(July 8): Take a minute to think about just how much technology has changed your life, in ways previously un-imaginable. The introduction of ride sharing was one such development. Has it occurred to you to be a part-owner in the same company that you derive immense utility from?
Interested? You are not alone. But many of my friends express caution investing in the stock market and avoid it like the plague. Others live and breathe share trading and love the thrill of making a quick buck.
Some of you are more fundamentally grounded and choose to invest only domestically. There is no right or wrong, but do think about the compelling opportunities that lie abroad.
Investing domestically has its merits. However, the pool of investable companies with reasonable valuations is rapidly diminishing. Returns have been frustrating. Mid- to longer-term investments are giving way to short-term trades. But look around you, the world is changing. The confluence of push and pull factors towards investing abroad is growing stronger. Technology is a double-edged sword, as disruption and the lowering of barriers to entry have taken down many protected industries and cash cows of the past. And it is the tech giants, mostly in the US and China, that wield that sword.
But not all tech companies are the same. Earlier, I wrote about considering being part-owner in some tech firms. However, most investors follow a process and mine involves understanding the quality of a business model, competitive advantages and barriers to entry, among others. Valuations matter. You may have a different framework, but it is important to have one to begin with. With this in mind, not all technology companies may be good investment opportunities currently as they face increasing competition and significant cash burn or are simply at stratospheric valuation levels.
So how do you start?
You could begin investing overseas slowly via a mutual fund, or you could start by going solo. Choose wisely. I’d like to touch on the example of a ubiquitous technology platform that is easy to understand. A company with a proven business model, dominant franchise and strong free cash flow generation. Meet Google — a company that requires no further introduction.
Sometimes, opportunity lies in periods of transition and uncertainty. Google’s unrivalled ecosystem of properties, consumer stickiness and innovation has allowed it to grow at an enviable pace, at 19% organically in the first quarter of 2019 on a revenue base of US$39.3 billion ($53.3 billion). And the extension of its vast reach, secular forces of digital advertising displacing traditional formats and under-monetised properties such as Maps, Cloud services and potentially Waymo (driverless cars) and Stadia (cloud gaming streaming services) should allow for growth to further compound at an impressive rate for the foreseeable future. The company has many admirers, including Charlie Munger, vice-chairman of Berkshire Hathaway, who was quoted in May 2019 as being regretful of not buying Google and having “just sat there sucking our thumbs”.
But Google, whose parent is Alphabet, has had its fair share of disappointments in recent months. Investors have long been frustrated over its lack of financial disclosure and limited share buybacks. Recently, investors punished the company as organic revenue growth slipped below the psychologically important 20% handle, given concerns that growth was decelerating as the law of large numbers caught up. (Note that organic revenue growth has increased at an astonishing 20% or so for the past 14 consecutive quarters, an amazing feat, given its large absolute revenue base.)
Shares tanked 8% in a single day on the miss. Adding further insult to injury were headlines that the US Department of Justice and Federal Trade of Commission (FTC) was considering pursuing Google, Facebook, Apple and Amazon.com for anti-trust-related violations, leading to concerns that a break-up of the company was on the cards. A lengthy anti-trust investigation could ensue; old-timers probably remember the similar pain that Microsoft endured many years ago. And then came renewed US-China trade tensions and the Huawei ban. When it rained, it really poured and shareholders were left to endure a considerable amount of pain in a month or so.
But behind the pain is a company with a proven business model that is nearly consumer staple-like. What would your life be without Google, Gmail, Maps (and Waze), YouTube, Android, Search and other applications? The incumbent consumer staples are now beset by slowing organic growth, lack of innovation, competition and disruption but trade at similar earnings multiples as Google. Its financials are pristine, with the company generating US$23.2 billion in free cash flow in 2018 with net cash of US$110 billion in the latest quarter — no wonder investors are frustrated with the lack of shareholder return. And finally, it has a management team that encourages innovation and purportedly spends 20% to 30% of employee time on “side projects”, or ideas. On this note, former CEO Eric Schmidt’s book How Google Works is recommended reading.
Clearly, Google can do this only because it has built an unrivalled ecosystem with very limited competition. However, the biggest threat remains government regulation and how it could rein in Google’s lucrative returns, or even precipitate a break-up. I am not sure if anyone has the answer. Former FTC chairman William Kovacic was recently quoted as saying that a “break-up would be extremely hard to accomplish”. And it is unclear if breaking up America’s finest technology companies would be timely right now. Viewed from a different perspective, a break-up could crystalise Google’s sum-of-the-parts valuations above its share price, given that the company has suffered from heavy up-front spending for new projects, lack of disclosure, and frustration on shareholder return, among others.
Paying for revenue growth
Did you also know that only 23% of all companies in the MSCI World Index had revenue growth greater than 8% as at December 2018, a near record low since 1998? Revenue growth is an increasingly rare commodity and we are paying dearly for those that offer it. But rarer still is a company that offers the longevity and stability of growth, and immense free cash flow generation. Many unicorns are growing rapidly but are burning cash to do so.
I have compared a sample of companies that are worth US$15 billion and above, and are growing sales 10% organically (excluding mergers and acquisitions) against their one-year forward price-to-earnings ratios and free cash flow yields (see chart below). Please note that this exercise involves only companies in the major US, Europe and Japan indices, given my investment focus, and does not include Asian peers.
A powerful rule in investing is that of compounding interest. Money doubles at a rate of 8% within nine years and grows 20% in 3.8 years. Google’s unique characteristics of visibility of growth, limited competition and strong free cash flow generation should allow the effects of compounding to boost earnings per share at a rate faster than many others despite its enormity.
But there are two sides to every coin and each investment has its risks. Times are uncertain and recession risks have increased, even more so with the ongoing trade tensions and length of the current economic cycle. Further government regulation and scrutiny is another obvious one. Organic growth may continue to slow and Google may very well not change its shareholder return stance at all.
Major developed market company valuations relative to sales growth
Disclaimer: The author works as a portfolio manager at Nomura Islamic Asset Management Sdn Bhd (NIAM), which has approved the publication of this article. NIAM is a member of the Nomura Asset Management Group. Nothing in this article should be construed as an offer or solicitation to sell or purchase any security; nor is it investment advice. Opinions, analysis, projections and other information contained herein are merely expressions of belief. No representation or warranties are made on the accuracy or completeness of such information.
