by Andrew McKie

Since mid-June this year, Information Technology Sector and online Consumer Discretionary companies have enjoyed quite a tailwind. This has only blown stronger as COVID cases and lockdown measures have increased. Is this boost to prices sustainable or are speculators headed for the same kind of tech wreck that we saw 20 years ago?

It was twenty years ago when Warren Buffett had this to say to Berkshire Hathaway shareholders. “Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerised by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.”

In some ways, he could be describing the tech speculation in the market today. The key factor driving the rush of money into these sectors, has been the view that these businesses have “structural growth” which is internally driven, not requiring growth from the broader economy.

An example of this “structural growth” story was the increase in online retail sales as consumers who were in lockdown had no choice but to shop online. This is currently viewed by the market as confirmation of an inevitable long-term trend towards online retailing.

At Elston, we understand these businesses and the benefits of operating leverage that can be derived by Information Technology, E-commerce, Asset Management industries and platforms.

“Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.”

Operating leverage can be a wonderful thing, if it can be extracted via scale. Unfortunately, it also works in reverse. Often these businesses need to invest heavily in marketing, R&D or reduced prices to drive sales.

Reducing prices to increase sales and raise barriers to entry for competitors is a very legitimate business strategy, known as the “flywheel effect” (illustrated at the bottom of the page.) Amazon have used it to good effect.

Historically, we have seen several periods in stock markets where investors extrapolate the success of one business to all businesses within the same sector. Amazon has been successful, so who will be the “next” Amazon?

At Elston our process includes continually balancing up the prospective growth of a business with the price paid for that growth in profit. Valuation ultimately comes back to a return.

If we are going to invest in a business, what will we receive back in terms of earnings and dividends to compensate us for the risk of investing in that business? Business is not easy, outcomes can be uncertain, things can and often do go wrong. When investing client capital in a business, we must receive a reasonable level of compensation for the operational and financial risk taken on. If a business is not making a profit or paying a dividend, then what is the return investors are receiving?

Currently the Information Technology Sector in Australia is trading on the highest absolute and relative valuation in its history, including the previous tech bubble period in 1999. Investors should avoid speculation and proceed with caution into this sector at current valuations.

At Elston, we will never speculate with client capital and will always maintain a margin for safety when valuing a business to ensure clients are adequately compensated for risk.

If you would like more information please call 1300 ELSTON or contact us to speak to one of our advisers.