Two Ways to Separate Value from Vice Among High Technology Stocks

Separating value from vice among high technology stocks that have fallen from grace—trading at a low PE—is a tricky proposition.

First, high technology stocks are economically sensitive, so it’s hard to determine whether a stock is trading at a low-PE because of fundamental reasons or because of a slow economy.

Second, the high technology industry is subject to economies of networking whereby “winner takes it all.”

Third, high technology companies have their own product cycle, which makes it difficult to predict whether a fallen high-technology angel is about to rise to paradise again or burn in hell.

As a result of this difficulty, investing in high-tech stocks that have been on a correction mode can be both very rewarding and very risky.

So what are the criteria for separating winners from losers?

I use two. The first criterion is revenue growth. A high -- and ideally accelerating -- growth rate is an indicator of the current competitive strength of the company. That’s a company in the right business at the right time.

Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) are two cases in point. Both stocks have a low PE, but still command high revenue growth, as they ride an exponential trend for mobile devices.

By contrast, a low or even negative growth is a signal of competitive weakness—the company is the wrong business. Hewlett-Packard (NYSE:HPQ) and Intel are examples of these. They have a low PE but their revenue decline—they ride the declining trend for PCs and PC-related products.

The second criterion is the product pipeline. A strong product pipeline is an indicator of the future competitive strength. This criterion is hard to quantify, however – a lot of products doesn’t necessarily translate into a lot of future revenue growth.

Here are three companies, which enjoyed a strong competitive advantage in the past, but failed to reload their product pipeline. Revenue growth stalled and eventually declined, dragging along their stock, and trapping investors who thought they were in for a bargain.

SONY

Founded by legendary business leader Akio Morita, Sony has been a pioneer in transistor radios, color TVs, video cameras, mobile music and game consoles.

But over time, the company failed to introduce new products, especially after the passing away of Akio Morita in the late 1990s. Shortly later, the company lost market shares to Samsung (TVs), Apple (mobile music), and Microsoft(NASDAQ:MSFT) in games.

NOKIA

Nokia was among the first successful mobile communications companies. It played a key role in the development of the Global System for Mobile Communications– a revolutionary technology which became the wireless standard that connected the masses of users. As a result Nokia’s stock soared, peaking in the early 2000s.

Since then, however, the company failed to keep up with competition, especially with Apple’s iPhone, which eventually dominated the market.

RIMM

In its early 2000s, this company executed a shrewd marketing strategy by developing a series of BlackBerry products catering at first to business users, but eventually to everyone. RIMM offered consumers innovative products that beat traditional cellphone products.

Over time, however, the company failed to develop radically new products like the iPhone and the iPad, from Apple; and Android powered phones, from Samsung (SSNLF.PK), LG (066570.KS), and HTC (2498.TW). And its BlackBerry Storm and Torch failed to create buzz. Furthermore, RIMM was slow to introduce innovative apps, widgets, and games that come with Apple and Google phones. The rest is history.

The bottom line: What separates winning from losing bets on low PE technology stocks are two things: revenue growth, which determines the current competitive strength of the underlying companies; and product pipeline, which determines future competitive strength.

Also read:

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Why Google's Nexus 7 And Microsoft's Surface Tablets Will Beat The iPad

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