Investing in emerging technology companies
Look at attractive sectors and growth-stage tech firms through a listed fund approach.
An alternative investment is one that does not fall into any of the common investment categories such as domestic equities, international equities, bonds, listed property or cash. These common investment categories are the mainstays of a diversified portfolio and will remain so. Alternative investments are, in effect, anything else.
Alternative investments are very often added to a portfolio to provide a tilt to stronger capital growth. Depending on the tilt desired, the exposure to alternatives could be anywhere from 5 per cent to 20 per cent of a portfolio. Two approaches to achieving stronger capital growth are investing in faster-growing sectors of the economy and in earlier-stage companies.
A US index investor invests $21 of every $100 in information technology; in Australia every $100 invested in the broader ASX gives just $4 exposure to information technology. It is clear Australian investors need to look for other ways to tilt their portfolios to the fastest-growing sector of the economy.
Three approaches to technology investing
There are three broad approaches for Australian investors to gain access to information technology, each with their own benefits and shortcomings. They are:
- Invest directly in information technology companies listed on ASX.
- Invest in a private information technology venture capital/growth fund.
- Invest in a listed information technology venture capital/growth fund.
A direct investment in companies listed on ASX has the benefit of listed company governance disciplines, an independent board, comprehensive half-year and full-year reporting, and detailed annual reports.
In addition, if the company is large enough, it will be covered by analysts at broking firms, who will prepare detailed analysis and reports, and provide an independent view of the performance and prospects of the company.
Direct investors in listed companies pay no fees to specialist managers of a fund but transaction fees may be higher over time if shares are traded regularly or even from time to time.
The biggest challenge for direct investors in publicly listed information technology companies is to understand in detail what these businesses actually do and what their prospects are. This applies to valuation in particular.
The wisdom of Buffett
A direct investor must decide for themselves if an information technology company trading at a valuation multiple of 20 to 30 times revenue, as a number of large ASX-listed technology companies are, is good value or overvalued. Two of Warren Buffett’s many famous maxims come to mind:
“You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.” – Warren Buffett, 1996 Shareholder Letter.
“In the final chapter of the ‘Intelligent Investor’ Ben Graham [said]: ‘Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety. Forty-two years after reading that, I still think those are the right three words.”– Warren Buffett, 1990 Shareholder Letter)
Another significant challenge for direct investors in listed information technology companies is to manage and optimise diversification within the sector. In information technology, business-to-consumer models are different to business-to-business models, the prospects for e-commerce are different to the prospects for software-as-a-service, and growth by acquisition has a different risk profile to organic growth.
Investors in a private venture capital fund are investing in unlisted private information technology companies, most often at an earlier stage than listed companies.
A private venture capital fund will be managed by a specialist information technology investment manager. If the firm is well established it will have access to good investment opportunities and experienced investment and business development managers.
Most of the benefits of investing in a private venture capital fund derive from the earlier stage of investment and the fact that investment is into private companies, where valuations are lower. Earlier-stage investment gives the opportunity for outsized returns.
Variety of exposures
A typical venture capital fund targets an annual return of 20 to 25 per cent. A venture capital fund will build a portfolio of investments giving exposure to a variety of technologies and business models.
For optimal long-term market position and value, often it makes sense for fast-growing information technology companies to operate at a loss as they rapidly build customers and develop new products. This stage of development is usually more easily navigated as a private company.
Further, general macro-economic conditions that may cause listed information technology firms to decline in value, along with the rest of the market, do not impact private firms in the same way.
The downside of investing in private venture capital funds is the requirement to keep capital on hand to respond to capital calls and the lack of day-to-day liquidity. Money is generally tied up for at least 10 years.
Private investment funds can, in some circumstances, become something of a “blackbox” to investors. The money goes in and limited detail is available on the underlying investments. Often investors do not know if they have achieved a good return until the fund finally wraps up in year 10 or soon after. And, often, the minimum investment requirement, perhaps $100,000 or $250,000, is beyond many smaller investors.
Listed fund approach
A listed information technology investment fund, of which Bailador Technology Investments (ASX:BTI), the fund I co-founded, is the most prominent, sets out to combine the governance, liquidity and capital raising benefits of a public company with the potential benefits of private company investing as set out above.
Investors are able to invest in a portfolio of private businesses and technologies at various stages of development (but all well beyond start-up) and gain access to the greater returns available from investing earlier in private companies. At the same time, they can invest as little or as much as they like and have the day-to-day liquidity of a single share listed on ASX.
The potential disadvantage of a publicly listed technology investment fund is that it may trade at a discount to the value at which the investments are held in the fund. This discount is largely because of the lack of detailed information on the underlying investments and the inherent uncertainty in valuations of fast-growth technology companies.
However, so long as the discount does not widen during an investor’s hold period, which is very likely to be the case if the investments are doing well, returns will be solely driven by the performance of the underlying investments.
In any event, when investments are realised by trade sale or listing on ASX, investors will access the full value of the investment.