The 3 Mistakes Growth Investors Make With Technology Stocks

By Fool.com

U.S. stocks are higher in early afternoon trading on Wednesday, with the Dow Jones Industrial Average and the S&P 500 up 0.85% and up 0.99%, respectively, at 12:15 p.m. EST.

The Nasdaq MarketSite on Times Square. Image source:bfishadow, re-published underCC BY 2.0.

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This column regularly refers to Musings on Markets, the blog of New York University finance professor Aswath Damodaran -- it's a must-read for serious investors. The combination of exceptional writing clarity and deep insights make it a very valuable resource.

On Monday, Damodaran published the fourth post in a series on the compressed life cycle of technology companies, which addresses the specific challenges this poses for investors.

As you might expect from an academic, he methodically breaks these down by investor taxonomy between growth investor and value investor. Since growth investors are typically more attracted to the technology sector, I will highlight the three challenges Damodaran identifies for that constituency. This is the first:

This reminds me of a passage from Berkshire Hathaway's1992 letter to shareholders, in which Warren Buffett points out that "the two approaches [value and growth investing] are joined at the hip: Growth is always a component in the calculation of [intrinsic] value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."

Here's the simplest way to think about this: You're the owner of a business that is loss-making with no prospects for achieving profitability. Do you want to ramp up growth, or shutter the business?

The easiest way to forecast future growth is simply to extrapolate the recent trend; unfortunately, technology companies are particularly susceptible to inflection points at which the trend reverses.

A dramatic example of this is BlackBerry Ltd , which sold the eponymous handheld device. By the end of its fiscal year ended Feb. 26, 2011, the company had just completed a decade during which it grew its revenues by a factor of 90.

Alas, by Feb. 2011, the iPhone had already been released for nearly four years. In its next fiscal year, BlackBerry's revenues fell 7.5%; within four years, revenues had collapsed by more than four-fifths.

Due to its compressed life cycle, investing in the technology sector is particularly tricky. If you understand the three caveats related to growth that Damodaran identified, that is at least a sound basis for beginning to think about technology investing.

The article The 3 Mistakes Growth Investors Make With Technology Stocks originally appeared on Fool.com.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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