the rewards of these new ideas by investing in private equity funds focused on the technology sector.

“Wealth is frequently created by getting in on things early before they’re big, and then just letting them ride.” —Deborah Koch, senior technology analyst and technology fund portfolio manager, Northern Trust

The key is to invest early. “Everybody talks about the big, popular companies, but there are a host of other companies out there primed to be major successes if you can access them early enough,” Morgan says.

Plenty of venture capital opportunities exist. According to PitchBook, the second quarter of 2012 registered the most venture capital financings of all time for a single quarter.

The trade-off when investing in venture capital funds versus the public market is that the former is highly illiquid and could take many years before seeing any return. Money could be locked up between seven and 10 years for a seed-stage tech company and between four and five years for companies in their expansion stage.

3. Consider Earnings and Cash Flow

Both earnings and cash flow growth are typically indicative of a high-tech company with solid differentiators and an effective business model. On the venture capital side, firms that have historically produced strong results for investors tend to continue that record of success. “In the venture capital market, we call that a ‘strong persistence of skill.’ Success begets success,” Morgan says.

To have the opportunity for the best returns, investors must access top-tier venture capital firms, he says. The challenge is, because those firms are so successful, they’re also highly selective about who can invest in them. “That’s where [investment advisors] come in,” Morgan says. “We specialize in getting clients into those firms.”

4. Stay Diversified

To mitigate risks in either the venture capital or public market, a well-diversified portfolio is essential. Morgan suggests spreading investments across several areas to reduce risk, including high-tech companies at various stages of growth – some at seed stage and some further along in development – and in various locations around the globe.

Koch points out that investing in a tech sector fund can also increase exposure to a variety of technology-related companies. These funds invest in companies operating in the three industry sectors of technology, media and telecommunications, irrespective of any geographic focus. Rather than investing in one particular company, a tech sector fund spreads an investment across several companies, thus arguably reducing risk.

5. Stay the Course

Above all else, investors should not let the daily news cycle dampen their view of the high-tech sector, and instead should focus on the long term. “Wealth is frequently created by getting in on things early before they’re big and then just letting them ride,” Koch says.