How to Play Cybersecurity Stocks Without Getting Burned


Nowadays, it seems that not a single month passes by without another high-profile security breach. It’s all over the news.

CyberSecurity stocks

Who can forget the humiliating Sony (SNE) hack? Or what about the cyber-attacks on JPMorgan Chase (JPM) or Home Depot (HD)? Or more recently, the news that data from OPM leaked, releasing financial data, social security numbers and much more, affecting no less than 22.1 million U.S. citizens.

As the public hysteria rises and high-profile hacks continue to hit the headlines, the valuation of cybersecurity stocks keeps breaking new highs. No doubt, the constant headlines get you psyched to buy into the sector.

Yet, a quick glimpse into the valution of some of the sector’s hottest names, like Palo Alto (PANW) and FireEye (FEYE), and you’re apt to develop the chills.

What if you’re a long-term investor who believes in the growth of cybersecurity stocks? Is there a way to play it without burning your hand? (Hint: The Hack ETF is not the solution.)

Cybersecurity Stocks Resting on Shaky Fundamentals

Don’t get me wrong, the rapid growth of names like Palo Alto, FireEye, CyberArk (CYBR) or IntraLinks (IL) is impressive.

Of course, what happens quite often is that fast-growing companies sacrifice profits for long-term growth. It should come as no surprise, then, that most of the “hot” names are either losing money or just barely staying afloat. But that’s not the problem.

The problem is the sector is capital intensive because of all the technical support personal that is needed in order to service existing and new clients. As can be seen below, some of the big names, invest almost all their revenue in SG&A (Sales, General and Administrative) to support their product.

How long can mid- to smaller-sized companies keep up with such high costs without their IPO money running out? Not long. Some have already taken out loans and credit to fund their expenses. And what happens if sentiment sours on the sector? Those same hot names will be forced to drastically slash their expenses and risk being left out of cash.

Now if valuations were reasonable, or even moderately high, then that might be bearable. Unfortunately, valuations are lofty, and so is the risk.CyberSecurity stocks
Click to Enlarge

The Solution: Follow the Cash

As a general rule, if you want to reduce your risk during periods of uncertainty, it’s best to focus on profitable stocks with strong cash flows. Cash flows enable those companies to manage relatively effectively with fewer loans or credit, meaning they can better weather difficult times.

Because cash is the biggest risk in cybersecurity stocks, what’s the best way to protect yourself? Follow the money. Allocate the most to the cash-rich and the least to the cash-poor.

You may think the PureFundsISE CyberSecurity ETF (HACK) or the First Trust NASDAQ CEA Cybersecurity ETF (CIBR), two of the newest ETFs that offer exposure to cybersecurity stocks, may offer just that … but they don’t. Both ETFs have high allocations in some of the riskier names we mentioned.

Cybersecurity Stocks With Cash

No need to wrack your brain trying to come up with some contenders for the high-weighted cash rich — that’s why we’re here.

Cisco (CSCO) has a strong net cash flow of roughly $12 billion per year and little dependency on loans. Check Point Software (CHKP), the archrival of Palo Alto, has a positive cash flow and little dependency on credit, all while being profitable.

Those are the Cyber security you might want to allocate more to while Palo Alto and CyberArk should have a lower weight. Of course, the potential upside may be more moderate, but as Warren Buffett likes to say, the first rule of investing is not to lose.

As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.

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