Over the past decade, our society has witnessed tremendous technological advances that have fundamentally altered how we live and work. The uptake and pace of these developments, whether it’s the meteoric rise of e-commerce and food delivery apps or the significance of semiconductors in maintaining the conveniences of modern life, have been accelerated during the Covid-19 pandemic in ways that would have previously been impossible to predict.
As a consequence, you might anticipate that technology-focused fund managers would be witnessing their best performances to date, but this isn’t the case. Most technology funds underperform most technology benchmarks in most years, often by quite a lot.
Investors tend not to notice this fact as, in absolute terms, their technology investments do quite well and perform better than their other investments – they may well have returned 20-25% a year over the past three years. However, in most cases, this still falls short of an industry up 25-30% a year over the same period, as measured by index performance, and fund managers have sought to draw attention away from this fact by adjusting their benchmark to include telecom and media stocks, or by comparing their fund’s performance to other technology funds, many of which will also be lagging behind the benchmark.
In contrast, BlueBox has outperformed the benchmark by a comfortable margin, returning an annualised net return of 31% since our launch in 2018. So, what do successful technology investors do differently?
Avoid constant change and high turnover
Investing successfully in technology isn’t about trying to jump on each hot tech stock or investment theme and then onto the next. Instead, it’s about thinking very carefully about the underlying trends that are driving the sector’s long-term growth, and then investing in the companies key to those trends.
Technology stocks have consistently outperformed non-technology stocks for the past 10 years for one very clear reason: the information technology sector accounted for all the earnings growth of the entire economy over this period…which is, to say the least, very abnormal indeed.
The reason for this peculiar state of affairs is, in our view, due to a fundamental change in the way technology operates that began in about 2005. We describe this as direct connection, by which digital computers have begun to interact directly with our real, analogue world.
In the 20th century humans translated real-world problems into digital questions that a computer could understand, generally using a keyboard. Once the computer had done something very clever, we would need to interpret its digital output (on a screen or a printout), and we, the humans, would then act on the world. We were the input and output devices for the system, translating analogue to digital and then digital to analogue.
Today, with the internet of things, GPS, and all manner of sensors in everyday objects, the computers in our lives increasingly understand some aspects of the world directly, without needing a human with a keyboard anymore. They also now act directly on the world: through automation and robotics, the system is no longer just suggesting what humans should do, but actually changing the world itself.
As a result, humans have been removed from the loop, and thus processes now run millions of times faster, because we humans were by far the slowest bits of the system. And if processes can run millions of times faster, hundreds of times more applications become viable: stuff that was simply impossible in 2000 is now just “very difficult indeed”, and the tech sector is all about making “very difficult indeed” happen!
Enablers not disrupters
Many of today’s disrupters are benefiting from this underlying technological trend of direct connection.
Take Uber as an example. When compared to a minicab firm, Uber has dispensed with the human operating a phone to take your order as well as the dispatcher sitting in an office, organising rotas, and radioing a cab driver to pick you up.
Instead, Uber, by making use of your phone’s GPS, the driver’s phone, and a range of back-end software, has negated the need for human input beyond you typing in your destination. As a consequence, Uber has disrupted this segment of the transport market and can operate largely without human involvement, which is many times more efficient than the traditional cab company.
This is not only true of Uber, but also of every other company disrupting their industry with technology, whether that be retail and e-commerce, healthcare and health-tech, manufacturing and industrial automation, or banking and fintech: each disruptive innovation relies upon directly connecting systems to the real world, and thus removing humans from the loop.
However, the disrupters themselves often make poor investments.
Most disrupters do not make any money. In fact, they’re much better at spending it. Think Deliveroo, Peloton, Slack, WeWork, Uber and Lyft.
Worse yet, disrupters’ competitive edge is quickly diminished once their peers invest in analogous technology and they are, in turn, eventually eclipsed by a new disrupter.
Focusing on the technological ‘enablers’ is the more prudent move for long-term technology investing. These are the companies selling the modern-day equivalent of pickaxes and shovels in the gold rush.
EPAM is a good example of a technology enabler. EPAM enables non-tech companies to benefit from direct connection by connecting and digitising traditional products or services, which encompasses everything from building a system that enables customers to track their parcel deliveries, to automating drug discovery and development for a large pharmaceutical company. EPAM applies digital transformation to a vast range of industries and customers, which has enabled it to generate healthy profits and then to grow them around ten times in nine years – putting its shares amongst the world’s best-performing large-caps since its 2012 IPO.
Avoid ultra-high growth
EPAM may not be as exciting as a company like Tesla, and it may not grow revenue as fast as Tesla, but its profitability is in striking contrast to Tesla and many of today’s other most popular disrupters.
It’s an awkward truth that many of these disrupter companies are built for growth and for the pursuit of market share in the hope that they will displace the traditional industry incumbents. This comes at the expense of profit and long-term sustainable growth.
Take WeWork: its founders and initial backers ran the company to grow as fast as possible, in order to attract venture capital investment. It was tremendously successful in this respect and raised a lot of money. In particular, huge sums came from SoftBank’s Vision Fund to fuel further growth – whatever the cost. This entailed ignoring the basic economics of business, and once a company has been run like that for a few years, it becomes almost impossible to transition it into an inherently profitable enterprise. Ultra-high growth and profitability are in effect mutually exclusive aims for a business, but in the long run only profitability creates value for shareholders.
Of course, investors can make a terrific amount of money getting into and out of these companies at exactly the right time, before anyone else realises that they aren’t worth anything, but that timing is the tricky bit.
Ultra-high growth companies are obvious to everyone in the market, they’re expensive, and, if a company is growing at two hundred per cent, then it will inevitably slow down. Predicting when that happens can be very difficult.
So, when sentiment turns against these businesses, their valuations, bolstered by investors’ fear of missing out, collapse as they’re entirely disconnected from the company’s fundamentals. The nice thing from an investor’s point of view is that there are always more of these companies falling than going up – so you can just ignore the whole lot of them, and already be ahead of market. FOMO is the single most dangerous emotion in technology investing!
Profits now (or very soon)
The traditional hallmarks of a good investee company are something that technology investors often dispense with; preferring instead to focus on a strong underlying technology trend and high barriers to entry in hope of identifying the next ultra-high growth company.
Now, those indicators in themselves are not bad – we look to identify companies aligning with a technological trend, direct connection, and high barriers to entry. However, we also want the often-overlooked ability to create economic value for outside shareholders (our clients) from that trend.
So, we are looking for four things in an investment:
- A strong technology trend;
- An ability to create economic value from that trend (profits, free cash flow);
- Barriers to entry; and
- A reasonable division of the value created between outside shareholders and other stakeholders.
In every other sector, most investors are also looking for all four of these factors, but technology investors focus almost exclusively on number 1 (revenue growth) and number 3 (a strong product). They buy a company growing fast with a great product, and expect it to outperform…but are then surprised when this doesn’t work very well.
That’s because there is a general misunderstanding about what the role of “technology investors” is: people think that the job of technology investors is to invest in technology…but it’s not! The job of technology investors is to invest in technology companies, and a company has to create economic value for its outside investors at some point in its history or it is worth nothing – it was never worth anything, and it will never be worth anything. You might be able to sell it for more than you paid, but that is largely a matter of luck and very difficult to do consistently. And yet that is what everyone is trying to do!
In contrast, to be successful, investors need to centre their approach to technology around the understanding that their role is not to invest in the technology trend itself, but to invest in good quality technology companies that can deliver economic value by enabling that trend.
It’s also crucial to understand who captures the value being created by the business and, in the technology sector, there are generally five main issues to be aware of:
- Stock-based compensation that delivers most or all the value to insiders – often the scarce but crucial software engineers.
- Frequent, expensive technology company acquisitions that deliver value to sellers as a result of absurdly inflated valuations.
- Avoiding accountability, whether that’s through self-appointed boards or non-voting shares, which tend to indicate a business run in the interests of management not shareholders.
- Lack of business focus, whether that’s overly focusing on growth or pursuing technological leadership (the perfect, over-engineered product).
- Repeated restructurings, which lead investors to over-estimate the underlying profitability of a company.
Helpfully, these flaws in the business model all tend to be recorded in the same place: the pro forma adjustment to earnings and EPS. This is because these are issues that investors don’t like to think about. So if you want to find out the biggest problem with a tech business, have a good look its pro forma adjustments.
Don’t focus on the mega-caps
If we take mega-cap to mean a company with a market cap of more than 1% of the S&P500, or roughly $300bn, we are left with seven firms: Apple, Microsoft, Visa, Mastercard, Taiwan Semiconductor, NVIDIA, and Samsung Electronics.
These seven companies dominate technology indices, often comprising more than 40 per cent of global technology benchmarks, which means that if you own a passive global tech fund, almost half your capital is tied up in just seven companies – a total that rises to more than half the investment in just five companies in the context of a passive US tech fund.
In actively managed funds, this problem can be even more acute, as they will often also own Alphabet, Facebook, Tencent, Tesla, Amazon & Alibaba, which are not technology companies, but consumer and communications stocks. The result is that active tech funds will often have more than half their capital invested in these 13 mega-caps.
That really doesn’t seem very clever: in technology, mega-caps are the companies that won the last round of disruptive innovation and they have everything to lose in the next round, so most of your capital is tied up in a series of companies with their best performance days behind them.
In contrast, focusing on stocks with a market cap of $10-100bn is the sector’s sweet spot. These companies are established, have plentiful liquidity, and when one of them takes off, it can become a mega-cap, meaning an increase in value of thirty times or more.
This growth isn’t possible at the mega-cap end of the market. For example, were Apple to double in size, that would make it a $4 trillion company. But is there currently enough money in the market to support that kind of valuation? Probably not, as it would make Apple a bigger proportion of the S&P than any company before it.
2020 was an exceptional year for many of these mega-cap companies and the temptation to try to catch their next growth spurt or to pile into the next great tech trend, as proclaimed by a celebrity CEO or social media stock picker, has been heightened with all the time we’ve recently being spending online and at home.
However, avoiding this groupthink and decisions driven by the fear of missing out is core to securing long-term sustainable growth.
Indeed, the traditional rules of investing apply to the Technology sector too: continue to screen for the traditional characteristics of good quality, profitable companies that are on the right side of long-term technology trends; do not be taken in by those who promise a lot and under-deliver; ensure holdings are diversified and not focused on yesterday’s winners; and understand what you buy and why.
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