How to decode technology investments (afr.com)
The race to identify and invest early into the next technology unicorn is relentless, and sometimes it feels like investors are chasing the bragging rights as keenly as the financial gains. However, technology investing is littered with more disappointments than successes. Great code looking for a problem that doesn’t exist, startups that are unable to demonstrate an ability to move through the innovation cycle and scale a protype, or a lack of customer validation undermining expansion capital rounds are all common reasons why technology firms don’t gain traction and ultimately fail. But when the stars align, and great technology solves a great need, the rewards can be spectacular.
While it is important to look at the opportunities where technology itself is the asset, it is also important not to forget the impact that technology will have on the existing businesses in your portfolio. Some of these companies will be able to identify and embed new technology and transition to truly tech enabled operating businesses while others, rooted in old ways and legacy systems, will be left behind. In protecting your capital, it is sometimes just as important to spend time exiting the losers as chasing and predicting the winners.
Technology companies have been the structural industry winners in markets over the past 20 years. The digitization of data and collapsing cost of cloud-based data storage has allowed for ever increasing data bases and unstructured data lakes. Private clouds have become more efficient through the evolution of flexible and instantly scalable cloud space management via Kubernetes style deployments. Leaps in computational processing power has now allowed artificial intelligence and machine learning to analyse big data and provide actionable business insights that could only have been dreamed about a few short years ago. Combined with the application of radio frequency identification (RFID) technology, the world of interconnected objects via the internet of things is rapidly approaching with endless possibilities.
Understanding the broader community context and a business’s social licence to operate is a necessity in reviewing any investment, but none more so than technology businesses in the current environment. The documentary “The Social Dilemma” and the television series “Black Mirror” pose some challenging insights into the negative implications of technology for society. Privacy concerns, political manipulation and allegations of tax avoidance are just some of the major issues that some global technology giants are currently confronting. There is a rising risk of monopoly regulation enveloping a few of the global technology behemoths due to their concentration and anti-competitive behaviour in certain markets. All this while the community is trying to decide if technology will simply replace the human workforce and drive up unemployment or ultimately create totally new industries with better paying roles with improvements in living standards and leisure time.
What is clear is that the speed of change in this fourth industrial revolution is faster than any previous regime shift in history and will touch every industry in some format. Processes will be automated using industrial robotics, artificial intelligence and autonomous vehicles. The health sector will see advancements through improved medical diagnostics, therapies, robotic surgery and digital health platforms. Communications will be impacted by the roll out of 5G related digital infrastructure and collaborative software. Payments and banking systems will continue to be disrupted with new technologies and supply chains in manufacturing services will be streamlined by real time monitoring and optimisation. Ultimately customer experience and creation of true value will be the driver of those who come out on top.
Mainstream investors have several avenues to gain exposures to later stage technology investments. There are a multitude of sector focused products, exchange traded funds or investors can purchase shares directly into well-known listed companies on the ASX and global exchanges. Increasingly the democratisation of capital via crowd funding platforms and venture capital funds are increasing the opportunities that retail investors will see more interesting opportunities. However successful technology entrepreneurs are creating their own virtuous circle of success in early stage investing as budding technology startups seek not only the capital they can provide but additionally the insights and connections that these entrepreneurs can bring to the table.
Understanding where a technology company sits in the ‘hype cycle’ is critical in the valuation of opportunities. Media attention about a new technology can often trigger significant investor attention before even a viable product is produced and commercial viability is tested. A range of startups will pop up to test alternative use cases and most will fall over as experiments and implementations fail to deliver. Often a period of disillusionment can follow before one or two use cases begin to gain traction with early adopters. Second and third generation products generally follow as mainstream adoption starts to really take off.
Business fundamentals still apply for when putting a value on a high growth technology investment and all opportunities need to be looked at through three broad lenses – the maturity of the business and how leading is the technology, the total addressable market of the technology and how well the management team can navigate the resource requirements necessary to fulfil the growth agenda and finally the broader industry context and competitive landscape. Traditional valuation metrics are difficult to apply in high growth technology companies and investors need to look much further out to where the company matures to a more sustainable growth rate. Valuations will include assessments about customer-penetration rates, average revenue per customer, sustainable margins, and return on invested capital. Investors need to make several very bold assumptions about where a company might end up, and the path the company is likely to take in getting to that point. This leads to a very wide dispersion in analysts’ valuations and generally much higher share price volatility.
While technology as the asset often grabs all the attention, the impact of new technology developments on existing businesses will be profound. Linear value chains are likely to be replaced by value networks, where businesses operate in ecosystems and partner with a range of suppliers and even competitors. Understanding a company’s ability to adapt to the changing landscape will be pivotal in driving investment returns across your broader portfolio. Existing businesses with a multitude of legacy systems that were right for the time, but are no longer appropriate, will need a new technology architecture. Many companies will need to embark on large scale and complex transformation programs as legacy systems are replaced. Some firms will project manage these transformations flawlessly while others will suffer major issues and budget blowouts. Companies with a reputation for executing technology transformations well will trade at a premium to their less successful competitors. Data, as the saying goes, is the new oil and businesses will need to drive far greater insights and business intelligence from their own customer records in order to provide the customer experience that will come to be expected.
While there are a few notable examples of Australian technology companies, technology in the domestic equity index remains a relatively small sector in by global comparisons. As a result of the relatively few investment opportunities, our listed technology companies tend to trade at a decent premium to global peers on most metrics. In a world where technology ideas and capital can come from anywhere, investors will need to be looking far and wide and remembering the need to calibrate their position sizes wisely in a space where an investment can either be a hero or a zero.