Why I'm sticking with tech
Tech stocks have had quite a hard time lately, particularly in the small to mid-cap range, but if we look through deeper, at a fundamental level, we can see how quality tech companies will likely outperform. To do so we need to unpack what quality means a little further.
What makes a good investment?
Let's start at the top - Shareholder value creation (Stay with me, I'll keep the boring accounting speak to a minimum). If we strip away speculation, the primary driver of profits in the market is shareholder value creation - that value created by the business that falls to the shareholders.
So what drives shareholder value creation?
There are literally 100s of factors that make up a great long-term investment but fortunately there's only two factors that account for most of the difference.
- Growth in revenues
- Cash flow production
Or said more specifically, compound annual growth rate (CAGR) of revenues and return on invested capital (ROIC). All cash flows collected and retained by the company stem from revenues so if we are going to grow our investment those revenues must be growing too. Yes, the company can increase efficiencies and widen margins but to be able to continually grow cash flows over time revenue must be growing and at a substantial clip. Greater than 8% to 12% per annum if we are going to beat the market.
The efficiency of the business to convert those revenues into cash flows from operations is captured in return on invested capital. The best business model is one that can produce high cash flows from a relatively small investment. Think of the amount of investment required to build cash flows in a bricks and mortar shopping centre like Mirvac (ASX: MGR) vs an online real-estate platform like realestate.com.au (ASX: REA).
A study by McKinsey (2018) proved this out by showing that out of 2,393 businesses those which outperformed over 10 years had the winning combination of both high revenue growth and high return on invested capital. Not that we needed the study. We can think through logically that a company growing revenues quickly with strong cash flow production building its balance sheet will grow its stock price faster than one doing the opposite.
Companies who solve problems with technology are amongst the highest performers in growing revenues quickly and consistently over time with the highest returns on invested capital.
We can see these qualities empirically displayed in Figure One below. Software companies stand in a league of their own in terms of average annual economic profit as compared to other industries.
There are, right now, a number of exceptional tech businesses with strong moats at quite attractive prices. I'm not suggesting here that an investor should buy a tech index or ETF, this is very much an argument for individual stock selection (where governance, industry, strategy, and valuation all come together). We see these types of companies at attractive valuations in the small to mid-cap range.
At Blue Oceans Capital, we begin our search for investments by filtering the equities universe according to Revenue CAGR and ROIC. This, of course, only begins as a starting point for a weeks long journey of business, industry, and governance analysis but it allows us to get off to a good start by fishing in the right ponds to begin with.
We don't only invest in technology companies, occasionally we find other business models, such as manufacturing, that can compete with the shareholder value creation of our best technology investments.
Reference: Bradley, C., Hirt, M., & Smit, S. (2018). "Strategy to beat the odds." McKinsey & Company.
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