I’m an optimist by nature.
As my longtime readers know, I believe we are on the verge of an age of abundance. And this new age will be driven by the companies and technologies that focus on the top trends we cover in my newsletter, The Bleeding Edge.
I’m referring to technologies like 5G wireless networks, precision medicine, artificial intelligence, cloud computing, quantum computing, and the next generation of clean energy production – nuclear fusion.
But we have to be realistic.
Not all technology companies are great investments. In fact, even great technology companies can be bad investments. And I’ve predicted we’re on the verge of a “splintering” in the market.
What does that mean? Companies whose products and services are well-positioned for this new economic environment are absolutely booming. And those that aren’t are suffering badly. The next two years will be brutal for companies that don’t adapt quickly to this new environment.
This splintering will send a small segment of the tech world – one that was largely ignored until the pandemic – much higher.
The pandemic pulled forward some tech trends by 5–10 years. For example, we’ve been talking about teleworking for the last 20 years. But what happened?
Organizations and their management teams became even more centralized, and urban centers grew. Companies and managers were reluctant to have their workforce go remote. After all, managers felt they couldn’t control and manage their employees if they couldn’t “see” what they were doing all day long.
But now they’ve been forced to.
In March, it was estimated that almost 6 out of every 10 Americans were working from home. And as of October, a poll reported that 58% of workers are still working from home “sometimes” or “always.” And this trend will persist even after the pandemic passes. For example, Pinterest forked over nearly $90 million to break its contract on a San Francisco office complex. It won’t need the space in a remote work environment.
Or consider e-commerce. Earlier this year, many online retail categories showed a 74% increase in online orders immediately following the economic lockdowns. And now that consumers understand how convenient these services are, there will be no turning back.
Let’s consider one more example. Earlier this year, Nokia released data saying that most wireless networks around the world see 30–45% growth in traffic over a year. But peak usage jumped 20–40% over a period of just four weeks during the lockdowns.
These numbers are beyond crazy. And it’s all because people have been working and entertaining themselves from home. Videoconferencing traffic – for both work and socializing – spiked 300%. Gaming traffic exploded 400%… because the kids were staying home from school.
To put this growth into context, network data traffic would more than double every 12 months if this persists. We are talking about exponential growth. And it is overwhelming networks all over the world.
But not all technology investments will be winners in the years ahead.
In fact, investing in some companies right now could actually be dangerous. Some tech stocks have reached absurd valuations. And these are going to crash hard.
Today, I’ll show you two warning signs to look for when considering whether to invest in a tech stock…
Stodgy Old Darlings
Our first warning sign concerns tech stocks that some consider “darlings.” They’ve been around for decades and seem like safe, solid investments.
But we shouldn’t let brand recognition trick us into investing in companies whose best days are behind them. Just because we’re familiar with a company’s products or logo doesn’t mean they’ve stayed on the bleeding edge of progress.
To be successful in the tech sector, companies must be innovative. Their product strategy and road map are critical. And they must be improving people’s lives. At one point, every successful tech company was an innovator.
But some companies have simply lost their touch. They got buried in their past success and fell prey to unnecessary processes and groupthink.
Some Silicon Valley “old guards” are trying to profit off their reputations from 20 or even 40 years ago… But they will be a black hole for investments.
These companies may even look like good “value” plays right now. But they are dangerous investments.
Or put another way, there are far better places for investors to put their money.
Overhyped Tech Stocks
Our second warning sign comes with “hype.” Whenever we see news headlines blazing and hear chatter on social media, we want to be careful to not get swept up in the current of excitement.
While public enthusiasm doesn’t disqualify a stock from being a good recommendation, many stocks either don’t deserve the attention they’ve received or have gotten so much attention that their numbers no longer make sense.
Right now, I see a lot of tech stocks trading at insanely high valuations…
These valuations are so high that even if these companies meet their aggressive growth assumptions, the stocks won’t rise much over the next five years. This future growth is already priced in. And if these companies see even one misstep or market downturn, the stocks will plummet.
Understanding a company’s valuation is the most important part of any investment. Even the best companies with technology that none of their competitors have are not good investments if they are trading at too high of a valuation. Investing at an irrationally high valuation in a fantastic company will still lead to investment losses.
We can see the dangers of investing in overvalued technology companies by looking back at the dot-com bust. Back then, companies were going public at absurd valuations with little more than a vague business plan and a “dot-com” in their name.
The founder and former CEO of Sun Microsystems, Scott McNealy, put it best. In an interview in 2000, he said:
We were selling at 10 times revenues […] At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
As you can see in the chart below, Sun Microsystems peaked at $257 and plummeted 96% to $9.68.
The company’s fall didn’t happen because Sun Microsystems had bad technology. In fact, its Java programming language is still in use today. It fell because the valuation was way too high to support its future growth expectations.
I want to be very clear about one thing.
I am not suggesting that the technology market is poised for a broad collapse like we saw in the dot-com era. Broadly speaking, many technology companies are much healthier than they were in the late ‘90s. And the companies in the model portfolios of my research services are some of the best companies to own.
I retell this story to simply point out the dangers of investing in a company with an absurdly high valuation.
McNealy said an enterprise value (EV) to sales of 10 was crazy high. I disagree with him on that. Some companies can justify an EV/sales ratio of 10 as long as they have the gross margins and growth rate to support it.
But now we see some companies trading at an EV/sales ratio of 90 or more! That’s an absurd valuation… and investors could lose most of their money if they hold on to these companies.
I want all my readers to be on the right side of this splintering.
Because when reality catches up to these extremely overvalued companies, we’ll see more bankruptcies… And the share price for some popular companies will plunge. Based on my analysis, some are set to fall by as much as 92%.
So the decisions we make today will determine if we profit in the years ahead or suffer potentially catastrophic losses.
I recently put together a special presentation to show my readers how to be on the right side of market history. I share which specific stocks you shouldn’t fall prey to – and which ones are set to boom in the coming months. I encourage you to go right here to prepare.
Regards,
Jeff Brown
Editor, The Bleeding Edge