Tips and Tricks of the Pros

1. Time to Build Wealth
2. 10 Gems for Value Investor
3. Shorting Stocks
4. How to Invest $20, $100, or $1,000+
5. Stock Pricing Theory
6. 18 Warning Signs to Dump A Stock
7. Investing in Tech Stocks
8. The Michael Murphy Approach
9. The Essential 6 Point Check List
10. The Three Almost Bulletproof Investment Strategies
11. Sell Alert Spreadsheet
12. The Motley Fool Rule Maker
Back to Main

Investing in Technology - The Michael Murphy Aproach

Part 1: Introduction

The potential for tremendous profits attracts many to technology stocks. However, without a well-constructed methodology for identifying promising technology stocks and determining their value, success is far from certain in this highly volatile sector.

Michael Murphy clearly outlines his approach to selecting technology stocks in his book "Every Investor's Guide to High-Tech Stocks & Mutual Funds," published by Broadway Books (800/323-9872; $27.50). Murphy is the editor of the California Technology Stock Letter (800/998-2875; www.ctsl.com), a highly regarded and well-followed investment advisory newsletter that tracks and makes recommendations on technology stocks.

Murphy regards technology not so much as a sector, but rather as the growth driver of the U.S. economy, covering a relatively diversified group of companies. His approach seeks to identify technology stocks that are most likely to be the future leaders, and then buy those stocks when they become undervalued relative to their growth potential.

Why Technology Stocks?

Murphy believes that the U.S. economy is currently in the midst of a paradigm shift-a "once-in-a-century revolution" that is creating massive changes in almost all areas of the U.S. economy, creating new infrastructures, jobs and sources of wealth, while destroying old ones. The changes are similar to those brought about by other major innovations-for instance, the industrial revolution and later the introduction of mass production and a consumer-based economy. In today's economy, the change is being brought about by technology-electronics and computer technology, as well as medical and biotechnology.

The result of this shift, says Murphy, is that the technology sector is the fastest-growing and will quickly dominate all other sectors in terms of size. It is also a sector that is becoming very diversified, with seven major industry groups. Yet the market in general has not fully recognized this massive change. Murphy believes that most investors are underinvested in technology stocks. Murphy states that fewer than 10% of Wall Street analysts cover technology stocks, and only a few mutual funds specialize in technology. Murphy also feels that many investors lack an objective perspective on the traditional business cycle of technology stocks and get too wrapped up in the market's emotions surrounding a stock-buying in at too high a level and cashing out when they should be acquiring additional shares.

Murphy says this relative lack of coverage provides investors with a great opportunity to buy leading technology companies with significant growth potential at very reasonable-and sometimes cheap-prices.

He also explicitly rejects investment guru Peter Lynch's dictum that individuals should not invest in things that can't be easily understood. Individuals don't need to understand the underlying technology, only the company and its competitive environment-the same way an individual may invest in a car manufacturer without understanding the technology behind how a car actually runs.

Identifying the Stocks

Like many successful investors, Murphy divides the investment process into two segments-first identifying good companies with the management, products, and markets that you would like to invest in, and then determining the appropriate price to pay for each company. Murphy warns investors against purchasing any company just because it is cheap as well as falling in love with a company and paying too much to purchase its stock. Murphy first develops a small list of good-quality companies and then waits to acquire them at attractive prices.

Part 2: Identifying Good Quality Technology Companies

Is the Business Growing?

Real growth is a critical test for a company. Sales growth, or top-line growth, drives the company's bottom line. Murphy requires that a company exhibit sales growth of at least 15% per year. Growth at this level helps indicate research and development efforts that are proving worthwhile. It also indicates that the company is participating in a rapidly expanding market or taking sales away from a competitor.

To apply the Murphy growth-flow screen, Stock Investor Professional is used because its detailed financial statement data provides information on research and development spending. For our first filter, we screen for companies with annual sales growth of at least 15% over the last three years. We select three years because it is a short enough time frame to reflect a relevant period, yet long enough to identify a significant trend.

As with any screen that deals with a growth rate, it is important to study the sales figures on an individual year-by-year basis to confirm the strength of the growth figure. It is also important to study the passing companies to identify changes that invalidate historical performance as a predictor of future performance.

Is It Profitable?

Murphy looks for pretax profit margin of at least 15% to measure the profitability of a firm. The test helps reveal a company that may have a proprietary edge because it is able to deliver its products at a substantial profit.

A high profit margin validates the strength of the sales growth rate. A firm may be able to boost its sales by "giving away" its products, but this can only be sustained for a short period of time. In fact, this strategy can hurt the company in the long run if it does not produce enough profits to reinvest in research and development, provide for expansion as well as reward the shareholders.

Some technology industries have inherently lower margins yet create potentially interesting technology companies for the more sophisticated investor. Hardware manufacturers (original equipment manufacturers) who sell the majority of their goods to computer manufacturers, not consumers, typically have lower pretax margins but offer great growth potential. The lower margins, however, will translate to a higher level of volatility, requiring more diligent quarter-by-quarter tracking.

There are a number of ratios that can be employed to measure profitability. For example, the gross profit margin is often used as a top-line representation of profitability. The gross margin (sales less cost of goods sold divided by sales), however, can be very industry-specific and not as useful as a broad screening measure. For some companies, the actual cost of selling their goods (cost of goods sold) is small compared to the sales, marketing and support costs needed for the success of the firm's operation. Pretax profit margin includes the cost of goods sold, marketing and administrative expenses, as well as research and development costs, so it is a more universal profitability measure within the technology sector.

Murphy requires a pretax profit margin of at least 15% and this represents our second screening filter.

How Is Invested Capital Used?

Murphy looks for a minimum level of 15% for a company's return on equity as a measure of a firm's ability to finance its long-term capital requirements internally. Murphy feels that this test is particularly important for companies in capital-intensive industries, such as semiconductor production. Assuming no dividend payout, the return on equity (net income divided by shareholders' equity) equals the long-term sustainable growth rate. Faster growth has to be financed with additional debt or equity. Taking on debt has absolute limits and must be done carefully by companies in volatile industries. Issuing additional equity dilutes the ownership of existing shareholders, making their stock worthless on a per share basis. Murphy therefore prefers companies with a return on equity that can comfortably fund growth. Our next screen looks for companies with a return on equity of at least 15%. With high margins, it is not surprising to also see high levels of return on equity for the high growth-flow companies. When screening for high return on equity, it is also a good idea to carefully study the level of debt carried by the company. Any final company analysis should include an examination of the financial structure of the company.

Is It Reinvesting for the Future?

Murphy feels that the success of a technology company depends upon its commitment to research and development (R&D). A company's ability to apply its research is critical to its success. A company must be willing to sacrifice a portion of its current earnings to fund research and create new products or variations of old products. Good management must be willing to make its own products obsolete, rather than waiting for a competitor to do the same.

New or improved products drive rapid sales growth often by creating their own demand. These new products frequently carry higher profit margins because there is usually little competition when the product is first introduced.

If a company is spending a significant portion on research and development, the amount will be listed as a separate line item on the company's income statement. Dividing the company's research and development spending by its sales for the same time period tells you in percentage terms how much the company is spending. As a test of significant research and development spending, Murphy only looks at companies spending at least 7% of sales on R&D. At less than 7% investment in R&D, Murphy feels that the company is not committed to growth. Michael Murphy cites Apple's decline in research and development spending back in 1993 as the root of some of its difficulties.

Our next screen requires that a company spend at least 7% of sales on research and development.

Beyond looking at the raw dollars spent on research and development, the company's track record in successfully bringing out new or improved products must be examined. Annual reports will provide some qualitative feel in this regard. Research discussed one year that turns into a product launch the following year and a success the third year is a good indication that the company is able to turn out a steady stream of new products.

Murphy also suggests calling the investor relations department of the prospective company and asking what percentage of revenues today come from products introduced in the last three years. If the company's research is productive, the answer should be over 50%. These four basic screens establish the universe from which to seriously pursue further analysis.

Part 3: The Growth-Flow Model

Identifying a potentially interesting technology stock is the first step, but Murphy does not believe in paying any price for growth. Instead, he prefers to follow the potential companies and purchase them only when valuations reach attractive levels.

The problem, however, is that traditional valuation approaches are misleading for technology companies. R&D spending directly cuts into a company's current earnings; as a company spends more on R&D, its current reported earnings lower proportionally. The result will be a relatively higher price-earnings ratio for companies that spend more on R&D.

However, from a shareholder's viewpoint, earnings invested for tomorrow in the form of R&D are as important as reported earnings today. Murphy therefore adds per share R&D spending (R&D spending divided by the number of shares outstanding) to earnings per share to determine what he terms a company's "growth flow." Dividing the current price of a stock by the growth flow per share provides the price-to-growth-flow ratio. Murphy uses this ratio to measure the underlying investment value of a technology stock.

Murphy feels that the price-to-growth-flow ratio identifies cheap stocks both earlier and more accurately: R&D spending is usually stable and does not drop when earnings suffer. Thus, when share prices drop due to disappointing earnings, the price-earnings ratio will tend to change little, whereas the stock will immediately look cheaper on a price-to-growth-flow basis.

Murphy points to Tektronix in the late 1980s as an example, when it sold for $12 per share. At the time, the company's earnings were depressed, at about $0.35 per share. Based on the company's price-earnings ratio of 34.3 ($12 ÷ $0.35), the stock did not look cheap. At same time, however, it was spending $8 per share on R&D, so its price-to-growth-flow ratio was 1.4 [$12 ÷ $8.35], a "screaming buy." Murphy says the company continued to successfully develop its products (high-resolution monitors and color printers), and the stock went to over $60.

As a guideline, Murphy views technology stocks as fairly priced when price-to-growth-flow ratios are around 10 to 14; anything under eight is cheap and below five is a real bargain; 16 and over is too expensive.

Murphy provides a number of other useful rules of thumb for using the price-to-growth-flow model:

Compare the price-earnings ratio to the price-to-growth-flow ratio. If the price-to-growth-flow figure is a small fraction of the price-earnings ratio, it is a strong indication that the market is mispricing the stock by placing too much emphasis on current earnings. Murphy contends that this is a common problem among Wall Street analysts.

Compare the price-earnings ratio to the percentage of sales spent on R&D-for example, a price-earnings ratio of 13.3 and 19.6% of sales spent on R&D. In general, if a company's price-earnings ratio is below its percentage of sales spent on R&D, the stock is worth a look.

When examining R&D spending, pay attention to the actual number of dollars being spent. Many firms can spend $3 million; a lot fewer can spend $30 million. As the sheer dollar amounts get larger, there are few companies that can afford to spend at those levels, and with less competition, the payback should be even greater.

As a final screen we specify eight as an upper limit for a company's price-to-growth-flow ratio. Murphy recommends tracking a small universe closely and taking advantage of price drops when the market pounces on a company's mistake.

Like all screens, this represents the first step in the investment process, but it provides an interesting starting point when looking for ideas and an analytical framework to analyze companies. The growth-flow valuation technique should help to keep greed at bay when pursuing technology stocks.

Part 4: Building and Managing Your Portfolio

Taming Risk

The volatility of technology stocks is well-known, and Murphy does not try to play it down.

One approach Murphy suggests to quantify risk is to examine downside risk-the price to which a technology stock may plummet if everything turns sour. To estimate this, Murphy uses three worst-case valuation estimates:

· The price-to-sales ratio drops to 1.0.

· The price-to-book-value ratio drops to 1.5.

· The price-earnings ratio drops to one-third of the growth rate for the last three years-for instance, if the growth rate were 30% over the last three years, the worst-case price-earnings ratio would drop to 10.

Murphy determines the price level for each of these scenarios and then takes an average of the three. For instance, if sales per share were $7.84, the first downside price would be $7.84; if book value per share was $7.23, the second downside price would be $10.85 (7.23 × 1.5); and if the growth rate was 36.3% and earnings per share were $1.92, the price-earnings ratio would drop to 12.1 and the third downside price would be $23.23 (12.1 × 1.92). The average downside price would be $13.97 ([7.84 + 10.85 + 23.23] ÷ 3).

The difference between the current price and the downside price, divided by the current price, produces the percentage risk of the stock-in other words, the percentage amount the current price would fall if the worst were to happen. Obviously, the lower the percentage risk, the better. A downside risk of 50% is common, and a good buying opportunity occurs when the downside risk is only 25%.

Portfolio Building

Another important aspect to controlling risk in technology stocks, according to Murphy, is to diversify among the seven major groups:

· Semiconductor equipment producers (companies that make the equipment that makes semi-conductors);

· Semiconductor producers;

· Large computers;

· Personal computers;

· Software;

· Communications, including data communications (computer-to-computer data) and telecommunications; and

· Medical technology, including both biotechnology and medical devices.

Murphy's book includes a considerable amount of information on each of these industries, including descriptions about what drives the industry, its growth cycles and expected changes.

Murphy suggests that investors build a portfolio of at least 10 stocks, with companies from each of the seven industry groups. Keeping an eye on diversification among the various industries is particularly important, he notes, because at any point in time, the cheaper technology stocks are likely to be within one group; paying attention only to valuations, and not to your portfolio mix, can lead to a dangerously concentrated group of holdings.

For portfolios up to $300,000, he suggests holding up to 12 stocks, and for portfolios over $300,000, he would increase the number of holdings to 20. However, he says 20 is a good upper limit, since it is difficult for individuals to track more than that number. If new money is added to the portfolio, he suggests adding proportionately to the existing holdings, or putting more in those that are more undervalued rather than buying a new stock. If you simply must buy a new stock, he suggests selling your least attractive. This approach, he says, not only keeps the portfolio to a manageable level, but also is a good way of pruning shares.

When to Sell

Murphy provides one sell signal on the upside: Sell if the stock's price-to-growth-flow ratio gets as high as the growth rate. However, in general, he suggests that investors use relativity to guide their stock sales-sell when there is a better stock to buy, rather than simply because the stock has gone up in price. On the other hand, if the stock grows so much that it represents more than a third of your portfolio, he suggests that it be trimmed back, with the proceeds reinvested in the most attractive other holdings.

What if prices fall? If the stock is still attractive on a price-to-growth-flow basis, Murphy says these are great buying opportunities. However, if the fundamentals have changed, or if management appears to be failing-for instance, new products do not get out, or management seriously misleads shareholders-sell.

Murphy in Summary

Murphy is firmly wedded to the notion that technology is the major force in the economy. Because of that, his recommends that individuals commit a high percentage of their total assets to the area: 100 minus your current age. That's probably too high for most investors to stomach, amounting to total domination of many investors' stock portfolios. Nonetheless, Murphy's book provides a solid approach for individuals who want to invest in technology stocks, combining elements of both the growth and value styles of investing. It also provides an excellent overview of the industry. Murphy summarizes his approach best:

"Investing is a two-step process. The first step is to identify situations-managements, products and markets-with which you would like to associate your capital. The second step is to decide what price you are willing to pay to associate your capital with those situations. "[Individuals should] focus on a small list of superior companies with rapid growth and excellent financial ratios. Then wait for each of them to get knocked down by Wall Street to the point where they are cheap on their price/growth-flow ratio."

^ back to top ^