The bursting of the tech bubble in the early years of the new millennium still makes some individuals nervous about holding stocks in the sector. David Kirk demonstrates how investing in technology companies at a particular point of their life cycle can reap rewards while minimising risk.
What do Uber, Airbnb, Twitter, Workday and Dropbox have in common?
All these companies are valued at more than $10 billion, but were all formed less than a decade ago.
Technology companies can get very big, very quickly, reflecting the size of the global markets they are addressing and their ability to scale rapidly.
Figure 1
Source: Based on GICS® sectors. The weighting for each sector of the index are rounded to the nearest tenth of a per cent; therefore, the aggregate weights for the index may not equal 100%. As of September 30, 2015. Chart: S&P 500.
Australian technology companies too have had rapid rises in fortunes with names such as Atlassian, the global software development tools provider, OzForex, the currency transfer business that is challenging a traditional domain of the banks, and Freelancer, the world’s largest outsourcing marketplace.
In addition, Australian emerging software-as-a-service businesses, such as SiteMinder, are already world leaders. These companies are all addressing very large opportunities by using technology to provide a more efficient service.
Naturally, Australian investors want the opportunity of participating in businesses that have the potential to achieve such phenomenal growth and global reach. Some investors want to diversify their investment portfolios to include technology as an asset class. Investors also want to manage the downside risk of technology.
Solid foundations
Today’s technology sector businesses are a long way from the dotcom bubble of the late 1990s. The underlying foundations for the growth in the technology sector have been progressively laid over some time. Key elements include:
- digitisation of information,
- increased computing power,
- broadband proliferation,
- widespread use of smart devices, and
- the development of cloud-computing services.
These elements are driving structural shifts in the way business is being conducted in almost every industry. Some companies are failing to adapt quickly enough and are at risk of value erosion. This, however, provides an opportunity for tremendous value creation for those companies nimble enough to embrace the change and allow it to drive their own growth.
These industry structural shifts are sizeable enough to override underlying economic conditions for companies taking advantage of them. Investments can perform well even if the overall economy does not. For this reason, the technology sector is an interesting counterbalance to the historical portfolio weighting of most Australian investors.
The technology sector is well established as a portfolio allocation
In larger markets such as the United States, technology is very well established. For instance, did you know the information technology sector now comprises over 20 per cent of the S&P 500 index and is a larger sector than financials or healthcare (see Figure 1)? The NASDAQ Internet Index has returned 17.9 per cent a year over the past four years, and IT is one of only two sectors rated as outperform by the Schwab Centre for Financial Research, as shown in the Table 1.
Table 1
Source: Schwab Centre for Financial Research and Standard & Poor’s as of 31/7/2015
The overseas experience is that technology is well and truly established as a credible asset allocation, but also that the sector can be an important hedge against disruption to legacy businesses in an investment portfolio.
Technology investment opportunities in Australia
The market capitalisation of companies in the IT sector listed on the Australian Securities Exchange (ASX) and New Zealand Stock Exchange has more than tripled over the past five years, but still represents only 0.8 per cent of the ASX 200, according to S&P as at 30 September 2015. This compares to financials, which comprise 47.4 per cent of the ASX 200 (see Figure 2).
Figure 2
Source: Based on GICS® sectors. The weighting for each sector of the index are rounded to the nearest tenth of a percent; therefore, the aggregate weights for the index may not equal 100%. As of September 30, 2015. Chart: S&P 500.
Many investors in Australia are looking to gain some exposure to the technology sector, recognising the industry balance in Australia is likely to trend towards other developed markets over time. Some portfolio allocation to IT is a way to obtain exposure to potentially high-return investments while providing some industry balance to their portfolio.
Recently there have been several technology companies listing on the ASX. Some of these companies have had stellar performance, while others less so. A number are perhaps not fully understood by the market.
There is no question investment in the technology sector can produce exceptional returns, but can also come with a level of risk.
How to reduce risk?
A number of measures can be taken to reduce risk in technology investing, including:
1. Specialist technology sector expertise
A manager who focuses only on the technology sector will have the experience of reviewing hundreds of potential opportunities of a similar nature. This means experience and a deep understanding of relevant technologies, business models, management teams and appropriate valuations.
2. The appropriate stage of company development
Companies that are past the start-up or early stage will have a dramatically greater chance of success. This means several million dollars of annual revenue, repeating customers, proven globally competitive technology, proven business model and a seasoned management team. This is referred to as the expansion stage, where businesses are looking to accelerate growth of a proven model.
3. Capital structure and contractual protections
Investing in private companies at the expansion stage allows for bespoke shareholder agreements, providing substantial protections and rights for investors. These include investing through convertible preference shares, which provide all of the equity upside, but have the benefit of a priority return of all of the principal before any other cash goes out of the company.
4. Diversification through a portfolio of investments
Having exposure to a number of investments in this space is a sensible diversification of risk, a well-established principle.
A listed investment company for this segment
Bailador Technology Investments (BTI) has been specifically established to provide retail and institutional investors with access to a portfolio of private information technology companies at the expansion stage and with the risk management features set out above.
BTI employs proven investment criteria and applies them rigorously when it makes investments. The BTI investment criteria are set out below.
BTI invests in companies with proven technology, proven management and a proven business model and that are growing very fast. These are already successful businesses. BTI brings needed capital and expertise to help the companies go to the next level.
The money invested by BTI is typically invested in continued product development, more senior and experienced management, more sales reps and continued international expansion.
The company has an established portfolio of six high-growth private companies. These six companies all operate in large markets, including travel, media, language translation, communications, and safety and compliance and are well positioned for continued growth.
The six companies all generate significant international revenue. Two of the six companies are headquartered in Sydney, one in Brisbane, one in Auckland, one in San Francisco and one in New York.