The 2 ASX tech companies this investor would hold for the next 5 years

When you think of tech, chances are you think of Silicon Valley. And while Australia’s tech sector may seem like a drop in the ocean given its tiny size, Fidelity’s James Abela believes investors shouldn’t discount the innovations and potential in this space.

Even better, there’s breadth and depth to the opportunities, meaning you aren’t looking at the concentration risks of the US tech sector.

“I wouldn’t forget broadly in technology that we still have Fintech, education technology, medical technology and then just general software technology. There are four angles of technology you can get exposure to,” says Abela.

In fact, Abela's two top picks come from the med-tech and fintech segments, both where he sees the potential for significant future structural growth.

In this episode of The Pitch, Abela discusses the Australian technology sector, key risks and opportunities and his two top tech picks for the next five years.

This interview was filmed Wednesday 7 August 2024

Edited transcript

The Australian tech space has actually been very innovative over the last 20 years. You’ve had Seek (ASX: SEK), REA Group (ASX: REA), Carsales.com (ASX: CAR), Altium (ASX: ALU), Resmed (ASX: RMD) and Fisher & Paykel (ASX: FPH). 

That’s just seven I can mention that are innovative and across a range of sectors, like software and medical tech. For me, there is a lot of innovation in the Australian market and in some things, we have actually led the world. I think Australia is still quite an exciting place to be.

Does Australia hold the same concentration risks that we see in the US?

The US is much more dominant in their IT exposure in their indices. The Magnificent Seven are each up to $3 trillion in market cap so that concentration has been really high. We don’t have the same concentration risk in the Australian market. In mid and small-caps, it is small, around 10% of the index and that is not high compared to the US.

What do you see as the key opportunities and risks for the Australian tech space?

The key risk is valuation. Valuations have gotten up there because Australia is ultimately quite a narrow and shallow market. When you do want to get exposure to certain themes or stocks, the number of stocks you can buy in that universe is quite small which tends to push up prices and push up multiples.

For example, Pro Medicus (ASX: PME) is a med-tech business that is on 150x [earnings], Wisetech (ASX: WTC) is on nearly 100x. Two stocks, Netwealth (ASX: NWL) and Hub24 (ASX: HUB) are both around 40-50x. It’s a market that is on 18x, so valuation is a big issue in the tech space. But apart from that, they do have a lot of growth opportunities available.

What are some of the key opportunities you're watching?

Some we own in the Australian Future Leaders Fund are Netwealth and Hub24. I think the structural growth they offer is still very strong. They are still winning the market share of legacy systems from the big five that owned the market 10 years ago. They’ve come into the market with a new technology stack innovation and really strong service leadership and because of that, they are very flexible. 

That has allowed them to move with the market, which has changed dramatically in terms of fragmentation. A lot of advisers were in the big banks or had big groups, and now they’re fragmenting out and using their technology stack as their platform with higher service and more innovation. ETF innovations have also changed the market.

All these innovations have come, and I think technology leadership has been very important for advisers in the Australian market. Hub24 and Netwealth are dominating that space.

Touching back on valuation risk, which you mentioned is a key challenge, how do you manage that in the portfolio?

It’s a tricky one. Valuations do rise when it’s a quality and momentum cheerleading market because the market has gone from fear to recovery and that’s when quality and momentum multiples start to really expand.

I tend to look at three things generally: the PE level absolute, the PE level relative to the index and then the PE relative to the ROE, which is a bit of an unusual one.

Looking at Pro Medicus as an example.

The P/E is 150x, but the ROE is around 70x. The P/E to the ROE is around double, but if you look at just the absolute – 140x compared to the index at 18x, it just seems crazy. It’s nearly 9x the index. But if you look at it relative to its ROE, it's just over double the return on equity of the business. The multiple of the market is around 19x and the ROE of the index is around 10x at the moment, so that’s almost double itself. The extra relationship between the ROE and the P/E is almost similar to the benchmark.

That allows you to get your head around it because the ROE tells you what the organic growth potential of the business is. Then you look at the PEG ratio – the P/E to the G ratio - and just see what the PE is to the EPS growth on a one, two and three-year basis as well.

That’s how you start to get your head around valuation.

It’s much easier in quality. In momentum stocks, it’s much harder because you are always pushing your head three to five years out. Valuations can get excessive. We saw that recently with a few technology companies such as Audinate (ASX: AD8) and Life360 (ASX: 360) where valuations have gone up substantially because the market is looking at three to five years of growth. 

As soon as that growth disappoints, you can have a very sharp movement down, which is mainly multiples. Sometimes I don’t even have earnings and that’s where it is even more tricky. That’s when you have to look at the price-to-book and other things.

In quality, you have to look at P/E to ROE and then on momentum, it’s more challenging but there are several things you can do there as well.

What's the next big innovation that you are watching in the Australian market at the moment, and do you already hold it?

In the Australian Future Leaders Fund, we already hold Netwealth and Hub24, which I mentioned are in a beautiful space where they have a lot of market share gains for the Australian market and then can innovate into adjacencies and continue to grow on that basis. They are also high return businesses, high viability, high sustainability and high credibility businesses which for us, demonstrate the future leaders attributes you want to see.

I wouldn’t forget broadly in technology that we still have Fintech, education technology, medical technology and then just general software technology. There are four angles of technology you can get exposure to.

I’d encourage all investors to think about that because there is a lot of opportunity in technology generally, but there is a lot of breadth in terms of where technology is actually going. It’s software in healthcare, software in financials, and software in education. I think software businesses over the last 10-20 years have now facilitated themselves across a whole range of industries. I think that is exciting, even in the Australian market.

If you had to pick one Australian tech company to hold for the next five years, what would it be?

I’ll halve my bets and take two.

Pro Medicus would be one. I think it’s a really innovative radiology business that will continue to grow but valuations are very high.

I would choose Netwealth as the second one I would buy and hold because I know it is a great business that has a lot of structural growth ahead of it as well.

A portfolio of future leaders

James uses a rigorous bottom-up stock selection process that focuses on finding attractively valued companies with strong competitive positioning and sound company management.

ETF

Fidelity Global Future Leaders Active ETF (FCAP)

Global Shares

View