Stockhead – Thoughts from a leading fund manager on the recent selloff in ASX tech stocks

25 Oct 2019

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Sharp falls among big-name tech stocks has been a key discussion point among investors this week.

Is it a blip in the ongoing growth story, or a signal that earnings metrics have diverged too far from underlying fundamentals?

For two companies — Wisetech and Afterpay — the view of some industry analysts suggests the latter. Wisetech continues to fend off a research report that was highly critical of its acquisitive growth strategy — a battle that looks to have some way to run yet.

Market-darling APT fell back sharply from recent all-time highs following a report from UBS, questioning its growth metrics and highlighting risks in connection with increased sector regulation.

While the price action was driven by external catalysts, for Dean Fergie, portfolio manager at Cyan Investment Management, the aggressive selloff is also partly reflective of some broader scepticism now facing the sector.

Cyan’s C3G fund is well-versed in the growth narrative around leading tech stocks, having reaped strong returns from an early investment in Afterpay. But speaking with Stockhead, Fergie said he’d noticed a shift in sentiment.

“I think some of the demand has been driven by marginal day traders who were saying “I’ll just buy it today and sell it next week for a gain — that market’s reversing now,” Fergie said.

“But also the longer-term investors who’ve been thinking ‘yeah it looks a bit stretched, but every time I procrastinate it goes up’ — they’re now really questioning whether these businesses are worth the multiples they’re trading at.”

At their peak, both companies were trading on multiples of more than 100-times earnings and around 20 to 30-times sales.

“I think it’s difficult to justify any business valuation on a multiple of more than 10 times sales,” Fergie added.

“Forget the bottom line. I know interest rates are low but you’ve got to have something really special to justify that. I think the market’s lost a bit of rationality in that sense.”

Risk management

Cyan’s C3G Fund has performed well in 2019, posting a monthly gain of 8.6 per cent in September which brought its year-to-date return to around 30 per cent.

And when it comes to the tech growth narrative, the fund has been more discerning in recent weeks, reducing some holdings including its position in Afterpay.

“It’s just risk management,” Fergie says.

“Saying I’ve had a good run — let’s take some chips off the table because as an investor, whether it’s a run of luck, market sentiment or business performance, things never go up in a straight line forever.

“As fund managers, we think it’s prudent to be trimming these positions when we’ve made some good returns. It’s about not being greedy.”

He said that of the leading WAAAX stocks — Wisetech, Appen, Altium, Afterpay and Xero — the latter two stood out.

“They’ve both got good products that end-customers love. And certainly in Xero’s case it’s quite differentiated and there’s not much of a competitive threat.

“Afterpay doesn’t have the same barriers to entry, but their growth has been achieved through execution and first mover advantage.”

But looking ahead, the investment team assessed that Afterpay would have to execute on another unexpected leap forward to justify its current valuation.

“Our view was that at current prices, there’s so much good news already factored in. Will it continue to be better? We think the outlook is more uncertain,” he said.

“We decided to balance the portfolio look for the next opportunity, rather than trying to run with something that’s been good and build an overweight position.”

In light of the outsized gains among leading ASX-listed tech plays, it’s not hard to see the allure of the sector.

Low incremental capex costs and the capacity for rapid customer acquisition growth creates an environment where companies can scale up at heady speeds if they get the execution right.

And in an environment of low interest rates and slow (if steady) growth, there’s still plenty of liquidity on the sidelines ready to pour into the latest success story.

But in response to recent market ructions, Fergie said one of the main takeaways is that companies will have to work harder to demonstrate growth is converting into earnings.

“It’s a really interesting time. A lot of money has been made very easily in this market, and equally now, a lot could be lost very quickly.

“It’ll depend on the underlying strength of each business. But I think companies that are trying to create a variety of growth channels from acquisitions, or aren’t stacking up on underlying sales, they’re the ones that’ll get hammered in an environment that’s not quite so buoyant.”