Where can the next generation of technology returns come from?

We will leave bio-technology for another day, but this area is also seeing rapid advances and exceptional growth opportunities.  

Some investors have missed the technology boom, or have a value style which makes assessing the stocks difficult.  Others blandly call the whole thing a bubble – maybe more a matter of sour grapes than because they have checked their valuation work.

Investing in scientific breakthroughs suggests that you have to understand post-graduate level science.  I doubt that this is necessary or wise.  I have spent some time over the years with academics and I have found that many believe their ideas have commercial potential.  

However, there are multiple busts for each bonanza and not every scientific breakthrough leads to a commercial success.  

The problematic ratio of busts to booms can maybe be demonstrated: for the last twenty years IP Group plc has had privileged access to Oxford University’s chemistry research alongside other UK university rights.  

Punching air

Its share price has gone from 58p to 48p over those twenty years, peaking at 214p about nine years ago.  They say early stage investing needs patience – shareholders in IP have been patient for no reward.

Quoted technology companies are more mature businesses than ideas out of University labs.  

Indeed investors are often wary of the returns that private equity managers have made ahead of IPO – maybe forgetting these seed investors have always had many failures you never hear about.  Also, the companies coming to the market will tend to have a fair amount of revenue, even if some years from earning an operating profit.  

When a company is ready to take a stock exchange listing, its technology tends to be comprehensible, if challenging, to the layman.  Over the years, one learns about ‘the cloud’ ‘artificial intelligence’ or ‘chatGPT’ by reading about new companies in these areas.  Personally, I have often had to read about a  number of IPOs (and miss a number of opportunities) before I start to understand the new technologies, but if I didn’t read the IPO prospectuses I would not be keeping up.  The reading can be challenging, but it’s also enlivening and can lead you to other online sources explaining new technology areas..  

Working out whether to invest in an IPO is, however, daunting.  I base all my investing on cash flow based valuations.  I am happy to use ten-year discounted cash flow valuations, but for young technology companies these tend to be very fragile.  You have some evidence of revenues and even revenue growth, but costs and longer term margins can only be guessed at by looking at similar, more mature companies.  I also view stock-based compensation as a cost of doing business; adjusting for this very often deters me from investing in young US technology stocks.

The approach I prefer is to focus on more mature businesses – this requires me to care little how much these stocks have risen before I invest.  The market has already sorted out the strong from the weak and I should expect the shares of the strong to have performed well ahead of my investing.

Looking at Technology investing over the last twenty-five years one is struck how the very large companies have tended to continue to capture value from new developments and how few smaller players have joined the elite.  In software, Microsoft and Adobe prosper, online Amazon and Google still dominate.  

The barriers to entry that these companies have created appear to give their shares ample cash flow backing.  

Managing valuations

You can still invest in technology through the leaders without taking much valuation risk or risk their technology is overtaken – the risk of monopoly legislation seems the greater unknown.  It therefore does not seem necessary to seek out lesser known second line stocks, you can just invest in the majors.

Hardware is a more competitive area than software or digital services.  Intel and AMD lost their leadership in processors to Nvidia some decade ago and the latter has led in every processor hungry application since: gaming, bitcoin and now AI chips.  Maybe they will catch up, but that’s quite a gamble.  Similarly, decades ago Nokia, Ericsson and Motorola were the world’s leading  phone companies, not Apple – that led to quite a difference in share price performance.  

Meanwhile in semiconductor area, AI capital spending by the major online companies is immense.  It fills the existing fabs, supporting the TSMC share price, and more fabs are being built which supports Tokyo Electron, Applied Materials and LAM Research.  These shares have modest price-earnings ratios, but they are cyclical (after the fab boom ends) so they are trading holdings.  

As these fabs come into use, they will demand more silicon (Shin Etzu Chemical) and more photoresist masks (Toppan).  As a multiplicity of new chips are produced, they will need to be designed (Synopsys, Cadence) and tested (Advantest).

Investors could also consider opting for a fund that keeps an eye on these developments for you.  Neither of the UK’s main technology investors seem to have captured the run in Nvidia in a significant way, but Polar Capital Technology now has a fair exposure to the better areas, while Scottish Mortgage seems to have more risk capital in China than in these technology areas.

The current technology boom benefits many companies.  Those listed in the technology sector have generally performed well, though there are still many on acceptable cash flow multiples.  The stocks mentioned above tend to be on high price-earnings ratios that can only be justified by the growth coming through – so far it has.  Any investor can select stocks according to their tolerance of higher valuations.  When I find valuations full, I tend to buy smaller positions in a broader range of the stocks with the best potential.

However, it is worth reflecting that the advances in data processing that excite technology analyst affect sectors which have not performed so well.  

One example is the ‘travelling salesman problem’.  Academic mathematicians have been puzzling for decades whether there is a formula to show the shortest route a salesman should use, given a number of cities he needs to visit and the distances between them.  While the academics continue to struggle, advances in computing power have come up with better and better routes (through crunching billions of worse routes, not through an elegant equation).  

So perhaps alongside the poster child stocks of the current technology boom – Nvidia and Microsoft - the lowly rated logistics companies might benefit from the application of this technology.  Stocks such as US railroads and UPS seem a long way from the AI hype sectors – but then,  of course, there is one other company which has millions of travelling deliverymen: Amazon.

Simon Edelsten spent thirty years as a global equity fund manager