Why are tech stocks risky investments?

Question

I've seen this mentioned so much in writings about intelligent investing, but I don't understand why.

Are Amazon and Netflix tech stocks?

Answer 1

They are not. You will have to put up some really crazy explanation to define Microsoft as risky.

Generally companies without a solid business are risky. Netflix IS there - their idea is very valid (customer myself, I love them), but they run a huge deficit and it is unclear whether this will play out or not. Tesla is risky - the concept is amazing, but look at how much money they burn and how high their debts are.

Amazon - so far they quite nicely manage to reinvest their huge profits, but they (a) are profitable, (b) it is not something others can easily copy (logistics centers) and (c) they have some income streams (like Microsoft, Azure turns into a huge profit center).

Compare that to Apple - (a) very profitable, (b) unclear how the future looks as they (c) mostly depend on one income stream (iphone sales). While I would be sure they survive as a company, I sort of love saying there is no way to justify their price and unless they come up with alternative revenue streams, their upside is limited.

Unproven companies with mostly unproven business models are risky. One trick ponies are risky. Many of those are in tech.

The point about tech companies is that most (a) are unproven and often come with (b) unproven models. Also (c) they can easily get sidetracked. Look at AMD - they have an amazing processor lineup now. Many years ago their Bulldozer architecture flopped and it took them a long time - and doubting their survivability - until they managed to pull off the ZEN architecture. High risk - one wrong step and you may lose a lot of money.

Answer 2

The reason I think people call tech stocks are risky is that by some measures they are. Take Netflix ($NFLX), the company is currently trading at more than 200x their current earnings. So that tells you lots of the upside is already "priced in" as they call it. Also, $NFLX market cap (total value) at the moment exceeds the value of Disney, while disney has a revenue of 9 Billion dollars in income (+multiple revenue streams) compared to 749Mil for $NFLX.

In general Tech stocks have high P/E. Some even have very little profit. So these companies depend on growth. The moment they stop growing/stall growth/ stop growing their valuations will suffer. And these swings add to your portfolio volatility. (another way to measure risk is how hard the value of your portfolio swings up and down).

A good example is Tesla $TSLA and this video explains how they depend on the growth to keep their business going. https://www.youtube.com/watch?v=BHS0H5AwGjU&t=289s

In quick summary, Techs depend on growth (good when the economy is growing), they are volatile and you pay a high price relative to earnings. Hence according to some, they have more risk.

Hope this helped you a bit.

source P/E $NFLX (14/06/2018) https://finviz.com/quote.ashx?t=NFLX

PS: there is an etf out there called QQQ and they go passive on the nasdaq 100 (mostly tech stocks) so check that out if you want exposure to tech. It's cheaper and less risky (due to diversification than owning one (expensive in USD) share of amazon or netflix.)

Answer 3

In 2005, MySpace was on top of the world. Everyone had an account there.

In 2018, MySpace is a footnote. Even the people with accounts there don't bother to use them. They all moved to Facebook. And of course now people are talking about moving away from Facebook. If that happens, Facebook would go from being one of the big four tech companies to just another footnote.

Other examples include Napster, AOL, Digital Equipment Corp, Research in Motion, and the SCO Group.

It's not so long ago that there was a huge battle between Blu-Ray and HD DVD for determination of who would be the HD recording format of choice. Supposedly Blu-Ray won. But Netflix moved to streaming instead of Blu-Ray. Blu-Ray is still the medium used for recordings, but most people don't bother with recordings. They just stream.

When I had Netflix, I used it about equally for original content and distributed content. This suggests that someone else could jump in with their own original content and I would stream them. And the distributed content could move easily to a different platform. For example, Netflix and Amazon have been fighting over the Dr. Who streams.

What if Dr. Who said a pox on both their houses and went full on cable? Or BBC America dropped cable and became a streaming service? If every supplier did that and Netflix had some original content struggles, Netflix could become a footnote.

Answer 4

I think there is more to this question.

Why are tech stocks risky?

Is really also asking, what actually is a tech stock? At the turn of the century the automobile was a leap forward in human technological prowess, now that's the auto sector. Ford is an Automotive company, does Ford innovate technology anymore? Probably, to some extent I'm sure various manufacturing processes are improved but it's just an Automotive company. You certainly don't think, OH YEA Ford is a tech company because remember 100 years ago when Henry Ford figured out a production line?

Is Google a tech company? ~20 years ago a couple ultra-nerds figured out a new way to index the internet and took a quantum leap forward in internet search. More recently Google has assisted in other forward movements related to internet infrastructure. But what's Google's business. It seems that Google is now the advertising subsidiary of Alphabet. Alphabet also owns some essentially hedge funds that finance various tech R&D, but is Google a tech company?

Is Apple a tech company? It seems to me that Apple is a hugely profitable hugely vertically integrated tangible consumer products company.

Is Netflix a tech company? Seems to me that Netflix is a levered to its eyeballs video content producer and distributor.

You can go down the list. What is a tech company? To my mind, a tech company is an organization that exists for R&D. It employs engineers and scientists and other nerds to research things, then develop a product/solution/fix for whatever externality the research uncovered. This sort of business is risky because your research may never uncover anything interesting and the product you spend time developing might not have any market viability. I think calling Twitter a tech company just because the business fully relies on the internet, would be like calling FedEx an aerospace company because it relies so heavily on planes.

Don't just believe what the company tells you it is. Where is your money derived? That's the business you're in.

Answer 5

Some tech companies take a different approach, providing something people like first and looking for ways to profit second. Paul Graham of Y Combinator has recommended this course in his essays. Facebook appears to have concentrated on being widespread and indispensable before trying to be profitable. This approach has advantages (it's really hard to profit from something people don't like), but it's a two-step process and the second step can be iffy.

Answer 6

Tech stocks are risky because as Warren Buffet would call it they don't have a moat. Also some of them are burning money faster than I could burn money in a bonfire....

Take Netflix for example. How hard would it be for a competitor to mirror their business model ? The answer is: not. A gifted kid could write the code in their garage over a weekend.
Take Amazon. How hard would it be to mirror their (e-commerce) business model ? Again, you could open an online store in less than 2 hours by yourself. Take Yahoo. Old tech stock, established company, bought many competitors, made a few (in retrospect) bad decisions. Look at where they are now....
Sun Microsystems used to be a huge player in the server market....

I could go on, but you get the point. A company like Ford can make truly terrible decisions and continue for decades. Google could disappear in a few years.

Answer 7

Generally, tech stocks are considered risky because it's difficult to understand them. As famous investor Warren Buffett often says, “Risk comes from not knowing what you are doing,”. Hence, it's important to know the sector that you are investing in.

For many tech companies, the question “what creates your value?” is a tough one to answer. Also, most tech companies are new and unproven.

The bottom line is you should be able to easily explain why a certain company provides a useful service or product, and show that the stock price accurately reflects the company’s value and isn’t just an illusion. Next time you want to invest in a tech stock or any sector that you do not understand ask 4 questions to yourself -

Do you understand the company? Does it have a definite competitive advantage? Is the management trustworthy? What is the sale price?

I hope my answer could help.

Answer 8

OK, look at it this way.

Typically, the 500 biggest stocks in America (the S&P 500 list) deliver, let's say, a 10% average annual return. A stock with no growth prospects, conceptually, needs to pay a 10% dividend if its stock price were fixed. So we know what $10 of current profits costs: $100 or so.

Now imagine a stock like Netflix. According to Nasdaq, Netflix trades at over 250x past year's earnings. If so, $10 of 'current' profits is worth, all else equal, $2,500. What that really means is that if you invest $2,500 into Netflix, (1) $100 compensates you for what they have done already, and (2) $2,400 compensates you (hopefully) for what they will due in the future. Note that 96% of price comes from the future growth, not what they have done already. (https://www.nasdaq.com/symbol/nflx/pe-ratio )

Suppose we get a court ruling, or a legislative change, or anything else that could hurt their growth. If the growth forecast falls 25%, then 96% of the price should drop 25%. So, a small diminution of growth rate leads to a 24% drop in price, all else equal.

And, actually, such a drop may not only change everyone's profit forecast, but the sexiness of the stock. This would bring the PE multiple down. So, maybe, a 35% drop in price would be appropriate given the purported facts.