Henderson Global Technology manager Stuart O’ Gorman thinks the tech sector is heading for bubble territory once again as the combination of cheap credit and investor hype combine to push valuations of many small cap tech stocks to ‘nosebleed’ valuations.
O’Gorman, who runs the fund alongside Ian Warmerdam, told investors: ‘I’ve lived through the last tech bubble and seen loads of phenomenal companies that were going to change the world, and I’ve seen the valuations that were put upon them.
‘We are getting to the stage now where a lot of valuation multiples are extreme. Particularly given how shaky the global economy is, I think this is pretty terrifying because the valuations are starting to assume that these companies win, that their competitors don’t react with pricing [changes] or their deflation doesn’t end up making their end market less profitable.
O’Gorman cites a range of companies including Workday, Tableau, Splunk and Netsuite that have been in existence for some years but which are still not turning a profit despite trading on price to sales ratios of between 23 and 38 times.
‘They keep on having great sales but profitless sales. The major problem with the credit bubble we are causing is that it allows too many profitless businesses to exist.’
O’Gorman says the same analogy can be drawn from what is happening in China after travelling to the country last month to meet Mediatech, which supplies the silicon for white box Chinese handsets.
‘It is not just happening in areas like the cloud, it is also happening in handsets. [Mediatech] freely admit that most of their customers don’t make a profit but they are funded by the local Chinese government and some by the army. It will end in tears for investors. ‘
He points to a number of recent IPOs in the sector where companies are floating at what he calls ‘nosebleed valuations such as FireEye, Rocket Fuel and Benefitfocus.
‘We are back to the days of 50% plus IPO returns for really hot stocks. A lot of people are piling into these companies but they don’t know what they do, but they know it is very exciting. That terrifies me and I think it can go badly wrong.’
He points out that on the flip side, a lot of profitable large cap tech stocks are trading close to all-time lows as they are seen as too dull despite being cash rich and producing relatively steady and recurring revenues.
‘The price to earnings ratios of the largest 15 tech stocks versus the [wider] tech sector show that we are getting to one of the biggest discounts they have been at apart from the bursting of the tech bubble. ‘
O’Gorman says the relative valuations may see him move to increase exposure to the large cap tech giants.
He also believes some investors overlook the fact that while the US market has had a storming 18 months the tech sector has lagged and is now trading at relatively attractive valuations.
‘Owning tech as a play on America [gives] a mixed message. Within the US the tech sector is the biggest exporter so while tech versus the world [indices] has done well, within America it has not done so well [and] looks very cheap compared to the S&P 500.’
He admitted to being disappointed with returns year to date, despite strong long term performance.
‘We are not particularly happy with performance year to date. We are third quartile. Over the last five years there have been periods when small caps have raced away and over the last 12 months there has been further massive outperformance by small caps.
He cited a ‘massive movement towards beta in the market’ where investors were bidding up ‘rather more speculative stocks.’
‘The question is do you participate or hold your line? We decided to hold the line on some of these very expensive stocks.'
Over the last three months however the fund has relatively outperformed with the main positive contribution coming from semiconductors and semiconductor equipment.
The fund’s underweight to Apple was reduced last summer while another positive contributor came from an underweight to Intel.
‘[Intel is a] fantastic manufacturer of technology but the problem is its core market. There is less demand for PCs and most growth in units is coming from mobile in both the handset and tablet areas.
‘I think it will be very hard for them to break into the mobile [area] as barriers to entry are quite high.'
A recent detractor to performance was not owning Chinese internet giant Tencent.
‘We were worried they would have to spend an awful lot of money fighting off competitors. They have, and margins have been hit by about 1000 basis points since we sold Tencent, but the stock has continued to [rise] as the whole Chinese internet sector has seen a huge re-rating.’
Cisco has also been a poor performer recently.
‘We still like Cisco but like other large cap tech stocks it has suffered from a decline in emerging market demand.’
Over the five years to the end of September 2013 the fund has returned 102.4% compared to 85.8% by the MSCI ACWI/Information Technology benchmark.