Don't avoid quality 'growth'

It was by no means a universal outcome, with some of the smaller cap companies delivering unexpected negative surprises, but the Technology sector crowned itself as the best performing segment on the ASX throughout the August reporting season.

It wasn’t just about WiseTech Global (ASX: WTC), whose share price has been handsomely rewarded this year (40% up post August result), but equally about Car Group (ASX: CAR), Hub24 (ASX: HUB), Pro Medicus (ASX: PME), REA Group (ASX: REA), ResMed (ASX: RMD) and smaller cap companies such as Bravura Solutions (ASX: BVS), Breville Group (ASX: BRG), Codan (ASX: CDA), DUG Technology (ASX: DUG), Electro Optic Systems (ASX: EOS), Life360 (ASX: 360) and Temple & Webster (ASX: TPW).

Not all of these names are part of the local Technology Index, but respective core businesses very much revolve around innovations and keeping up with the latest developments in technological advances and breakthroughs. In extension, we might even include some of the direct beneficiaries of Gen.Ai, Goodman Group (ASX: GMG) & Co, which are not technology companies in se, but their growth momentum and attraction are very much related to the latest megatrend, which is technology-driven.

For most of these companies, in particular the large caps, August has not been a one-off. Anyone opening up a 10-year historical price chart, or longer, can easily see how strong, consistent and prolonged the rewards for loyal shareholders have been.

Taking into account how both banks and resources tend to go ‘missing’ for long periods of time, there’s but a fair argument to be made achieving positive returns from the local bourse has become a lot easier through Technology in the post-GFC era, which still continues.

As I have observed on multiple occasions over the years past: the local Technology sector offers Nasdaq-alike returns, or better. Yet, your average Australian investor might be forgiven for completely missing that point.

From mainstream media to local newsletters and tip sheets, most reports and commentary revolve around banks and other financials, and about mining companies and energy producers, China, coal, lithium, housing, dividends and franking.

Only occasionally there’s time and space left for your typical high-achieving local Technology champion.

Why is this so?

At the recent Livewire Live 2024 conference, Dushko Bajic, head of Australian equities growth at First Sentier Investors, suggested Australian media, and by extension Australian investors, are misguided by their perception of what makes an attractive investment.

Most commentary around local Technology companies focuses on the elevated Price-Earnings (P/E) ratios these stocks trade on, and that’s usually where the attention stops.

Indeed, if a high P/E automatically translates into dismal investment returns ahead then the companies mentioned have collectively done an excellent job in proving otherwise.

Bajic also made the point the Australian share market harbours some of the best Technology companies in the world. His number one favourite? WiseTech Global, still.

Others with dedicated interest have throughout the years past expressed similar views, including myself. This does not change the fact your average Australian investor is constantly directed towards ‘cheap’ looking small-cap cyclical and dividend-paying financials, away from the better performing, ‘expensive’ looking segment.

To help those who’d like to overcome their natural inhibition against investing in higher-valued, champion performers, let’s address some of the issues seldom discussed or explained.

Our starting point is by acknowledging Technology stocks on the ASX do trade on P/E multiples that are well above the market average, not to mention banks and resources that usually trade on below-average multiples, making stocks like Pro Medicus or WiseTech Global look extremely expensive.

Equally important, when comparisons are made with international peers, usually in the USA, multiples on the ASX tend to be noticeably higher as well. The usual complaint made is something along the lines of: I can buy Microsoft or Apple while trading on much lower multiples, why would I bother with WiseTech shares or Pro Medicus on such high multiples?

An expert like Bajic would defend the local choices by stating they are among the highest quality performers globally, often grabbing market share and exerting dominance in sectors and sub-sectors that offer faster growth with fewer threats from regulatory intervention, while allowing for higher margins behind a solid operational moat.

A recent study by analysts at Canaccord Genuity backs up that view, concluding the better-equipped Technology performers on the ASX offer world-leading financial metrics, placing them among the best of the best, globally.

It is equally true that the ASX offers less choice for institutional investors who’d like to stock up on exposure to high-quality growth performers, and this probably means these investors have to accept that seeking out quality growth locally comes with a higher price tag.

The latter is often highlighted by your typical value investor as a stern no-no, but it’s important to also highlight the first factor, as well as the fact none of the above has prevented the local sector from delivering above-average returns over extended periods.

Just like CommBank’s (ASX: CBA) premium valuation has not prevented Australia’s largest bank from delivering superior returns vis a vis the rest of the local sector over the past 15 years.

Within this context, Bajic referred to WiseTech Global shares that debuted on the ASX at $3.35 in April 2016 and have traded on an average P/E of 75x since. Sounds expensive? The share price today is $133 for a total market cap of $43.68 billion, making WiseTech a Top 20 member locally by company size.

For those who like to see numbers: the total return over 8.5 years is 3,870.15% or 47.22% CAGR per annum.

Others have equally provided outsized returns, be they Hub24, Pro Medicus, REA Group, TechnologyOne (ASX: TNE), Car Group or Xero (ASX: XRO), and over longer periods as they listed much earlier.

One observation to add is the number of IPOs has pretty much dried up in recent years while numerous promising names have left the ASX, including Altium, Elmo Software and Nearmap while others such as ReadyTech Holdings (ASX: RDY) and Bigtincan Holdings (ASX: BTH) might soon succumb to take-over interest.

The good news is expectations are building for a pick-up in fresh IPOs which should add new ideas to the bourse for investors. Canaccord analysts report the relatively higher valuations on the ASX to make it extra-attractive for technology companies to list locally.

Which brings us to the most tricky part of this story: if not by P/E ratio, how does one ‘value’ these high-performing, high-quality, sustainable growth companies?

I often refer to consensus price targets myself, but many of these companies have repeatedly, if not persistently, traded above targets set by analysts, which yet again feeds into the perception these stocks are always too expensive, keeping investors at bay.

As such companies’ valuation typically benefits from lower bond yields, I’d wager some additional premium is built in because of bond markets pricing-in aggressive cutting from the Federal Reserve & Co (though continued robust growth is what ultimately makes the share price trend upwards).

The study by Canaccord Genuity concludes the best valuation methodology remains the so-called Rule of 40, whereby revenue growth and EBITDA margin combined sum up to 40 or more. Companies that outperform are typically those that can accelerate either top-line growth, expand their margin, or both.

Looking back at FY24 results in August, Canaccord Genuity has highlighted Bravura Solutions, Catapult Group International (ASX: CAT), Domain Group Australia (ASX: DHG), Superloop (ASX: SLC), Objective Corp (ASX: OCL), Praemium (ASX: PPS), Megaport (ASX: MP1), Nuix (ASX: NXL), Smart Parking (ASX: SPZ), hipages (ASX: HPG) and SiteMinder (ASX: SDR).

The obvious observation to make is most of these companies are still loss-making or making a comeback from not-so-great times. This means their current momentum might not last and prove temporary only.

Also, as witnessed in August, smaller cap growth companies are more at risk for succumbing to the unexpected hiccup than the larger cap peers mentioned.

Think Audinate Group (ASX: AD8), for example, or Hansen Technologies (ASX: HSN).

Also taking into account a company’s return on invested capital (ROIC) refocuses the attention towards the better capital allocators. Canaccord’s study highlights some with the highest ROIC: Netwealth Group (ASX: NWL), Pro Medicus, Jumbo Interactive (ASX: JIN), RPMGlobal Holdings (ASX: RUL), TechnologyOne, and REA Group.

For those who’d like to still get on board some of Australia’s prime success stories, but do not want to overpay for the privilege, the strategy that suits best might be to draw up a short list of desired exposures and wait for that calamity that eventually will impact on the share price.

Another strategy might be to start nibbling but keep enough powder dry to purchase more exposure over time. If share prices rally higher, you may not have the full allocation, but you are benefiting already. If the share price falls, you’re averaging in with a longer-term focus.

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