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It pays to be choosy when weighing tech stocks

Nicki Bourlioufas  |  08 Oct 2019Text size  Decrease  Increase  |  
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There are many reasons to like quality technology firms such as Afterpay, Altium and Wisetech but investors need to be mindful of inflated valuations and dubious business models.

Globally and in Australia, technology shares have had a mixed year. Locally, Afterpay Touch Group (ASX: APT) and cloud software provider WiseTech Global (ASX: WTC) have rallied hard, despite volatility in recent weeks.

In the US, Microsoft has led returns among the big technology companies. While gains could continue, experts are cautioning investors against buying overvalued stocks.

Microsoft has jumped among FAANG stocks - Facebook, Apple, Amazon, Netflix and Google-owner Alphabet.

Some of the major internet and marketplace businesses such as Amazon have been weaker over the year, even Google and Apple, due to rising competition or regulatory concerns. But over the longer term, the ultra-low interest rate environment will underpin the relative attractiveness of owning quality technology companies, says James Tsinidis, portfolio manager, Munro Partners.

“We currently see little long-term risk to the underlying earnings growth of our investments and hence we have maintained our core holdings throughout the recent volatility. We have chosen to use our hedging tools to mitigate the sudden bursts of volatility including deploying hedging around major tariff deadlines or meetings,” says Tsinidis.

Afterpay has pros and cons

Among local tech stocks, Afterpay has been one of the strongest performers, its share price having doubled over the last 12 months.

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Having recently been added to Morningstar's equity research coverage, the buy-now-pay-later company is growing its customer and merchant partner base faster than any competitor, and is exporting its technology to the US and UK.

However, Morningstar currently views the stock as overvalued. Afterpay currently trades at a premium of around 50 per cent to Morningstar's $22 fair value estimate, having opened at $33.70 on Tuesday 8 October.

Morningstar equity analyst Chanaka Gunasekera believes the company is in the early stages of its life cycle and faces challenges including more direct competition. Afterpay also needs high sales volumes due to low margins earned from merchants and the low dollar value of sales.

But his revenue projections are largely in line management's expectations, anticipating some $20.5 billion worth of financed sales by the end of fiscal 2022.

"This would represent an approximate quadrupling from $5.2 billion worth of financed sales in fiscal 2019, which in turn was up from $2.2 billion in fiscal 2018.

"Growth should primarily be fuelled by Afterpay's global expansion into the United States and the United Kingdom,” Gunasekera says.

Picking winners isn't easy

There are several factors benefiting the tech sector, including:

  • increased technology spending by corporates
  • the rise of cloud-based computing
  • expanding penetration of e-commerce.

But picking winners isn’t easy, and investors need to be very selective given the wide spread of stock prices across the numerous companies operating within the technology sector.

"There are certain stocks where the market has become far too optimistic on future earnings potential, with extreme overvaluations leaving investors exposed to painful corrections," says Sam Twidale from asset manager DNR Capital.

“With low interest rates pushing investors up the risk curve, there’s multiple signs investors have been disregarding traditional valuation measures. A clear sign of this is the number of tech IPOs with inflated valuations, negative earnings and questionable business models. We continue to avoid these."

Twidale emphasises the importance of a long-term view when considering tech stocks, and the focus on high quality businesses, singling out financial services software company Bravura Solutions (ASX: BVS) as one example.

“The share price has fallen sharply given short-term concerns around the impact of Brexit on its UK pipeline. For long-term investors, we think this near-term uncertainty provides an opportunity to buy a quality business on a discounted valuation,” he says.

Portfolio balance is crucial

Jun Bei Liu, portfolio manager, Tribeca Investment Partners, says investors need to manage the risk of technology stocks by having a balanced portfolio.

“The sector is highly correlated with what is happening in the NASDAQ, which has been volatile in recent times. Investors need to be mindful of the volatilities of those stocks and keep them as a smaller component of the overall portfolio,” says Liu.

“Another risk faced by tech companies is the growth assumption; because their valuation is so exposed to future growth assumptions, if they disappoint, the share price will likely be sold off materially. Investors need to do their homework and be confident in the growth profile.

“At this point, we like tech names such as Afterpay and Altium as both have demonstrated strong earnings momentum as well as enormous market opportunities globally,” Liu says.

In the US, Tsidinis says Microsoft’s valuation is appealing. “A dominant cloud computing winner like Microsoft trades at quite a reasonable valuation relative to its own growth rate. Whereas a company like Uber is fighting fierce competition in its key geographies and is trading at relatively high valuation multiples.”



is a Morningstar contributor.

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