Everything You Need to Know About Investing in Technology

The technology sector includes everything from major companies that everyone knows, to players both big and small that operate largely behind the scenes. The category is also home to emerging companies of all sizes, start-ups, and billion-dollar household brands.

In a broad sense, the category includes stocks involved with the research, creation, and distribution of technology-based goods or services. That can be everything from computers to software, televisions to websites. Hardware is the physical device -- a computer, a television, a smartphone, etc. Software is the computer code and platforms that make those devices work.

Technology stocks offer investors a lot of opportunities. In fact, the sector offered the highest returns of all ranked market sectors at 34.28% in 2017.

Those strong returns, however, do not mean the technology sector is without risks. Technology changes quickly, and one-time leaders can quickly fall behind, or even go out of business. In addition, promising emerging companies may make a huge splash, only to fade out quickly.

Technology is an exciting space that includes trends from artificial intelligence (AI), to smartphones, blockchain, self-driving technologies, the ongoing to trend to software-as-a-service (SaaS), the Internet of Things (IoT), streaming media services, and more. It's an area full of opportunity, but also some risk.

Returns may vary

When you look at the past ten years of returns for the technology sector, the numbers vary greatly. The category topped all tracked sectors in 2009 and 2017 but underperformed the average of all sectors in four of the ten years.

As you can see above, the technology sector can be boom or bust. The same is true of individual companies and market segments within the space. Sometimes a technology seems like it might be the next big thing -- think 3D television just a few years ago -- only for it to fail spectacularly in the marketplace.

Areas for investment

Technology is a wide-ranging term: It has expanded far beyond what would have once been considered the typical tech stocks, including computer companies like Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), IBM (NYSE: IBM), and others. It's not even fair to call any of these three brands computer companies anymore. They operate in a variety of other segments that are all part of the technology market, including but not limited to:

• Artificial intelligence (AI): This is where computers perform tasks that might have traditionally require a human brain. AI also encompasses deep learning (where data scientists build computer models inspired by the structure and function of the human brain that essentially reproduces our ability to learn), and machine learning (a type of AI where computers learn without being specifically programmed to). Amazon's Alexa might be the most famous AI, though IBM's Watson has also achieved a lot of media attention.
• Smartphones: While Apple and Samsung lead this space, there are lots of secondary players making components, software, apps, and phones. "Smartphone" is sort of a catch-all name for handsets that can run apps, programs, and nearly anything else a computer might be able to do.
• Blockchain: While blockchain has gotten a lot of publicity because it's the technology behind Bitcoin and other virtual currencies, it's more than just an alternative payment method. Blockchain is "the digital, distributed, and decentralized ledger tethered to most cryptocurrencies that are responsible for recording all transactions without the need for a financial intermediary. In other words, it's a transparent and immutable (i.e., unchanging) log of all transactions that don't involve banks acting as a third party," according to The Motley Fool's Sean Williams.
• Self-driving technologies: Companies including technology leaders like Alphabet (NASDAQ: GOOGL) subsidiary Waymo, Tesla, and most major auto manufacturers are working on creating self-driving cars. In most places, that's not even legal yet, but some driver-assist technology has already come to market, and it's likely that self-driving cabs and even trucks will be in at least limited use reasonably soon.
• Computers and software: These are the companies that make the laptops, desktops, and tablets, and the software that runs them. This segment also includes component players like Intel (NASDAQ: INTC) and Advanced Micro Devices, which make the chips and processors that power computers, but also bigger well-known brands like Apple.
• The internet: Think of companies like Alphabet's Google, Microsoft's Bing and MSN, Twitter, and Verizon's Yahoo, along with companies like Yelp that offer purely digital products. Most of these players are at least partially supported by advertising revenue, though some sell subscriptions and monetize in other ways.
• The Internet of Things (IoT): The IoT is the network of devices connected to each other and the cloud -- the public internet that allows for links between far-flung systems. It's everything from a smart thermostat that can adjust the temperature in your home to complex medical equipment that can order its own repairs.
• Streaming Media: You could argue that Netflix is an entertainment company, but it's also a technology company that has created its own infrastructure. Netlfix creates content for its streaming platform, but it also creates and maintains the platform itself. A company like Roku (NASDAQ: ROKU), which makes streaming media players, is more of a traditional technology sector stock, but could also be considered a member of the next category as it manufactures devices. Streaming media has been growing as consumers look to cut the cord with cable, a trend that has been accelerating.
• Device companies: Players including Roku, GoPro, and Fitbit make devices driven by technology. In many cases, they also make the software that makes them run and gives them added functionality.
• The Cloud: The cloud is a system of computer storage that allows information and services to be accessed by devices from anywhere. The cloud allows companies (and individuals) to use services that are not resident in their devices. Amazon, Google, IBM, and Microsoft are all major cloud players.
• Cybersecurity: With data now housed in the cloud, on our devices, and even in the chips in our credit cards, keeping information secure has become a growing industry. Cybersecurity is about making sure information is only accessible to the people who are supposed to see it.
• Chip/Component makers: Some technology companies don't make finished devices at all, they make the parts that go inside them. Intel is a good example of this, as the company makes the chips and processors that make computers work. This segment also includes companies that make memory, screens and other parts that go into technology devices.

Technology is everywhere

You can invest in technology without buying a pure technology-sector stock. For example, Amazon (NASDAQ: AMZN) is a huge retail presence in the U.S. but it also has a multi-billion dollar cloud computing business and operates largely in the digital space.

Starbucks, which most would consider a retail sector or restaurant stock, has been a technology pioneer in the space of mobile payment. The coffee chain established mobile order and pay in its app. This allows customers to order before they enter a store and pay for items through the app (via a connected credit card or a gift card balance). Starbucks also lets customers pay via its app in its regular line -- a staple of many restaurant chains now, but novel when the cafe company introduced it. It's technology that makes it easier for Starbucks' (and now other restaurant chains) customers to pay and receive loyalty rewards. That binds the consumer to the brand and gives the company an added marketing channel.

These aren't technology companies in the way that, say, Microsoft and Apple are, they are brands known for doing other things (like selling coffee) that also develop technology -- but they are major players in the space. Technology has bled into nearly all areas of life, and a number of companies that at first glance are not specifically technology companies -- think the automakers developing self-driving cars -- are at least partially technology stocks.

A look at technology ETFs

An exchange-traded fund, or ETF, is a fund that invests in multiple stocks but is sold like a single stock that tracks a certain index and trades on a major stock exchange. It's a way to own a market sector without having to rely on specific stocks. For example, you might buy an ETF of IoT stocks or small-cap technology stocks.

Just like a mutual fund, an ETF has an expense ratio, meaning that a percentage of the fund's assets are used to cover management and other costs.< The expense ratio includes management fees, advertising fees, and administrative fees. It's expressed as the percentage of the fund's assets that are used to cover operating expenses each year. In a broad sense, lower is better, but you should look at overall returns and not just the expense ratio when considering an ETF.

The Motley Fool's Dan Caplinger broke down three technology ETFs he considered to be "can't-miss" in January. He included Guggenheim S&P Equal Weight Technology, iShares Exponential Technologies and the First Trust ISE Cloud Computing.

What metrics matter most?

There are really two major types of technology companies: Developing brands and mature companies. Even mature companies like Apple or Microsoft still have to innovate to survive in the long-term, but they have a base of products that have become entrenched in the market. That provides long-term revenue stability, allowing these mature companies to develop their next products without having to worry about keeping the lights on.

Microsoft, for example, has moved Office from a purchased product or suite of products to a subscription model. That means, in a very simple example, that an individual used to buy Word or Excel and own it. They might replace it in a few years, or use the software for as long as they could. Now Microsoft charges an annual subscription fee for Office. That actually makes it cheaper for consumers in the short-term, but they have to pay again each year.

A mature technology company is valued partly by traditional methods, including profit, revenue growth, and overall sales. Of course, because technology is an ever-changing space, even a company like Apple or Microsoft can see its stock price rise or fall based on an unproven product or even an announcement of a new development.

Developing brands like Tesla face a different challenge. These are companies valued largely on potential for sales, not profit. Tesla, for example, has a huge backlog of Model 3 orders to fill, but it has yet to show it can operate profitably. Palo Alto Networks, a cybersecurity company, is in a similar position, boasting a significant customer base but still not showing consistent profits. In most cases, these brands lose money -- sometimes a lot of it -- as they build out capacity and develop a market for their product. Emerging companies generally have more upside (at least at first), but they come with significant risk.

Who should invest in technology?

Technology stocks offer opportunities for both novice and experienced investors. Companies like Apple, and even smaller players like Roku, offer a chance for people to buy shares in companies whose brands have become integral parts of their lives. It's also a space where the average person can jump on emerging technology that they have experienced and believe will become a part of the future.

The technology space offers opportunities for both growth investors and income investors, who can choose from several mature, established companies. Of course, because this is a sector that's rapidly developing, there's some growth opportunity even in mature companies.

Trying to get a clear picture for the value of a technology stock can be difficult as sometimes the products and revenue streams can be more complex than a consumer goods company, for instance, like Johnson & Johnson selling brands and products the average individual is familiar with. Companies can be valued using a number of methods, including earnings-based valuations, revenue-based valuations, cash-flow based valuations, equity-based valuations, and member-based valuations.

Growth investors might like...

Growth investing is buying shares in companies that you expect will grow a lot in the future. You often pay a premium for them -- but these stocks aren't being valued for what the company has already achieved, but for what it might achieve going forward. These stocks often have a lot of analyst attention, sometimes belying the actual size of the company.

Of course, getting in early on a stock can bring tremendous returns. Facebook, for example, priced its initial public offering (IPO) at $38. Shares actually dipped to about half of that at times, but at the time of writing, shares were around $180, more than four times higher.

Roku, which went public in September, grew its overall revenue by 28% year-over-year to $188.3 million driven by platform growth of 129%. The company is unlocking growth opportunities by pivoting from being a device company to one that licenses its technology to other players. It has also significantly grown its advertising business.

Unlike many growth players, Roku is profitable, making $73.5 million in gross profits in 2017. That number, however, barely touches the surface of the potential the company has, although it's battling some much larger companies (Apple, Amazon (NASDAQ: AMZN), and Google among them).

When you decide whether to invest in one of these companies, look at valuation but also the market potential. There's no single method for doing that, but you should consider the company's forward earnings projections, and earnings growth rate for calculating forward price-earnings ratio and the PEG ratio. For growing companies paying attention to free cash flow and debt will help investors get a better picture of the overall financial health of the business.

Income investors might like...

The technology sector, of course, also offers investors the opportunity to invest in well-established companies that offer income in the form of dividends, a distribution of a portion of a company's earnings to shareholders. In fact, the technology space houses some dividend aristocrats -- members of the S&P 500 index that have had a minimum of one dividend increase annually for at least the last 25 consecutive years.

Of course, the fast-changing nature of tech actually suggests that income investors should look at companies that don't quite make the 25-year threshold. Many of today's top technology players were either in their growth phase or did not exist 25 years ago. Apple, as an example, only went public in 1980.

Technology as a sector generally offers lower yields -- just over 1% on average -- than the S&P 500's average yield across all sectors of 2-2.2%. That's at least partly because it makes sense in many cases for technology companies to invest more heavily in research and development than other sectors. Still, it's possible to find high yields (a yield is a dividend expressed as a percentage of the current share price). Microsoft, for example, offers a 1.83% yield and has grown its dividend for 14-straight years.

Top technology stocks

As noted above, it's not easy to nail down exactly what a technology stock is. Most of these companies are clearly tech companies, but Netflix and Tesla could arguably be considered an entertainment company and a car company, respectively.

Apple

One of tech's true titans, Apple has a loyal following for its iPhones, Mac computers, and iPads and Apple TVs. The company does not dominate when it comes to market share, but it sells its devices at consistently high prices compared to its rivals. The company also has many of its phone customers locked in to replace their phones every year or every second year, which keeps profits flowing.

Apple has a lucrative business selling entertainment and apps. It controls the store for iPhone and iPad apps. That allows the company to take a piece of the profits, while also ensuring that only apps that meet its standards make it to its platforms. That creates what's known as a sticky ecosystem -- an environment where a customer has to stick with Apple to utilize all of their previous purchases, which can be leveraged to get consumers to buy new devices and remain in the ecosystem.

Microsoft

Once the unquestioned leader in this space, Microsoft went through some stumbles as smartphones and tablets began to challenge traditional computers. That made Windows, the company's operating system (OS), less dominant, and created sales challenges for the company's Office suite as well.

Tablets and smartphones running Android and Apple's iOS could perform many computer-like functions. That made Windows less necessary and gave consumers an option. That also impacted Office, because for many years Microsoft barely supported Office on Mac computers, and did not offer Android or Apple iPhone and iPad versions.

Over the past few years, however, CEO Satya Nadella has righted the ship. He has opened up the company's products to all platforms, invested heavily in the cloud, and moved Office to a subscription model successfully. Now Nadella has bet heavily on AI and IoT, positioning the company to continue to profit from its established products while also setting it up for future growth.

IBM

Today's IBM shows just how much a technology company can change over the years. A brand once known for being a pioneering leader in home computing no longer even operates in that space. Instead, the company has recast itself as a cloud computing player and a leader in AI with its Watson-based initiatives, consulting services, and data farms.

During its transformation, IBM had the support of Berkshire Hathaway and its CEO Warren Buffett. Interestingly, Buffet's company sold off most of its stake in the company right as it began to show signs of a turnaround. IBM had suffered through five years of declining revenue before reversing that in the fourth quarter of 2017 and continuing to grow in the first quarter of 2018. That's good news for investors, but the company is still finding its way and developing a market in emerging spaces, ranging from machine learning to automated driving and more.

Intel/AMD

Both of these companies make computer chips, processors, and other internal computer parts. That's not a publicly visible business, even though Intel has made significant efforts to get its name out there with its "Intel Inside" labels.

This is a growing space, driven partly by gaming and the need for better and faster processors to run functions like virtual and augmented reality. Still, increased competition from rivals including Nvidia has pushed both Intel and AMD to focus on improving design, creating smaller chips with higher yields, and generally trying to do more for less.

As an investor, these can be challenging stocks to follow because of their lower public profiles and reliance on partnerships. Still, you can partially anticipate sales for Intel and AMD based on which devices are using their products. For example, Intel provides processors for Apple's iPhone. That business may not be a long-term partnership, but if Intel is inside the next generation of iPhones (as it's expected to be) then shareholders get a year of predictable sales for a sizable chunk of the company's business.

Tesla

Like some of the other players on this list, Tesla is not purely a technology company. It's a car company that differentiates itself with technology. The company is also a pioneer in the battery space and is creating advanced solar-powered solutions.

The biggest challenge for Tesla has been ramping up production of its lower-priced Model 3. In theory, if the company could hit its Model 3 production goals, its long-term future would be more clear. Until that happens, however, the company continues to burn cash, and it runs the risk of being choked out of business by more-established car companies as they move more fully into electric vehicles.

Roku

A tiny player that has done well fending off giants, Roku makes streaming players and licenses its technology for embedding in televisions. The company, as noted above, also sells advertising, which has been a growing business.

Roku operates in a market that's still developing. As consumers cut the cord with cable, more people will opt to buy devices or televisions that can access the various streaming services. That creates demand for Roku, which has a product line that covers entry-level through upper-tier devices.

The biggest challenge for Roku is that the other players in its space are Google, Amazon, and Apple. So far, the company has more than held its own, but there's certainly risk associated with competing with rivals that can outspend you into oblivion.

Netflix

You can't define a company that produces so much original content as a pure technology play, but Netflix's foundation is its streaming platform. The company has leveraged that platform to grow its subscription-based business globally. It now has 118.9 million paid members, split somewhat equally between the U.S. (55 million) and the rest of the world (63.82 million), as of the end of the first quarter of 2018.

In Q1 the company saw its revenue jump by 40.4% to $3.7 billion. That was its best quarter for growth since 2011 thanks to a recent U.S. price hike. In addition, Q1 saw the company add 7.4 million customers after adding 8.3 million in the previous quarter.

Netflix still has considerable room for growth, both in its home market and globally. The company will be helped by cord cutting and increased adoption of streaming devices and streaming-equipped TVs but it will also have to continue to invest billions in content ($8 billion in 2018) to keep current users happy and bring in new ones.

Amazon

The online leader is, of course, a retailer, but it's without question also a tech leader. In addition to developing its own digital platform Amazon has become a device leader with its Echo speakers -- which have the Alexa digital assistant embedded -- its Kindle tablets and e-readers, and its Fire TV products. Alexa on its own would make the company a tech powerhouse, as the AI/voice-controlled assistant has set the standard for consumers when it comes to offering practical, useful in-home integration.

Amazon also has a pure technology play in its growing Amazon Web Services cloud business. AWS produced over $20 billion in revenue in 2017, making it the largest provider of cloud services, and it has shown no signs that growth will slow down any time soon.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool’s board of directors. LinkedIn is owned by Microsoft. Daniel B. Kline owns shares of Apple and Microsoft. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Berkshire Hathaway (B shares), Fitbit, GoPro, Johnson & Johnson, Netflix, Nvidia, Tesla, and Twitter. The Motley Fool is short shares of IBM and has the following options: long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and short May 2018 $140 calls on Johnson & Johnson. The Motley Fool recommends Broadcom Ltd, Intel, Palo Alto Networks, and Yelp. The Motley Fool has a disclosure policy.