How to invest in emerging technology stocks
First published in the ASX Investor Update Newsletter via asx.com.au
By David Kirk - Co-founder and Chairman of BTI
A diversified fund approach can help spread risk in early-stage tech companies.
It is odd, but not particularly surprising, that we should so clearly separate consumption and production in our minds.
We take a hot shower without a moment’s thought for AGL. We eat our cereal and banana for breakfast without wondering if Queensland banana growers are having a good year, and we buy a coffee on the way to work oblivious of Nestle’s most recent performance.
Yet as investors we know that changing demand for products made by the companies we invest in is one of the most important things to consider when assessing their prospects.
We think about demand as an abstract thing, invented by economists to put in their models. But it real terms, in everyday terms, demand for a company’s products is simply the sum of what we all choose to do and buy.
The IT revolution
No sector of the economy illustrates this more vividly than the information technology sector. Look around you: chances are you can see someone talking, texting, reading or watching something on their mobile device.
If you are in an office, everyone around you will be sending, replying, analysing, accounting, planning, booking, paying or searching using information technology software and applications invented in the past 10 years or so.
The demand for information technology products and services has exploded in that time. We all know this because we are the demand; we use all the new products and services.
But strangely enough, we have been slow to follow the loud and clear signals our consumption habits are sending us when we make investment decisions.
There are some good reasons for this logical inconsistency. Information technology and internet-related products are complicated. Many investors and advisers do not understand the business models, competitive environment and prospects of information technology companies well enough to provide confident advice or make an investment.
If you are one of them, you do not need to feel bad about it. You are in great company: Warren Buffett has not invested in any companies in the information technology sector. He believes the IT sector is outside his circle of competence.
Fortunately for Buffett he is brilliant at finding other places to invest but he has left billions of dollars on the table over the years by not investing in the information technology sector.
Lack of opportunity
Another reason portfolios in this part of the world are underweight in information technology has been a lack of investment opportunity. There have been few large technology initial public offerings (IPOs) on ASX and few listed vehicles through which investors can gain access to domestic and international technology success stories.
This has changed rapidly in the past few years on ASX and other exchanges. There are several large publicly listed blue-chip funds focused on giving investors access to the best international companies, and this inevitably means access to the big five global platform information technology companies – Google, Apple, Amazon, Facebook and Microsoft – and a raft of other great tech companies all over the world.
Investors in international funds invested in the big global tech companies have done very well in the past few years, but three things now count against the continued growth of these global behemoths at the rates they have managed in the past.
The first is simply size. It is much harder to grow at a very high annual percentage rate when you are already huge.
Second is economic concentration, or monopoly market positions. It seems very likely regulators will act in some cases.
The third handbrake on the future growth of global platforms is social/political. Much of the value of these companies is tied up in personal information derived from their vast customer networks. Privacy laws and other limitations on the collection and use of information will very likely slow the growth of these companies.
Investment alternatives
There are three main options beyond big international share funds to invest in global tech.
The first is to invest in a private venture capital fund, where you gain access to expertise in selecting and managing private technology investments that hopefully grow and are sold for a profit, part of which is returned to you.
The disadvantages are your money is tied up for 10 years or more and you must make payments when the fund calls for capital to make an investment. The full amount you have committed needs to be available at all times should a capital call be made.
The second option is either yourself, or your adviser, to select a portfolio of ASX-listed (or international if you feel you or the adviser has the capability) information technology companies.
Reduced fees is one advantage of this approach and investment in public companies provides more transparency than private companies. However, the disadvantages are considerable.
I can say from personal experience that it takes a lot of work to understand the business model and prospects of fast-growth information technology companies.
Furthermore, it is likely that once a company becomes listed, much of the earlier-stage three to 10 times multiple-of-money investment opportunity has been taken by earlier investors.
The third option (below) – using a listed investment company - was specifically designed to address some of the disadvantages of the first two.
LIC approach to technology investing
(Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article).
Bailador Technology Investments (BTI), of which I am a co-founder and chairman, has invested in 10 private information technology companies at the “growth stage”.
This stage is important. Growth stage means a well-established company with proven successful technology, a broad customer base, a first-class management team and a big opportunity for future growth. Revenue will typically be $5 million to $10 million at the time of investment.
The 10 companies in the BTI portfolio are all private companies and the investments have been made at a stage that still allows for the potential return of many multiples. Three years ago, the fund was listed on ASX, so investors can access 10 private information technology companies through one public share.
The current revenue to 31 December 2017 for the companies in the fund is $172 million, growing at an annual rate of 35 per cent, and 60 per cent of the revenue is from outside Australia.
The advantages compared to the earlier two options are considerable. BTI provides a team of specialist information technology investors to select and manage a portfolio of well-established high-quality companies with proven growth and management (both characteristics of the best private venture capital funds).
Bailador also provides governance and oversight by an independent board, public company reporting and the everyday liquidity of a publicly listed share (all characteristics of a self-selected portfolio of listed technology companies).
If you are attracted to investing in early-stage tech companies there is one very important personal attribute you must have: mental strength not to worry about the share price on a day-to-day basis.
Investment in private information technology companies is not about short-term invest and flip, but long-term international business building. There will be periods when, notwithstanding continued strong operating performance by the companies in BTI, the share price will trade at a discount to the net asset value of the investments in the fund. We are in such a period now.