How I find high-quality technology stocks after a market selloff

[Music] [Music] welcome everyone great to have you here i'm your host jason maddock think back to the spring and summer of 2020 for a moment it was the depths of the market crash sparked by a global pandemic many businesses struggled to adjust to the new normal as did their share prices but one sector thrived through the turmoil it was the technology sector consider the nasdaq 100 index which tracks the largest tech stocks on the nasdaq exchange it roughly doubled from march 2020 to its high that it reached in november 2021 that crushed the performance of the s p 500 index etf which rose by about 55 over the same time frame and it continued the tech sector's outperformance of the broader market since the 2008 financial crisis this all may have had some investors feeling as though technology stocks were unshakable but that's not how things played out a wider market sell-off took place during the first half of 2022 and technology stocks were among those that tumbled the most some investors may wonder whether the golden era for tech stocks might be over or if there's a buying opportunity to be had we're going to get some perspective from vitali masanov he's vice president director and global technology analyst at td asset management vitaly will explain what's behind the drop in tech stocks and some factors that may help you identify undervalued tech stocks amid all the market volatility vitaly thanks so much for joining us today fantastic to be here thanks for the invitation jason yeah it's my pleasure could you maybe give us a really quick overview of kind of what you're what you do yeah of course um well uh every day i get behind a computer and uh uh read that's a big portion of what i do and what all the analysts in the team uh are engaged in doing but really it's my uh job to be an expert in uh the majority of the tech sector for north america western europe and other major markets and and ultimately understanding the businesses that are investable for for our clients as we make investment decisions uh understanding not only the fundamentals the strategy the track record uh having a good understanding of management many other aspects and ultimately coming to a decision a conclusion and a recommendation uh and a forecast how that business will do over the future and then deciding whether those securities are suitable for our clients absolutely and one quick thing and the word panic in the market is not something that we take lightly but maybe retail investors that might be more easily to succumb to emotions but i'm just curious about somebody maybe a professional in the industry how does that work for you at like the intensity of the everyday market it's uh we're all human beings and it's something all of us uh think about and try to try to fight that that instinct of emotion and i think in that in a professional setting there is uh there is no room for panic and there is a lot of um training and thought we put into controlling those strong emotions because i think there's abundant evidence to show that they don't they don't lead to good investment um outcome so one of the rules i think is that whatever the news is that's that's causing that sharp emotional response from an individual in a professional setting investors uh almost never uh act on that you know immediately whereas i think in a in more of a retail setting there is that propensity to go and act and click a button and take action the professional uh setting uh we have the advantage of uh of time and resources being able to uh get deeper into the information that we have all day it's what we do for a living follow up with the company speak to other experts and so you know they say sometimes when you're you get angry about something not to tell that other person what you're thinking but to take 10 deep breaths or whatever it may be and so i think in the professional setting we have that benefit of time which heals all wounds and leads to better decision making great okay so before we dive into our conversation here i have a quick trivia question for the audience all right so the question is how many technology companies are among the 10 largest by market cap in the s p 500 as of the end of june 2022 so stay tuned to the end of our interview and i'll show you the answer okay vitality let's talk tech some investors worry that the sell-off in technology stocks that we saw in the first half of the year could be akin to the dot-com sell-off back in back in 2000 uh what do you think about that comparison uh well there are certain similarities that exist for sure and i think those similarities are best summarized by emotion and hype in that stocks went up an awful lot in that period of well really 98 99 in the early part of 2000 and you had a similar phenomenon unfold also in particular around technology stocks through the course of 2020 and the majority of 2021 i think that on a fundamental level though if we separate ourselves from from the charts which again have some similarities the fundamentals underlying these businesses are particularly different we've gone and studied that period of 99 in 2000 and it varies but generally speaking there were an awful lot of companies that uh had very little revenue uh no earnings and were really seducing investors on the promise of of of of a bright future for a product that may not even exist or a product that only had eyeballs or clicks and so it was a very nascent time for the internet i actually would draw an analogy not to the technology sector of today but the technology sector back then was very much much what the blockchain ecosystem uh was during this period of 2021 so it was a nascent time for an exciting technology investors got behind it but you know 20 years later if you look at the technology sector um the these are um this is a different sector this is the sector with first of all uh it's underpinned by mega cap tech companies that dominate the lives of consumers enterprises and industries with very real products of course i'm talking about the apples and the microsoft and the alphabets the businesses at reasonable evaluations multi-billion multi-hundred billion dollar revenue and free cash flow streams deep entrenchment into our lives and so we're no longer in the hype cycle of of the internet and technology as we were 20 years ago it's a it's a mature maturing industry with real businesses and so um i would say if you're going to draw parallels again from the late 90s to today of 20 years later i would focus on the blockchain industry more than anything some investors are wondering if the technology sector is overvalued undervalued or somewhere maybe in between after the selloff in the first half of the year what does the data tell us based on the valuations we've seen in the past the data tells us that technology valuations are historically higher than that of the overall market so what we can look at is simply the p e ratio of technology stocks the entire sector and divide that by the p e ratio uh for the s p 500 which we'll call the market and what we would see is that over the last 30 years or so typically technology companies would trade at a premium they were traded a premium for a reason we can talk about that in a few minutes probably but what we're seeing today is that um that premium which has gone from has been at times zero at times it has been hundred percent uh the 2000 bubble which we spoke about that's that's what the premium rose to at that time 100 premium they double as much as an ordinary share of a general company today that premium uh after rising to about 45 50 percent during the height of covet has returned to near its historical average at 20 so according to this analysis and of course this is only one tool uh to employ this is telling you that technology companies are neither too expensive nor too cheap relative to history okay now many tax stocks have declined significantly as we've covered through this conversation already from their highs earlier or later in 2021 but their underlying business might still be strong so let's get into some factors you believe may help investors find high quality tech stocks the first factor is if the company's products and services address a large market of customers and what is a large addressable market in your opinion and why is this so important this is uh going back to our emotional um psychological conversation that we started off with jason and this is this is a sector for storytellers and narrative and it's going to attract enthusiasm and enthusiasm is going to attract money and higher valuations whenever something is valued at a high level we need to make sure that that's appropriate and and one way to make sure that's appropriate is to make sure that this product that's being presented as something extraordinary has enough potential users a large enough addressable market so that the company can grow into its valuation and of course so that the valuation can expand after all we're looking for our investments to grow um we can pick on the case of apple um apple has of course proven that the market is large enough uh a billion or so users of an iphone each phone about a thousand dollars and all the other services they can sell on top of it that has supported a a market cap that at times has been north of two trillion dollars and so that's of course made for a phenomenal investment for people uh have they made that in in the early days of 2012 2013 2014 uh that's an example about addressable market where you would have done your work and come to the conclusion that it's large enough to support this this wonderful story that apple was telling but there um there are many exceptions and from time to time what we'll see is is a company with an amazing story and um if only because we've already established this thread i'll go back to the example of blockchain but um we've met these many of these companies that um were doing really interesting things technologically but a multitude of them would come to the public markets and and say that this is this is the solution that i might that i that i have and and you would struggle to get an understanding of how the market was big enough meaning how can there may not be enough people that are interested in this product at a price that supports the current valuation so big returns in technology and good returns in technology over the long run are going to be coming from companies where there's a very large addressable market to support the growth we often hear having a wide economic moat is preferable to business in general how significant is it in the technology sector and what might give a company a wide moat if you're indeed investing in businesses you're you are buying when push comes to shove you're buying the stream of future free cash flow discounted at some rate and future free cash flows will only exist if that business continues to uh to do well and so uh thinking about moats what prevents uh i call it invading forces from taking uh your business and everyone's trying in an ultra-competitive world uh more than ever in a globalized competitive world is critical so that preamble is only to say get to the chapter on votes and whatever business you own technology or a grocery store figure out why it'll be around in 20 years because you need to support that valuation now but when it comes to technology and the modes that we typically see or that investors want to see well the surprise surprise the technological mode uh would be something that would be preferable typically we are speaking about businesses that are in the high-tech industry and intellectual property that is either protected by patents or internal know-how and manufacturing and research expertise is extremely important this is uh particularly true for the semiconductor industry where companies that thrive typically have a proprietary process or product that is very difficult or impossible for others to replicate um that's number one a lot of technology companies exhibit what we would call a the competitive advantage of uh learning and what i mean by that is if you now look at the space for enterprise software uh the businesses the likes of microsoft or oracle we use salesforce and all of these other products adobe you're really now banking on a very sticky a very sticky customer base that is loyal to your product and has very high switching costs and so uh even if a competitor product was to offer a lower rate a lower price or equal functionality very few people are likely to switch because it took them a long time to master their product and so even for something as simple as microsoft word uh as we've all noticed in excel and all this stuff it just it stays because no there's no reason for anybody to switch a word processor um or spreadsheet tool um so those are i would say two key things that uh we need to keep an eye on in technology and serve as typical modes now your second factor for finding high quality tech stocks is if the company's technology is mature enough to be commercialized what do you mean by that one of the things that is dangerous is to go and and and um look at a whole bunch of small cap technology stocks and and and some of them will have markets that are large enough that they could address but no one says that you can only be a publicly traded company when you have a great product and so what you see sometimes is technology companies that are become publicly listed with a great story that the analyst can can read the whole book and say this is a big enough addressable market but the problem is that that company hasn't reached critical mass has it reached sufficient level of development and commercialization of their product and so investors that um i think often make the mistake of pursuing those kinds of stories are taking on a disproportionate amount of risk they're really acting as almost a venture capitalist in the public market that is really not the intent of those investors they get fooled into doing this um and then often more often than not then pro that product um isn't isn't the one that actually um hits the proverbial jackpot because there's just too much competition and too many factors i'll just give you a practical example if we were to you know look at really we'll just call it you know virtual reality and i think that's going to be a massive a massive medium for consumer computing and so if that was a standalone hypothetical company you would look at that and you would say oh my gosh yes uh probably the market for these devices would be at least the size of the smartphone market and we've seen the size of the smartphone market has been large enough to support the world's largest company apple uh but where that would fall apart and this hypothetical example is uh the level of commercialization for something like vr right there's a few million units shipped every year the killer app has not yet been realized there everyone's piling a lot of money into it but really at this stage that would be a story that would fall apart at that stage of analyzing commercial commercial fit because there's still too many factors it could be and apple's working on a competitive device so sony we don't really know what form it'll take and so this company behind the scenes is making so many decisions there's so many variables that they can't control that would be easy to um it would be really easy to sort of mess up that that investment lens so commercialization of product very very important absolutely they need to make money somehow right yeah so another factor on your list for potential strong investments is investment efficiency why is this important and how can investors identify if the company has this potential there's a number of ways to do this but one way investors could look at this is to say this company in let's say 2021 spent a billion dollars on research and development sales and marketing and other opex and so they spent a billion dollars really building their products uh building the future of the product the development of it and paying sales people to distribute it and advertise it and so on look at the look at the mathematics look at the financial statements and ask yourself in the following year um what increase in sales did that billion dollars of sales uh generate and at the end of the day if a company went and spent a billion dollars in operating costs and they didn't grow the year after uh that is no matter what management says that that is a question why did you spend all this money and where did it go and why wasn't there a return on it and you can do this exercise across a universe of companies and then look uh rank them and find the most efficient companies with the best unit economics this is a very preliminary exercise but i find it's extremely helpful eating out the the best companies from the worst and in the best case you you will see that those numbers uh come to the surface those companies come to the surface where you'll you'll see no doubt a company that may have spent 100 million that that the next year saw a couple hundred million of sales increases and you you'll have to do more work and and read what what happened exactly but you would look at that and you would say this this is um this is a company that spends money to acquire revenue and they do it better than anyone and then the next question to ask is what is the nature of the revenue that they just acquired and so the second piece to that is to understand the business model is this um something that's a one-time sale or is this something that's a recurring revenue business meaning um is this a one-time sale of a hardware device like an ipad uh in which case the company really shouldn't spend much to get that consumer because that's a one-time sale or if this is the case of a software company then it's okay to to a greater degree because you can pay a thousand dollars to get a thousand dollars if that thousand dollars is something that you know users pay every single year for the next 10 years with no incremental acquisition costs so some of the things to consider but really it's uh how much are you paying to to get that next user uh or sell your product companies need to make money everything is a dcf at the end of the day and there are a lot of stories that come in public markets good storytellers that have companies with bad unit economics that essentially lose money on every product that they sell and always will and do you know what those companies are worth zero they're not worth anything because they'll never make money and so that investment discipline of understanding if a company is losing money which of course a lot of companies in tech are if they are losing money i we better understand what the path is to making money and we better see why it is that they're losing money today and that they're not just buying business all right so we've covered some qualitative factors that indicate a compelling story that a technology company may be looking to tell now let's get into some hard numbers to see what a strong tech company might look like under the hood what are some of those fundamental metrics that you're looking to see well i like to say a few things i like to see uh revenue growth first and foremost uh at the end of the day uh companies uh need to grow i mean there's different styles of investing but uh the world is growing uh progress is the name of the game and technology and so i like to see growth i like to see growth for successful technology companies that's some reasonable multiple of gdp if we think of gdp typically being two three percent normal times uh seeing a technology company grow their their sales at a rate of two three times gdp called ten percent uh is is a great sign that this is a business that is making a product whatever it may be that the uh public whoever that may be wants and that it's uh either capturing a new market it's expanding its penetration into and share of the wallet whatever it may be that's work that's additional work we have to do but revenue growth is a good starting point that revenue growth then we've alluded to this because we've spoken about unit economics but we'd like for that revenue growth um to be uh coming from a a product that is uh defensible i suppose that was our most discussion and i think looking at a company's gross margin is a typically a good heuristic um a reminder of course gross margin is your revenue minus your cost of goods sold uh businesses have gross margins ranging in everything from zero or negative i've seen all the way to 90 plus percent and the higher your gross margin the more dollars you have to work with um on for your operating expenses that could go ultimately to shareholders at the end of the day but uh i think equally important is higher gross margin is typically a sign that your product has a and your business has a larger moat around it so if i can manufacture something for two dollars and sell it for 10 and capture that whole value well i think there you know there's probably something special there because competition is not coming in and knocking you down whereas of course a generic product we see that with pcs and other computer components the margins you know could be razor thin as everybody rushes in and replicates it so i think gross margins over 50 percent is is another heuristic that's very helpful uh finally uh or i suppose third out of five give me four factors as we go down the income statement i look uh i really just transition into the cash flow statement but look for operating profits or the free cash flow margin uh to be in a healthy range 15 20 plus meaning the company's translating its strong market position that it's that it has with revenue growth it uh and a higher gross margin competitive advantage it's translating that it's not overspending it's not buying revenue it's actually translating that into real profits that can go back to us to investors that we can actually discount as part of our valuation and so 15 20 plus free cash flow margins that's the kind of uh that's the kind of level you see from these best of breed companies like microsoft uh historically and and other businesses and so that's a good sign to see and then finally i suppose this is the one that goes to unit economics uh you can probably readily pull this up but uh return on invested capital uh is an important metric ultimately uh management teams will talk about their capital allocation taking money plowing into the business and ultimately the question is if you're going to be putting money into the business what kind of return are you getting on it if you're getting a bad return on it don't do that give me the shareholder back the money buy back stock or pay dividends so it's very important to hold management accountable look for return on invested capital higher than the cost of capital ideally higher than 10 percent uh that is a good sign that management uh you have the right management at the helm and they're taking the money that we've given them as investors and they've put it into productive uses with the investments that they're making okay i'm just going to take a quick pause here before we jump to the next question because you've given us a lot of useful information i don't want it to be overwhelming for the audience so i want to show you how web broker can be a useful tool to track down and help you start to accumulate all of this information the web broker stocks overview page is much much more than just the last traded price of a particular stock on this page you get access to a wide variety of useful information from charts and news to independent third-party research reports to analyst projections let's start by looking at some of the fundamental data that's available here it can be located by selecting the fundamentals tab fourth from the left just beneath the stock quote from here we now have access to a significant amount of financial data from the company such as earnings per share price to earnings return on investment and many many more these fundamentals are compared to the industry average and a synopsis is provided on the right-hand side beyond comparing the company to the industry you also have the opportunity to compare that company to its closest competitors by choosing the peer comparison tab from the top of the page lastly the fundamentals tab offers you access to the company's financial statements where you gain access to seeing their income statement their balance sheet as well as their cash flow statement web broker has provided the tools to do your own fundamental analysis but you also have the opportunity to compare your findings and hear the insights of independent third party analysts that information is found by selecting the reports tab from the top of the page there are clearly a lot of reports to take in but one that i'd like to highlight is the morningstar analyst reports it can be located by scrolling down on the right-hand side this report offers insight on many financial metrics we've discussed here today comparisons to key industry players and a competitive analysis on economic modes beyond the fundamental research and analysis if you're looking for price projections and stock ratings web broker offers a comprehensive collection found by selecting the analyst tab from the top of the screen on this page you gain access to historic as well as future price projections to help inform your investment decisions the consensus of the analyst opinions is located on the right hand side but you also have a chance to scroll down and look at the analysts individually here we can see when the analyst last updated their opinion their rating their last action as well as their price projection on the right-hand side all right now many investors look to valuation metrics such as price to earnings ratio to help them gauge whether a stock is undervalued or overvalued but you say valuations aren't quite as straightforward as that with tech stocks why might that be well let's start uh jason with the point that valuations always matter and there are various tools that investors can employ in their valuation toolkit the tool that we that we often use a p e ratio is is not quite applicable because the you can say that the e the earnings are understated in a growth phase for the business and so uh for that reason technology becomes a little more complicated now uh that that what that doesn't mean but that doesn't mean is that you stop valuing the company and revert back to to uh evaluating just story right just story telling just the narrative that's where you get in trouble that's where um i think investors at times got in trouble in the last two years so just because the ratio doesn't apply doesn't mean that you drop all due diligence on valuation that that would not be correct uh for us that due diligence a lot of it comes from a classical discounted cash flow evaluation being able to model out the company for 10 20 years finding out some reasonable terminal value but really getting a sense of uh you're reinvesting in the business today you may not have profits uh tell us about uh how much you're spending to get a customer tell us about your capital allocation strategy tell us about your terminal profit margins if you're not profitable today when do you hope to be profitable and what will be the changes in your operating environment your your market your your customer demand for your product that will lead to those outcomes so um that and taking those results discounting it gives us a sanity check uh really of of whether something whether it's talk is is really just over hyped on narrative and can never ever be valued appropriately or if management has a point here it's investing correctly and there is value even if pe ratio might not apply today so i think um maybe the final point i'll say is this is what makes tricky a lack of evaluation what what also requires a higher level of diligence is often of course understanding these companies right a lot of them are in the business of um selling something intangible the world of high tech and so it it does take a sort of a greater degree of research and diligence you just have to invest more time to understand often an esoteric industry and the nature of competition in it in the future for that industry ultimately um if you have the time to to do some some valuation work try to understand what can revenues be in five years what can margins be and what can earnings be and i think just as a very basic exercise uh for business today uh sounds great but the valuation makes no sense just ask yourself from uh from your research where can this business be in terms of sales in five years a reasonable amount how much profits can it make can make 20 30 profit margins and then those profits in five years could the valuation make sense on that number and if that's still not working then you know you're gonna you're uh you're probably looking at something that may not make much sense at all right thank you very much vitelli for helping us kind of unpack and understand which can what can be a very complex topic and specifically when we're talking about the technology sector now we're going to head over to our live audience q a in just a quick moment but before we do let's reveal the answer to our trivia question we asked a little bit earlier as a refresher the question was how many technology companies were among the 10 largest by market cap in the s p 500 as of the end of june 2022 do you have a guess vitaly you know i it might have been a little higher at december 31st but i'm going to guess seven is that seven wow right on the nose okay the expert gets it right there were actually seven technology companies among the top 10 largest companies by market cap in the s p 500 as of the end of june 2022 apple took the top spot followed by microsoft and alphabet the parent company of google well i guess i'm guessing i'm not shocked you got that one right this is uh this is right in your wheelhouse so good job well i was guessing actually i was either six seven or eight but um it is a sign of the times and and um i think 30 years ago or so that that of course was was very different and so um you know maybe as as a part in comment that those companies are disproportionately what what you're investing in if if you buy um generally the technology sector because of their size and so as an exercise that's helpful if you're considering is the technology sector right for me or not a lot of it is really looking at those seven find those seven the apples the alphabets the microsoft's and looking at their levels of profitability and asking yourself hey you know i'm using google search today this is this is this is the product of google read their annual report and ask yourself is this a business that i think can uh can be enduring for the next decade or two so those are you know at the very basic level the kind of the diligence investors here should start with vitaly thank you again now let's let's head on over to our live q a and hear what the audience has to say thank you very much thank you you

2022-08-27 02:34

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