Why Salter Brothers is bullish on small cap tech; plus five tips for finding a winner

Investment management firm Salter Brothers expects big things from the tech sector, and has laid out a strategy to help investors pick winners.

Salter Brothers is bullish on tech. But, to be fair, this image is just for illustration purposes and might not reflect entirely accurately how folks behave in the company's office. Picture: Getty Images.

We live in what is often referred to as the technology, information or digital age.

While investors have been keen to get in on the latest disruptive tech, adverse economic conditions led to considerable market declines in the sector in 2022.

However, excitement among investors about the rise in the megatrend of artificial intelligence (AI), is giving the tech sector a much-needed boost in 2023.

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There has been focus on big name tech stocks in the US including the FAANGs (Facebook, Apple, Amazon, Netflix, and Alphabet) and the more lately popular grouping MATANA (Microsoft, Apple, Tesla, Alphabet, Nvidia, and Amazon).

A highly anticipated result from NASDAQ-listed AI company Nvidia in May allowed one of the biggest companies in the world to add almost $US200 billion to its market cap in a single after-hours session.

Salter Brothers director of equities and portfolio manager Gregg Taylor said the key initial driver was all around AI but that buzz had made investors remember the growth attributes and attractive nature of disruptive tech, despite the economic challenges.

“You can still growth in from these businesses even if the economy is not growing because there is a disruption in the economy driven by AI and other technology advancements,” he said.

While the big end of tech has received much focus in 2023 Taylor reckons investors shouldn’t overlook the small cap tech sector.

“We think there are key catalysts that are likely to see the tech sector have a very good FY24 and we’re probably talking about small caps,” Taylor said.

“The irony is the best performing sector calendar year to date has been tech, with the NASDAQ up 30 per cent, Australian large cap tech is the strongest performing sector year-to-date.

“What we saw with large cap tech was the US was really strong and Australia followed a few months later.”

Taylor said the big opportunity was in small cap tech, which was yet to rebound fully on the ASX. He said small cap tech in the US was the strongest performing sector in May and it had continued to perform strongly in June.

Taylor said there were fundamentals which could be positive for smaller-end tech.

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“We are probably getting to the peak of the increase in interest rate cycle and getting greater clarity around the inflation outlook – and they are two big drivers around tech valuations,” he said, adding that the small cap sector had its best growth outlook for the past 10 years.

“Overlaying that the balance sheet strength of small caps and the tech sector is the strongest its been in over 10 years so you have earnings growth, good balance sheet strength from the bottom up and all those top-down drivers,” he said.

“The relative valuations between large cap and small cap are the largest the gap has been for closer to 20 years.

“There’s a lot of factors pointing to small cap tech being very well placed for the next six to 12 months.”

So how do investors pick a tech winner? Taylor has five top tips for investors.

1. Unique intellectual property

Taylor said it all started with the intellectual property and how you unique the company’s tech was.

“That is important to define the competitive environment, their pricing power and also ability to win meaningful market share,” he said.

“Do they have something genuinely unique or, if it’s not the only one in the world, is there only a small number of companies that have the tech solution they have,” he said.

“If a company has unique technology, it’s less likely to result in high customer churn.”

2. Don’t overlook people

Taylor said people were often overlooked when it came to technology investing.

“A lot of investors focus on the technology and the megatrends but ultimately people still run businesses and people need to make the key strategic decisions in a business,” he said.

“The quality of the people like founders, executive team and those responsible for growth and development of the technology are all critical.”

3. Quality of revenue

Taylor said when looking at revenue there were several considerations including if it was recurring, such as SaaS (software as a service) or subscription revenue or if it was a one-off purchase.

“If you can get the recurring revenue without the churn, then each customer you win is likely to stay for three or five years,” he said. “Companies don’t have to go out and find new customers every day to retain their revenue levels.”

He said the cash conversion of that revenue was really important because it was not always instant.

“In some models businesses require a lot of cash to fund new revenue where other models there could be a positive working capital where customers pay upfront for a 12-month subscription,” he said.

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He said an example was a Microsoft subscription.

“That is a high quality revenue stream because it is recurring, not a lot of churn because you typically stick with Microsoft, pay every year and upfront,” he said.

“An alternative to that is paying as you use it, weekly or monthly and a customer may be able to pay 30 or 60 days after they’ve used the technology.

“So the company book the revenue but don’t get the cash from that customer for up to 60 days and that can get worse with institutional or corporate clients, who demand good payments terms.

He said it was like asking someone to do their job but not getting paid until two months later.

4. The cost of growth

Taylor said for any tech company there was a cost to acquiring a customer, whether an individual buying one subscription or a corporate needing many.

“The cost is obviously you have to build the tech but then you have to market to them and especially with corporate clients there is a sales cycle,” he said.

“You need to go and convince them and so there is a cost to acquiring or winning a customer.”

Taylor said five years ago in tech there had been a lot of talk about whether the revenue was growing.

“Where people got that wrong was the revenue was growing but costing the company a lot of money to get it growing,” he said.

“Most technology companies don’t make a profit because they spend more money chasing customers than what the customer pays them.”

5. The all important PE ratio

Taylor said ultimately investors were looking for profitable tech companies which could then be valued.

“The problem with tech is a few years ago everyone was focused on valuing a technology company by a revenue multiple and not a PE (price/earnings) multiple,” he said.

Taylor said for example if a tech company made $10 million of revenue it would be valued at five times revenue so the company would be worth $50 million.

“A PE ratio is the multiple of profit and so now you are looking for profitable tech and not just revenue and the PE is the multiple you put on the profit,” he said.

(Just for background, CommBank describes PE ratio as a way to measure how expensive a company’s shares are. It is calculated by dividing a firm’s share price by its annual earnings per share. “You end up with a figure that represents the amount of money you are paying for each dollar of its earnings,” CommBank says.)

Taylor said that, for example, if a tech company was making $1 million profit a year and it had a 10 times PE, that business would be worth $10 million.

He said Salters looked for tech companies with defensive growth that could prosper when the economy was not booming. It also wanted these firms to have good quality revenue and cash and make a profit.

“Then we want all those factors to be better than the average and buy those companies at a valuation lower than the average,” he said.

“We want businesses growing revenues and profits by at least 20 per cent per annum and the market average PE is about 15 times, so we’re trying to buy it at cheaper than that, so getting better quality companies with better growth but their valuations are cheaper.

“What we’ve been able to achieve at Salter Brothers fund is a portfolio of tech companies that tick those boxes of good quality tech, good people, cash, better growth and a lower PE than the average.”

This content first appeared onstockhead.com.au

The views, information, or opinions expressed in the interviews in this article are solely those of the interviewees and do not represent the views of Stockhead. Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.

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Originally published as Why Salter Brothers is bullish on small cap tech; plus five tips for finding a winner