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The technology sector is an inescapably huge investment opportunity for both corporate America and Wall Street. It is the largest single segment of the market, eclipsing all others (including the financial sector and the industrials sector). More than anything, technology companies are associated with innovation and invention. Investors expect considerable expenditures on research and development by technology companies, but also a steady stream of growth fueled by a pipeline of innovative new products, services and features.

The Importance of the Tech Industry

These products and services are then disseminated throughout the economy. There is no sector of the modern economy that technology does not touch and that does not rely upon the technology sector to improve quality, productivity, and/or profitability.

Tech is also notable for its rabid competition and rapid obsolescence cycles. Although the examples have been used so often they have become cliché, it is nevertheless still a fact that computers used to occupy entire rooms, 16 GB of hard drive storage was perfectly adequate for a tablet, and cell phones used to flip open and closed. With that constant drive to adapt and overcome competitors with new products, no company can rest easy for long in the tech sector.

This rapid cycle of obsolescence means that winners and losers in technology do not necessarily maintain those positions for long. Microsoft was founded in 1975 and after dominating in software for computers, has had to play catch up in the mobile space. Likewise, Apple was left for dead in the 1990s, but sprang back to vigor with its innovative smartphone products. Moreover, that dynamism and impressive growth make technology a must-consider sector for virtually every equity investor.

The "Mega Sectors" of Tech

Within the huge and unwieldy world of tech, it is possible to look at four key "mega sectors:" semiconductors, software, networking and hardware. While not every tech company fits into one of these four mega sectors, the majority do, and it is a useful way to talk about the sector as a whole.

Software

Without software, nothing much happens in the modern world. Software is everywhere and is present in critical components of everything from pacemakers to cars, but none of those devices can do much of anything without software. As such, it is not surprising that software is a huge industry as well – on the order of hundreds of billions.

Software is not noticeably cyclical in its own right, apart from the broader economic cycles that dominate business. When recessions arrive, companies typically curtail their information technology (IT) budgets and reduce software purchases. Meanwhile, the opposite is true when recoveries begin.

Software requires virtually no infrastructure and is difficult to protect via patents or copyright to any effective degree. Consequently, tiny start-ups with innovative new products can appear virtually overnight and with no warning. Though a software provider's reputation and ability to provide support after the sale are competitive factors and potential barriers, this is nevertheless one of the most fertile categories for new company formation and new product introductions.

Cloud computing, for example, allows several companies to offer software as an on-demand application (typically through the internet or a closed network) as opposed to code actually residing on an individual customer's servers and hard drives. This "software as a service" has major implications to the development, distribution and functionality of a multi-hundred billion-dollar industry in between software providers and the end user.

Networking and Internet

Networking, great and small, is arguably the biggest tech innovation since the microchip. The creation of networks has not only significantly improved efficiency within companies, but the internet itself (one gigantic network) has facilitated major changes to commerce and has underpinned entirely new business models like mobile banking and software as a service (SaaS). Networking is in many respects a sub-sector of the other mega-sectors; it requires hardware (which require chips) and software to function. That said, it is large enough and important enough to stand on its own.

Broadly speaking, investors can divide their attention between those companies focusing on the consumer (B2C, business-to-consumer) and those that focus on "behind the scenes" business conducted between businesses (B2B, business-to-business). In many cases, though, companies like Amazon, Facebook and Google blur those lines.

In 2017, U.S. retail e-commerce alone was estimated to be worth something in the neighborhood of $450 billion a year in revenue, and that did not include the value from electronic funds transfer, marketing, data interchange or online supply chain management.

Hardware

Hardware does not get the same amount of respect that it enjoyed in prior decades, but it is still a key part of the technology world. Although software is increasingly replicating the functions of many pieces of hardware, there is still a major market for many types of hardware and the sector is not as obsolete as many believe. Company-wide networks and the Internet itself only work because of a huge backbone of equipment, and software is still ultimately just a set of instructions; there has to be a "something" to be instructed and to carry out those instructions.

Computers have evolved into a stunning array of devices from self-driving cars to mobile devices that can essentially replicate and replace many of the functions of personal computers. New exciting products, such as virtual reality headsets and wearables can revolutionize consumer hardware, while the intense user demands for information technology can fuel ongoing innovation in routers, servers and data storage devices.

Getting a bit more specific, hardware can be broken down into many sub-sectors, including communications equipment, computers and peripherals, networking equipment, technical instruments and consumer electronics. Unfortunately, investors may find some of these segments to be arbitrary or incomplete; do advanced electronic defense systems belong in the traditional aerospace/defense category, or are they technology hardware? Consequently, investors should not rely too much on labels when deciding what is or is not to be considered "hardware."

Semiconductors

Semiconductors underlie virtually everything else in technology. The semiconductor industry is a huge market on its own, but it is thought to enable four times more in physical products that rely upon those semiconductors. Factor in all of the other types of products and services that depend upon semiconductors at least implicitly (what could software do without a chip-using drone or smartwatch?), and it is arguably the axis around which technology spins.

There are numerous types and categories of semiconductors. Chips can be divided into analog, digital and mixed-signal circuits, but it is more common to discuss chips in terms of their ultimate function – like power management, microprocessors, microcontrollers, sensors and amplifiers.

Although semiconductors are ubiquitous, the industry is highly-cyclical and follows a boom-bust cycle of ordering and capacity construction. Despite that cyclicality, what matters most for companies in the semiconductor industry is the ability to design superior products (more features per chip, less power consumption, more reliability, etc.) at the best price.

What Investors Should Watch

One of the other basic truths of equities is that tech stocks frequently sport higher premiums than almost any other market category. In theory, this high level of valuation is recognition of the above-average growth rates that successful technology companies post. In practice, though, even unsuccessful companies can carry robust valuations right up until the point where the market gives up on those growth prospects.

Technology also has an above average number of public companies that do not yet produce profits or cash flow. The absence of a track record forces investors to use more guesswork when building discounted cash flow valuation models.

Investors can take some encouragement that research and diligence pay off in the tech sector. Understanding a company's products (especially their advantages and disadvantages) and those of its rivals can produce an investable edge. Clearly, this is a sector where the details matter.

Whether or not investors should concern themselves with valuations in the tech sector is a subject of ongoing debate. Certainly, there are investors who have done well by following the growth and investing in category leaders (or emerging threats to the status quo) and nimbly moving from company to company irrespective of valuation. On the other hand, investors who are not so nimble, as they believe or misjudge the competition, find themselves holding very expensive stocks with no underpinning of value to support them.

The Bottom Line

Some investors continue to stay well clear of the entire technology space and regard it as impenetrable and irrational. Given the pervasiveness of technology, however, this is a significantly self-limiting view that cuts off one of the most dynamic and powerful engines to modern economies. A better compromise, then, might be to simply invest the time in careful research and self-education to invest where the valuations make sense.

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