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Investing in Technology Companies that Win

New-age tech businesses have seen euphoric interest from investors across the board, and rightly so, since they have yielded handsome returns over the last 15 years. But with the NASDAQ posting a 19.63% annualised total return over the last decade, it can seem difficult for actively managed funds to beat the market indices.

To learn more about identifying and investing in tech companies that outperform the markets and therefore can be suitable investment opportunities, Sahil Kapoor (DSP’s Head - Products & Market Strategist) interacted via a YouTube Live session with William De Gale, FCA, CFA (Portfolio Manager - Global Technology Fund, BlueBox Asset Management).

Headquartered in Geneva, Switzerland, BlueBox Asset Management was established in 2017. Its BlueBox Global Technology Fund (SICAV) has grown its assets under management to more than US$1 billion (Dec 2021). The fund invests in cutting-edge technology companies that enable industry innovation, such as suppliers of semi-conductors, hardware, software and services. This team is obsessed with Technology companies and the concept of ‘Direct Connection’. If you want to learn about how to invest in the Technology space, this is a team to follow & learn from.

What follows are sharp insights on capitalising on the tech revolution from the conversation.

Equity markets are flush with money and experts are divided on whether this uptick is warranted or a ‘bubble’ waiting to burst.

William De Gale had an interesting take on this. He opined that equity markets are a bubble but the tech sector isn't. The average US tech stock has been up 15.2% a year for the past 12 years! A bubble typically emerges when market growth isn’t backed by profit growth. However, tech companies have been responsible for all profit and market growth, as per his research. The various technology-heavy market indices such as the NASDAQ and S&P Technology index may grow at this rate even in the future because the trajectory of profits remains positive, he said. 

And this begs the question of why are tech companies able to generate these massive profits when the rest of the universe is struggling to keep up? Due to advancements in technology, humans have taken themselves out of the processing loops, which means processing runs a million times faster. Our business, personal, and government lives have dramatically changed as most innovations rely on directly connecting systems to the real world without human intervention leading to a massive tech explosion.

This may lead you to question - if disruptive innovation has already taken over lives, will this tech boom continue? A popular quote in the investing world says - time in the market matters more than timing the market. And our guest in the conversation agreed. This technological uptick is a multi-decade cycle, and it's hard to predict when it will shift or end. So take your pick and watch your investments soar, was the advised mantra for success.

What is the right investment framework to capture value from the tech boom?

BlueBox’s leading portfolio manager advised identifying long-term beneficiaries rather than focusing on short-term winners. He interestingly divided tech companies into two segments - the disruptors and the enablers. And while it sounds like disruptors will take the cake, read on to see why enablers are actually going to win the market.

Companies that use technology to disrupt other companies are disruptors. Early Amazon using an online marketplace to completely change the way retail shopping occurs, would be an example of a disruptor. On the other hand, enablers are companies that sell technology to other companies that use it for building products and efficiency. While the marketplace of Amazon is a disruptor, AWS (Amazon Web Services) is an enabler that provides essential cloud storage services to companies across the globe.

A primary distinction between enablers and disruptors is that enablers are often hugely profitable while disruptors make little to no money and are exceedingly focused on growing into new categories and geographies.

Buying stakes in enabler businesses that are extremely profitable and will outperform for years to come is based on traditional investing wisdom. This works even better in this sector because there are few takers for now. Most tech-focused investors typically chase the most exciting new innovations without evaluating whether it will make sustainable money or not. And not following the herd, in this case, may be your winning shot.

How does BlueBox value enablers?

This may be a hot-take, but our guest believes that value investing doesn’t work in tech. He advised that you should never buy companies just because they are cheap or sell them because they are expensive. The long-term business scenario should be your deciding factor in this space. You can evaluate this, basis the following:

  1. What return on equity can that company generate?
  2. What is the company’s revenue growth rate?
  3. By when is this company’s product or service expected to become obsolete?

In the tech space, there is a vast range for all the factors mentioned above. So relative valuation (such as using a price to earnings multiple) works better than absolute valuation based on discounted cash flows.

With the fast-emerging trends in tech, how does BlueBox differentiate between a fad and a sustainable trend?  

While the world is going gaga over the metaverse, one needs to be careful as it may not make any money in the long term. The right way to identify a sustainable trend is to simply wait and watch if an emerging trend can actually generate sustainable profits. New is not always equal to good and ultra-high growth stocks most likely won't be able to sustain their growth for very long.

Growth-focused disruptor companies typically find it difficult to pivot to a profit-generating business and may not generate long-term value.

So it is important to be able to distinguish between the ones that are positioned to win & deliver profits, versus those that are simply trying to ‘change the world’.

So how does BlueBox construct its portfolio and should geography matter?

The Global Technology Fund by BlueBox Asset Management holds 30-35 stocks that are rated from A to E basis their business prospects. Typically, each stock has 2.5%-5% weight in the portfolio.

They do not hold any small-cap companies that have a market cap lower than $1bn. Typically, the $10-100bn market cap range comprises a bulk of their portfolio. These businesses have the liquidity and advantages of large-cap investing but also have the potential for huge value creation. 

While the Technology Fund is heavily invested in the US, tech is the world’s most global industry. The focus should be on identifying companies that are the best at what they do in the world irrespective of whether they are in Asia, Europe or LATAM.

How does BlueBox decide when to exit and what is the ideal investment horizon for a tech-focused fund?

If the long-term business case becomes unexpectedly risky or the deep dive in the stock cannot be explained, an exit is warranted. Another reason to exit is typically that the business case has already been priced in the market. These parameters are systematically tracked through a stock grading process by BlueBox.

In William’s view, technology-focused investment funds should not comprise 90% of your portfolio because of their high volatility. A 5+ year investment horizon at the minimum may be necessary. It is also important to caveat that fund managers cannot keep up past performance every month and year. However, a 15% annualised return is probably sustainable, as long as you accept the risks that this will inevitably be accompanied with.

And lastly, should emerging geopolitical risks and Fed rate changes impact BlueBox's strategy while investing in this space? 

Investors often forget that interest rates don’t operate in a vacuum. A mildly inflationary economy is a good environment for tech companies because that implies demand exists and you can raise prices for your innovation if you have barriers to entry.

The interest rate does impact the discounted cash flow valuation model. Rising rates imply that future value will fall. However, this creates a significant impact if a stock has no profit now but the future looks exciting, as in case of disruptors. Enablers, on the other hand, are very profitable today and the majority of the value in the financial model is derived closer to the present and is less impacted by interest rates.  

William De Gale strongly believes geopolitics only impacts the short term. A sudden geopolitical clash will affect markets overall but it doesn’t change long-term business prospects of tech companies. In fact, geopolitical developments can also be beneficial as in the case of semiconductor companies. Taiwan and South Korea are hubs of the semiconductor business. Governments are increasingly offering subsidies to move away business from there to reduce overdependence. This can be good for the semiconductor companies in your portfolio because they can now capture the value instead.

Tech has outperformed global markets every year since 2008 and is likely to continue to do so. To help you to participate in this trend, DSP MF has launched one of India’s most innovative mutual fund schemes, that gives investors access to disruptive innovation as a key theme. Learn all about the new DSP MF scheme by clicking the button below.

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Disclaimer

This note is for information purposes only. In this material DSP Investment Managers Pvt Ltd (the AMC) has used information that is publicly available and is believed to be from reliable sources. While utmost care has been exercised, the author or the AMC does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers, before acting on any information herein should make their own investigation & seek appropriate professional advice. Any sector(s)/ stock(s)/ issuer(s) mentioned do not constitute any recommendation and the AMC may or may not have any future position in these. All opinions/ figures/ charts/ graphs are as on date of publishing (or as at mentioned date) and are subject to change without notice. Any logos used may be trademarks™ or registered® trademarks of their respective holders, our usage does not imply any affiliation with or endorsement by them.

Past performance may or may not be sustained in the future and should not be used as a basis for comparison with other investments.

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