Quality tech stocks and how to pick'em

Tech - it’s a sector that local investors just love to hate, but if you didn’t own a handful of these high PE names of late you missed out on some stellar price action. In August just four technology stocks generated ~60% of the returns for the small ords.

Stratospheric multiples and skinny earnings have worked a few investors into a froth, the reality is that the quality of tech companies in Australia is improving and we’re going to see more of them coming to market.

In this discussion, Oscar Oberg from Wilson Asset Management and James Dougherty from Lennox Capital deliver their insights on successfully investing in tech and share their views on the highest quality tech stocks on the ASX. 

Access via the video player or the edited transcript below.

James Marlay: Aussie investors, we tend to be a bit sceptical about investing in technology companies. What's your view on how to approach investing in the tech sector? 

James Dougherty: I think scepticism is probably not a bad mindset to approach any investment in a technology company. It's a very, very competitive space. So yes, the business models generally have large operating leverage, and that can generate extraordinary returns for investors. But that attracts a lot of capital and a lot of competition to the space. So, for us, scepticism is good. And then the three key things that we look at are: Is the technology compelling? Are the market dynamics’ favourable? And then finally, do management and board understand what they need to do and are they strong? 

James Marlay: Oscar, do you agree with that analysis as a starting point for looking at tech stocks in Australia? 

Oscar Oberg: Absolutely. I think you have to be a sceptic when you're looking at this sector. At WAM, how we approach the technology sector is to approach it like any other sector that we're looking at. We're looking for a catalyst, and we're trying to find an undervalued growth company.  

So I think with a lot of these stocks given the high valuations, it's very important to focus on sales growth and also market share. What you want to see is market share accelerating, and when you do, these tend to be very good investments. But at the right valuation. 

James Marlay: So what are some of the key markers that you're looking at when you're screening out these stocks; to say, "This is one's quality and worthy of better investigation or further research"? 

Oscar Oberg: I think earnings qualities is a huge characteristic that you need for these stocks. And certainly there are a number of accounting tricks that these stocks can play, and whether it be extending the life of software assets, to reduce your amortisation expense. Or capitalising your research and development, which can inflate earnings. So how we look at things at WAM is we're trying to find companies that are generating very solid cash flow and also expensing the research and development. We tend to find that these are the high-quality investments.  

James Marlay: James, anything to add to that? Are there any signs that maybe give you an early indication that the company's going to be higher quality than the others in the tech space? 

James Dougherty: Coming back to what I said about the three things that we largely assess a technology company on. We look at the quality of the technology, so do they have a clear competitive edge over some of the peers in the space? Is it easy to adopt? Does it maybe have a network effect, which means over time, that those sales would become self-perpetuating, and then you get that operating leverage, which is so attractive.  

Then you look at the market dynamics. Again, how competitive is it? Also, is the market large enough that you are going to generate an adequate return on that initial R&D investment? That's really important. And then you need the captain of the ship to understand the marketplace, to understand the business model when they're going to ultimately maximise the value creation out of that technology. 

James Marlay: I think it's fair to say that we're looking at these stocks on a different valuation scale to just about everything else that's taking place in the market. Do the traditional metrics like your PEs and that sort of stuff go out the window? How do you reconcile that? 

James Dougherty: I think you still need to be disciplined with valuation. Just throwing valuation metrics out of the window makes it very difficult to really understand these businesses. But near-term metrics make it difficult, provided there is a large market that they can address, or that they can penetrate. So if you're using a PE, maybe use the E that is a few years in advance, that's going to capture that growth. Or maybe you should think about present valuing the future cash flows that this business will create as they slowly penetrate the larger market. 

James Marlay: So looking a bit further out? 

James Dougherty: Yeah, I think that's necessary with technology companies. 

James Marlay: Oscar, anything to add to that on valuation? 

Oscar Oberg: Totally agree with James on everything he said just before. I mean, that's certainly how we look at these companies. But I think you go back to valuation. It is incredibly important for investors to monitor valuation. Otherwise, it's possible you end up with a BIG Un or a GetSwift. And I think management plays a part in that. I think you’ve got to follow what management is doing. Do they have plenty of skin in the game? Are they buying and selling shares? And are they continually beating expectations?  

I think using Afterpay as an example, one of the things they've done very well is they've had a huge inside ownership from the key management team, and have continually beat expectations in the market, ever since they listed. 

James Marlay: Well, you've thrown out a couple of names there. A couple of the higher quality and a couple of train wrecks. What's your assessment of the opportunity in the tech space in Australia right now? Has it got better over time? Are there more opportunities than historically? How do you look at that little universe? 

Oscar Oberg: It's definitely gotten better. And there's no doubt we're going to see more of these companies come to the market through an IPO into the future. I think it's, again, going back to valuation and separating those companies with a true competitive advantage. And those that don't have a competitive advantage. It does feel like there's a lot of companies out there, who basically say that they're a technology company when in reality they're not. And so I think it's very important that investors start to basically go through them and find the quality companies out there. 

James Marlay: James, some of the companies that have been at the forefront of the technology space, they've had quite volatile periods. How do you think about that in terms of stocks that might suit your characteristics, and pass your threshold for what you're looking at in terms of characteristics? But the valuations are swinging so wildly that it's creating a volatile ride? 

James Dougherty: I think it's a really good point. And what Oscar said, the opportunities for companies that we can look at are certainly expanding. There's a lot more interesting and good technology companies in the ASX listed space. But maybe investment opportunities right now are becoming a little bit limited because of those valuation hurdles, and because these things largely are overvalued across the board. So you do need to be disciplined with valuation. If you take a long-term view, then you should be able to capture the growth. If the short-term share price is capturing all the upside, then that's probably telling you something. 

James Marlay: Let's get down to nuts and bolts. I asked you to bring along a stock, a technology stock, that you think passes your filters? James, I'll let you kick off. 

James Dougherty: I think arguably one of the higher-quality technology companies listed in the small-cap space today is Altium (ASX:ALU). There's a lot of high-quality attributes of Altium. But if I could focus on one, it would be the management team. The depth and experience within divisional management and the top management are pretty impressive. Add to that you've got a CEO, Aram Mirkazemi, who has really been at the forefront of stating or articulating a growth strategy, setting measurable, clear targets, and exceeding them repeatedly. They currently have a growth strategy up to 2025, which is pretty unusual in our space. The CEO and the chairman, Sam Weiss, both have a significant investment in Altium. They're aligned with minority shareholders and they act that way. 

James Marlay: Oscar, your chance. Can you beat that? 

Oscar Oberg: Well, I was actually going to say Altium as well. I agree with James, that Altium, for us, consistently generates very strong cash flow. And it expenses all its R&D, it's just too expensive for us at this point in time.

If I had to name another stock that we own, that we like is Infomedia (ASX: IFM). I think recent results being very positive for its Superservice division. And they've fully cycled through the loss of their contract 12 months ago. So, we see a very strong pipeline for organic growth and acquisitions in that business. 

James Marlay: Aussie investors might be sceptics on technology, but it sounds like the quality's getting a little bit better down under.