It can be difficult to find the best technology stocks. Alex Daley of Casey Research talks about how he evaluates tech stocks.
The Investing News Network spoke with Alex Daley of Casey Research about investing in the tech sector. Finding the best technology stocks can be tough, so Daley spoke about what he looks for when investing in tech stocks, what red flags he watches out for and what he thinks about the amount of attention being paid to funding raises in tech.
Daley admitted that, for tech companies, successful capital raises provide a form of validation, while also making for a good marketing opportunity. “For them it’s free marketing, so they understand the value of pushing it,” he said.
However, Daley also suggested that when looking for the best technology stocks, it’s important to keep in mind that there are two types of tech companies out there.
Some companies are raising money because they have a great business model and are growing revenue. Daley cited Uber as an example, noting that the company is doubling its revenue every three months.
On the other hand, he stated that some companies are better at raising money than they are at selling product. “So you’ll see this kind of love-hate relationship with venture capital and technology,” he said.
In terms what he looks for when trying to find the best technology stocks, Daley pointed to growth as the predominant factor. More specifically, he said that a company should have the ability to reach a larger market, and have a good product and a strong management team that will help the company grow.
He also said that the best technology stocks have a “competitive moat,” or “something that can actually stop somebody from just copying them six months later, coming into market and destroying their margins.” For example, a company might have a patent in place on its technologies, or might keep some parts of its process as trade secrets.
And while it can be easy for investors to fall in love with new technologies, Daley stressed that it’s more important to look at growth and revenue, since new technologies can take longer to get to market than one might think. For example, he noted that though plasma TVs were patented in 1938, the first one wasn’t built until 1964.
“It’s the revenue graph you should fall in love with, not the underlying technology itself,” he said.
Don’t forget to check out the second part of the Investing News Network’s look at investing in the best technology stocks with Alex Daley.
INN: I’ve heard it’s suggested that tech companies get too much praise for simply raising funding. Is that something you see a lot of?
AD: Well, they push the brakes, right? Tech companies want to know – they want you to know how much money they raise because it’s sort of a validation on the market. Right, a technology company, that raises $10 million, that’ll be millions and millions of dollars in free publicity that they’ll get if they raised $30 million or $40 million or they do it in a billion-dollar valuation like Uber or Airbnb or these companies. For them, it’s free marketing. So they understand the value of pushing it and for new companies, it’s a good story. It’s interesting.
But there’s two kinds of companies – there’s those that are raising money because they have a great business model. They’re absolutely fantastic companies, they’re growing revenue. For a while there, Uber was doubling revenue every three months. It was absolutely incredible performance, they needed capital to grow, launch new cities, do things. So, Uber getting that much cash was necessary and they could put it to use very, very well. It’s going to be a huge company and it’s going to continue to be a huge company. And you see other companies who do that. Salesforce.com, back in the dotcom days. They’ve stuck around today a multi-billion-dollar revenue company and they’re not going anywhere.
On the other side, some companies are just really good at raising capital, and not so good at selling products. It’s easier to sell shares than it is to sell products sometimes. So you’ll see there’s kind of love-hate relationship with venture capital and technology over the people who are deploying these tens of millions of dollars – the venture capitalists, it’s about one win, one Apple (NASDAQ:AAPL), one Facebook (NASDAQ:FB), one Uber, those companies will turn $10 million, $100 million investment into $10 billion. So they’re absolutely happy to funnel capital into the companies that they think can survive and thrive. Because for them, it’s about hitting one grand slam homerun. They don’t care if they miss on 10 or 20 other investments completely and they just go bankrupt. But then, the return possibilities are still massive from having a Genentech launch Kleiner Perkins Caufield Byers, or having an Apple launch like the Sequoia Fund and so many others.
INN: Right. And how do you evaluate new companies that are tech? What metrics do you use?
AD: I’m a public markets investor. So what I care about is growth predominantly. What I’m looking for is a company that has the ability to reach a big market it’s not reaching today that has the execution and believe to actually get in there, they got a management team that goes and actually execute on the vision that they have in reaching that market and they have a great product, they have a competitive moat, something they can actually stop somebody from just copying them six months later, coming into market and destroying their margins. So they either have [a plan] in place or they have some sort of competitive process or trade secret something like that that will keep it so that somebody can’t copy them. Maybe they even just move so fast and so furious and have such a good brand like Airbnb, it’s going to be hard to displace them.
One way or another, that competitive moat, mind with a good management team and generally a wide-view addressable market is what you’re looking for. In a market like this where everything’s been rising for years on end, I mean, we’re talking about probably a whole market double the length of the average 3.7 year gold market, something’s going to have to come down. 80 percent of the growth of the NASDAQ over the last five years, has been multiple expansion as opposed to underlying earnings itself. So either the tech economy’s going to heat up rapidly to catch up with those valuations, or the market is going to come down at some point. It could be a month from now. It could be a year from now. It could be five years from now. I’m not trying to time it and say it’s going to happen soon, but it’s going to happen. It’s multiple expansion could only go on so long.
When that happens, what you want is companies who are rapidly growing revenue because those are the companies who on the other side of a market correction, are going to come out more valuable than they are today regardless of what the predominant multiple is. And when the markets are [strong], they’ll be really, really strong. Think Salesforce.com (NYSE:CRM), Netflix (NASDAQ:NFLX), Google (NASDAQ:GOOGL), all these companies were growing revenue going into 2008, they didn’t even notice the stock market crash. Not one of those companies, not Microsoft (NASDAQ:MSFT), not Cognizant (NASDAQ:CTSH), not Intuitive Surgical (NASDAQ:ISRG), none of those companies saw a single quarter during the crash in which revenue fell or earnings fell. They just continued to grow.
In fact, in some cases, like Salesforce, it grew faster during the crash because that’s when companies are looking to cut their budgets and so any company that automates, any company that improves margins, anything that can help basically automate people out of jobs, company like Salesforce.com, we can replace labor with software, that’s where you’re going to do it when the market crashes. And so it can actually be a counter-cyclical investment, sort of like gold, where you can guarantee that during the market, they’re actually going to help reform.
INN: That’s interesting. And the crash is a good segue to my next question, what’s the biggest red flag for you when evaluating tech companies?
AD: The biggest red flag is always time to market. One of my favorite examples is the Plasma TV, was actually patented in 1938. First one was built in 1964. The first LED was built in 1964, and they’re only just now taking over for incandescent, fluorescent light bulbs, right? Technology actually takes a much longer time to get to market that most people think.
One of the hot areas right now on Wall Street in biotechnology is an area called RNAI, the RNA interference patterns is basically a temporary off switch for a gene. So if you’ve got a genetic disease and don’t know how to treat it, genetic modification during the 90s and 2000s was a disaster. They found this temporary off switch is so good, it won a Noble Prize in 1999. This is an absolutely fantastic technology. Here we are 16 years later and the very first versions of RNAI are just making it to market now.
So it’s the science that started in ’84 that won the Noble Prize in ’99. We had to get to 2015 before it finally made it to market. A lot of people invested in companies like Isis Pharmaceuticals (NASDAQ:ISIS) way back in the late 1980s with dream and the hope that technology would take off in the anti-sense, as they call it, would make them billionaires. And in fact, this made quite a few people a lot of money. Isis has shot up in the last couple of years, great stock. But people had to wait two decades before it ever took that ramp up because technology can take a long time to get to market.
So what you really want to do is tech investors get in early on growth. Find a company that’s consistently post to growing revenues for three quarters or four quarters, or five quarters over and over again where they have that double-digit compound quarterly growth. If you can have that, 15 percent or higher year-over-year revenue growth, you’re looking at a company that’s starting up the ramp, that’s starting up the curve towards a much larger company. By then, and you don’t have to worry about timing risks with technology and you just go after the market when it’s starting to actually take off. That can be a huge boon to tech investors and is the opposite of what most people end up actually doing. They fall in love with the technology, they don’t fall in love with the management team. They don’t fall in love with a great execution. They don’t fall in love frankly with a revenue graph. It’s the revenue graph you should fall in love with, not the underlying technology itself.
Securities Disclosure: I, Teresa Matich, hold no direct investment interest in any company mentioned in this article.
Editorial Disclosure: The Investing News Network does not guarantee the accuracy or thoroughness of the information reported in the interviews it conducts. The opinions expressed in these interviews do not reflect the opinions of the Investing News Network and do not constitute investment advice. All readers are encouraged to perform their own due diligence.