Riding the Tech Roller Coaster

By Joe Light and Matt Jarzemsky 

Tech stocks aren't sunk. But the ship has sprung a leak. Should you bail out?

After climbing 244% from its 2009 low through March 5, the Nasdaq Composite Index has dropped 8.2%, tumbling 3.1% on Thursday alone--its biggest one-day drop since November 2011. Certain slices of the tech market look more perilous.

Biotech, for example. The iShares Nasdaq Biotechnology exchange-traded fund has fallen 20% since March 5. Highflying social-media companies Facebook and Twitter have sunk 18% and 26%, respectively, since then.

Speculating on a single sector, especially a volatile one such as technology, is risky, but if you want to try anyway, you should only use a small slice of your portfolio, say 5%, says Brad Barber, a finance professor at the University of California, Davis.

With that caveat in mind, here is the state of the technology sector now, and some ways investors can profit in it:

Initial Public Offerings

Remember eToys?

The online toy retailer went public in May 1999 at $20 a share, and the stock price nearly quadrupled on its first day. At the end of eToys' first day of trading, investors valued the company at $7.7 billion, a third more than Toys "R" Us.

EToys played up the convenience of shopping online rather than driving to a store. Instead of having to "circle [the] parking lot four times," its initial public offering prospectus said, customers merely had to turn on the computer.

EToys was right--online retailing expanded rapidly, often at the expense of brick-and-mortar stores. But the company went bankrupt in 2001 after the company's costs spiraled out of control and sales growth was slower than anticipated.

That is the challenge facing investors in some flashy biotechnology and social media IPOs, says Aswath Damodaran, a finance professor and valuation expert at New York University. Even though companies might get the "macro" story of their market right, it is nearly impossible to tell who is going to be the winner that takes that prize.

"Investors think about how big the diabetes drug market is, see a company offering a diabetes drug, and say, 'Let me make a bet on this,'" he says. "There are going to be a couple winners. But no one knows who."

By some measures, this year's IPOs are even more speculative than usual, says University of Florida professor Jay Ritter, who researches the IPO market. Among the 46 tech and biotech IPOs that he has tracked this year, only four companies have made a profit in the past 12 months, he says.

Historically, Mr. Ritter's research has shown that the average company that debuts with a market value of at least $50 million does no better or worse than the overall market. The average company that is smaller than $50 million underperforms the market.

"Other patterns come and go, but this pattern has held true in the 1980s, 1990s, and the last decade," he says.

So why bother setting aside money for IPOs at all? Picking a winner might feel like a good idea, but without knowing them in advance, investors are better off sticking with a broad market index fund. The Vanguard Total Stock Market ETF, for example, costs 0.05%, or $5 per $10,000 invested, and has about 15% of its portfolio in tech stocks. The Schwab U.S. Broad Market ETF costs 0.04% and has about 18% of its portfolio in tech stocks.

If you do that, you have to be prepared to let go of big gains when specific sectors rally, but you also will avoid big losses when they slump.

Biotechnology Stocks

The biotech sector ranges from established companies--there are seven in the S&P 500, including Amgen and Gilead Sciences--to young firms that haven't yet begun testing their products in clinical trials, let alone trying to sell them. Biotech firms usually are grouped with health-care companies, rather than tech firms.

The sector attracted investor interest in 2013, thanks to breakout sales of treatments for cancer, hepatitis C and a host of rare diseases, as well as the U.S. Food and Drug Administration's increased willingness to give new drugs a green light, money managers say. Share prices of many biotech firms rose sharply.

Given the recent reversal in the sector, it appears investors got a little too enthusiastic during the earlier part of this year. The Nasdaq Biotechnology Index closed at a record high on Feb. 25, capping an 87% gain over the prior 12 months. Since then, the index is down 21%.

Individual investors may want to steer clear of smaller, early-stage drug developers, unless they understand "exactly how much risk they're taking," says Ziad Bakri, a health-care analyst at mutual-fund firm T. Rowe Price Group. "If you're not trained in science and medicine, you should understand that this is very risky and there's a real asymmetry of information here."

If you have the wherewithal and risk tolerance, he says, you could consider making a handful of small bets on drug developers working on a potential blockbuster, keeping in mind that some of these investments will likely fail.

Shares of larger, profitable biotech companies, by comparison, can be less volatile. Amgen, for example, has tumbled 9.9% in the past month, while Gilead is down 17%. Intercept Pharmaceuticals, a smaller peer in the sector, is down 39%.

Still, larger biotech companies tend to see greater price swings than shares in major industrial or consumer-staples firms. For investors interested in larger biotech companies, Mr. Bakri recommends looking at rare-disease drug makers Alexion Pharmaceuticals and Incyte, both of which he says have strong management teams and a good chance their drugs will be approved to treat additional diseases, adding to revenues.

Like many high-growth companies, Alexion isn't cheap, at 31 times analysts' estimated earnings for this year, according to FactSet. But its sales grew by 37% last year. Given how quickly some larger biotech companies like Alexion are expanding, "the valuations don't seem crazy," Mr. Bakri says.

Among the top biotech funds, as ranked by three-year returns, is the Fidelity Select Biotechnology Portfolio, according to investment research firm Morningstar. The Fidelity fund has annual expenses of 0.81%.

The iShares Nasdaq Biotechnology ETF has annual expenses of 0.48%. Both the Fidelity fund and the iShares fund have included Amgen, Gilead and Alexion among their top five holdings in recent months.

Consumer Internet Stocks

Shares of social-media and consumer-focused Internet companies have been some of the hardest hit in the recent selloff. The episode serves as a reminder that richly valued stocks can be some of the most vulnerable to a pullback, money managers say.

Some of these businesses, such as microblog service Twitter or entertainment website Pandora Media, have yet to post an annual profit. Meanwhile, investors have been paying higher prices relative to profits for those companies that are generating earnings, such as entertainment company Netflix, than in many other corners of the market, leaving them vulnerable to a sharp fall when sentiment turned.

But the fast revenue growth for many of these companies, coupled with investor enthusiasm that they will leverage the power of the Web to shake up established industries, led bulls to pile in.

"With the big run-up that we had in 2013 and through the middle of the first quarter, you had companies that overshot their valuations in the near term," says Daniel Cole, who oversees about $550 million as a senior portfolio manager at Manulife Asset Management.

Investors should keep in mind that these rich valuations imply that much of the value of these companies lie in their future growth prospects, he says. When you are looking years down the road, even a small slowdown in the company's business or shift in investor sentiment can have a large impact on the stock.

Mr. Cole tries to identify companies that have a competitive lead and better business model than their competitors. For example, he says, Pandora is well-positioned to benefit from a shift from traditional to digital radio.

Investors in growth stocks must keep in mind that not all companies will succeed, Mr. Cole says. Therefore, picking out "great business models and great industry positioning is more important than what happens with the stock in the near term," he says.

He says it generally pays to favor companies that dominate their niche or have a first-mover advantage against their rivals, as the Internet tends to create a winner-take-all competitive dynamic. Other growth investors also stress the importance of watching whether revenue is accelerating or slowing from quarter to quarter. One warning sign: if a company is spending more on sales and marketing from quarter to quarter to keep growing.

The PowerShares Nasdaq Internet Portfolio ETF includes among its largest holdings shares in major firms that have established deep relationships with consumers on the Internet, including eBay, Amazon.com, Priceline Group and Facebook, according to Morningstar. The fund charges annual expenses of 0.60%.

Older Tech Stocks

With the spotlight on consumer-technology companies nowadays, it is easy to forget that more-established companies such as hardware and document-management company Xerox, networking-equipment company Cisco Systems, chip maker Intel and search-engine giant Google belong to the same sector.

But these are the exact stocks that will benefit the most if tech's falter turns into a longer slump, says Pankaj Patel, a quantitative strategist at ISI Group, a research firm in New York.

That is because older tech stocks are some of the cheapest in the market.

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As the tech sector took off in January and February, the priciest decile of tech stocks--as measured by the price/earnings ratio, or the price divided by earnings per share, and other valuation yardsticks--beat the cheapest decile by more than four percentage points, according to ISI. But in March, the cheapest stocks trounced the most expensive stocks by eight points.

Mr. Patel says he isn't yet sure if the reversal will last and that the past month might just have been a blip. But if cheap tech stocks continue to beat others through April, he says he will tell clients to shift more money to old tech companies.

Apple, for example, has a price/earnings ratio of 12.9, based on the past 12 months of earnings, according to FactSet. Intel has a P/E of 13.9 and Microsoft has a P/E of 14.5, versus a P/E of 16.3 for the S&P 500.

To avoid taking a risk on an individual stock, investors can turn to a broad tech-sector ETF, such as the Technology Select Sector SPDR Fund, which charges annual fees of 0.16%. Because long-standing tech companies tend to be larger than the upstarts, the ETFs are already tilted toward cheap, big companies.

For example, the Technology Select Sector SPDR ETF has a P/E of 16.8, slightly above that of the S&P 500.

What's more, many mature tech companies have billions in cash on their balance sheet, which makes them look even cheaper, NYU's Mr. Damodaran says.

Do such companies' growth prospects look boring when set next to say, GrubHub, the online food-ordering-service company, and mobile-game maker King Digital Entertainment? Sure. But their earnings also are much more certain to persist.

Write to Joe Light at [e-mail] and Matt Jarzemsky at [e-mail]

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