The idea of investing in tech stocks can be quite appealing – after all, the associated industries are on the rise, and anybody investing in this sector has an opportunity to achieve great results fast. However, not everything is as promising as it may sound. High tech is, by definition, an untested and highly volatile field where great opportunities go along with high risks. The dotcom crash of 2000 scarred an entire generation of investors, wiping out entire companies and losing those who invested in NASDAQ Composite Index 75 percent between 2000 and 2002. However, between 2002 and 2021 the index increased almost eightfold.
On the one hand, it means that investing in it can make some serious money. On the other hand, it may signify that we live in yet another bubble that can burst in the near future – which some experts believe to be likely, as even Google’s earnings are falling. As always, high rewards come with high risks – and in this article, we will cover some of the most significant dangers of investing in high tech.
1. Planned obsolescence makes tech companies extra vulnerable
A vacuum cleaner, kitchen appliance or vending machine bought forty years ago, if used carefully, may have lasted until now. With their modern counterparts, you should feel lucky if they last four or five years – and it is not a “good old times” rant, but a well-known (although widely denied) practice called “planned obsolescence”. It means that tech companies intentionally design their products so that they become obsolete after a certain period – just in time for their owners to buy a new and improved model. It is even more salient with electronics and software: companies like Apple or Microsoft make it increasingly inconvenient to keep using their older products after newer models appear on the market.
It is most evident when we talk about touchless vending machines. Instead of shutting down your business due to regulations preventing in person contact during pandemic time, you may consider investing in a vending machine to operate when and where people can’t. Touchless vending machines allow the users to use their smart phone to select items and then complete the transaction using the touchless payment terminal on the physical vending machine that is actual today and will be widespread in the nearest future.
While it is annoying for consumers, it also makes tech companies extra vulnerable to competition. If they fail to predict the market trend or their customers’ wishes, they are always one step away from becoming obsolete themselves – one need only to remember the once proud names of Blackberry or Nokia.
2. Tech industry is often inscrutable
Warren Buffett famously instructed investors to “never invest in a business you cannot understand”. High tech is one of the worst offenders in this respect – people tend to intuitively understand things like retail, manufacturing, transportation etc., even if they do not know the details of how such businesses operate on the inside. Retail sells stuff, manufacturing produces stuff, transportation moves stuff around. But what exactly does a new cloud service startup do? What value does it offer?
Before the dotcom bubble burst, investors pumped their money into glamorous companies with vague and incomprehensible business models and unclear value propositions simply because they were the next big thing. In other words, if you cannot easily explain what is so useful about a product or service offered by a company, do not invest in it.
3. Disappearing switching costs
When investing in software producers, one of the most significant risks is the potential for disappearing switching costs. When an individual user or (even more notably) an enterprise customer uses particular software, switching to another provider can be tremendously painful, even if there are obviously better alternatives on the market. However, if another software provider appears that offers to pay switching costs, guarantees that the switch will be fast and easy and that the new software will be so intuitive as to lack the need for employee retraining, the choice immediately becomes between a worse and a better tool. This means that no software company’s position is ever certain, just as your investment in it.
4. The tech market is unpredictable and prone to disruptions
The technology market is, by definition, unstable and volatile. You may invest in a company that offers a device, software tool or service that far outshines the competition or even creates an entirely new niche. If you choose wisely, your investment will skyrocket. B`1ut unbeknownst to you, an obscure startup is currently developing a product, tool or service that will utterly disrupt the industry, causing the company you invested in to lose market and devaluing your investment. It is particularly true for hardware and semiconductor companies that have great inertia and cannot reorganize quickly.
Brown Capital Management International Equity Fund recently released its Q4 2020 Investor Letter. The fund highlighted a few stocks and SAP SE (NYSE:SAP) is one of them. In the last three months, SAP SE (NYSE:SAP) stock gained 2.7% and on February 26th it had a closing price of $123.35. Here is what the fund said:
“SAP, headquartered in Germany, is one of the largest software companies in the world. It is the global leader in enterprise resource planning (ERP), supply chain management and procurement software. In the quarter, SAP management updated its long-term projections and now expects a faster shift to cloud services, as well as a delay in implementations due to the impact of COVID-19. The news had a negative impact on the stock price. We believe the transition to the cloud is positive for SAP in the long run, as the lifetime revenues and profitability for cloud products are higher, although this is offset by lower recognized revenue in the short term. This dynamic contrasts with SAP’s legacy business which typically sells software licenses, providing a large up-front payment but lower recurring fees. Positively, there are benefits of scale in the cloud business, and as SAP grows its client base, we think margins should improve rapidly.”
All this does not mean that you should not invest in high tech companies – you simply have to know what you are doing. So, if an investor wants the highest possible appreciation, they would do well to devote a segment of their holdings to tech stocks.