Why structurally growing tech stocks are highly regarded and valued by investors.

The western world was already awash with growth headwinds before the COVID-19 pandemic, including demographics, debt and the adverse effect on employment from the technology efficiency dividend.  

By way of example, the working-age population in Japan has been declining for over 25 years and in Europe for the last decade. Europe and Japan are finding it hard to sustainably grow and consequently, it is challenging to find a government (risk-free) bond in these markets with a positive yield.  

About the only thing growing sustainably in the west is debt. Western economy debt levels accelerated after the Global Financial Crisis (GFC), and achieved warp-speed after global economies stopped dead in response to the COVID-19 pandemic. Clearly, to tolerate record debt piles, low interest rates must be maintained.

Meanwhile, technology is playing its part, with huge swathes of the western world’s “knowledge workers” facing disruption from technology.  

Western economies and markets are also now “centrally planned”, with central banks injecting just enough, but no more, support than needed to sustain economic activity above zero. The world we live in today is therefore a low-growth, low-interest-rate and low-return world.  

There are positives, however, and one is that stocks in structurally growing companies, including technology, are regarded and valued highly by equity market investors.

Structural growth

A centrally planned, low-growth world is a problem for cyclical businesses as there is insufficient economic energy – even at the right point in the cycle – to render these companies attractive. And with that veneer of growth gone, the risk increases and the investment appeal declines. 

In contrast, structural-growth stocks look appropriately prepared for this low-growth world. These companies have their growth destiny in their own hands, and importantly the growth is not dependent on the economic cycle. 

The best structural-growth companies have the DNA of market share-takers and grow by leveraging their competitive advantages.  

The view of our Small Cap team – Gary Rollo (Gary’s first real job was as a technology consultant over 25 years ago and technology has been part of his professional life ever since) and Dominic Rose – is that investing in structural growers in a low-growth, low- interest-rate and low-return world is a more profitable, and lower risk, investment strategy than trying to invest in cyclical stocks with their fortunes tied to a weak economic pulse.  

Technology: what to look for

The key for investors is to think of growth, like any other commodity. It is priced on supply and demand. As “growth” becomes scarce, and concentrated in certain sectors, like technology, it becomes more valuable. And under the “lower for longer” scenario, growth also becomes more expensive (more on that soon).

The trick is to look for tech companies that have:

1. Large addressable end markets that offer a multi-year runway for growth;
   
2. Products with an inherent competitive advantage that have earned the right to take market share, preferably against less-nimble competitors.  
   
3. Business models that offer scale, so that when sales growth emerges there is “line of sight” on a deep, fast-growing, defensible profit pool.  
   

Of course, management needs to be credentialed, as well as resourced for the task and preferably with adequate skin in the game – investing their capital alongside ours. 

It is helpful to establish and maintain access to many stakeholders, including customers, competitors, regulators and management.  

Technology megatrends: E-commerce, Digital Payments and Cloud

In Australia, there is no bigger technology trend than e-commerce. Australian consumers have shown strong appetite and preference for convenient e-commerce experiences and COVID-19-related lockdowns have accelerated that trend.  

Roughly 11 per cent of consumption is conducted online in Australia, but this is merely half that of other jurisdictions. The lower penetration means there is a long runway for growth.

Another theme is the trend to digital payments. By way of example, 75 per cent of customer banking now occurs online and consequently the technology that enables banking, payments and transactions digitally is growing exponentially.  

A third megatrend we have a particular affinity for and believe is a resonant value driver for the small-cap investment universe is represented by cloud-enabling technologies. 

Cloud-deployed technology tools effectively allow small companies to have access to capabilities hitherto only affordable by large companies. 

Are tech stocks expensive?

Technology company stocks can be hard to value because a large portion of their value is future dated and therefore subject to greater uncertainty. Because future earnings power is hard to forecast, dependence is placed on a competitive advantage playing out and on management’s ability to deliver.  

Just as you would not value a property development on the income it receives before construction, it makes sense to consider what a growth stock might earn in the future and value it on that basis with adjustments for the risks and time associated with success.

Technology stocks are often described as being over-hyped and overvalued. Investors in the space are also often dismissed for expecting too much.   

The table below shows the returns of several mega-cap technology companies. You would expect the likes of Microsoft (MSFT) – 34 years at 26 per cent return per annum, Amazon (AMZN), and probably Google (GOOG) to have been investments with fantastic returns, and they have been for many, many years. 

But what about those tech companies that were floated with huge valuation frameworks? Facebook (FB) and Alibaba (BABA) were both floated at market prices deemed unrealistic by many commentators at the time.  

Despite these objections, both companies have successfully leveraged their competitive advantages to grow into their initial valuations and beyond. Consequently, they too have produced attractive returns.

Table 1. Mega-cap Technology Returns

Source: Iress, Montgomery Investment Management. Price in US dollars

Markets tend to focus on what they can see. With structural-growth stocks investors tend to underestimate the future and “fade” revenue and earnings growth in long-term forecasts. Consequently, future winners look expensive initially.  

But the optionality of market share-takers is not captured by such analysis. So, while many of these stocks do not look cheap, the megatrends beneath them may render them good value.

Finally, risk.

There are dangers in concentrating one’s portfolio in one or two technology hopefuls. Growth stocks can be volatile and share prices can head south quickly, even if only temporarily. 

At Montgomery, we deal with this risk by adopting a portfolio approach, spreading and layering our investments, with a risk-management emphasis on position sizing and thematic exposures. 

Our exposures are managed in real time, with each investment chronically re-assessed for every new piece of information. And that is after these stocks have earned the right to be included in the portfolio, which is no easy thing.