Rudi’s View: Technology’s Moment Of Truth

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In this week's Weekly Insights:

-Technology's Moment Of Truth
-Conviction Calls
-Research To Download

By Rudi Filapek-Vandyck, Editor FNArena

Technology's Moment Of Truth

Big Tech on Wall Street has fallen off its pedestal in October with share price weakness following the release of Q3 financials.

For some, like Meta (formerly known as Facebook) the latest disappointment simply added more pain for loyal shareholders who have now witnessed the share price tanking by some -70% from last year's peak.

While the consequences for the likes of Amazon, Apple, Alphabet (Google), Microsoft and Tesla have been less severe, they are making big headlines nevertheless and have started to sow the seeds of doubt among investors.

Maybe Big Tech is not immune from the global slowdown; might it pay the price for being over-owned by investors across the globe?

For investors in Australia, there are multiple important points of interest to consider.

The first is the observation that positive market sentiment will not be deterred – at least not by disappointments from individual companies, no matter how big their size or marketweight.

This could well turn out to be all-important (in the short-term) as market observers had formed doubts about the outlook for Big Tech and how markets might respond to upcoming "misses" and downgrades.

Even after recent sell-offs, the marketweight of the so-called FAANMG stocks still represents around 11% of the FTSE World Market cap, so it would not be much of a stretch to think where goes Big Tech, there follow global indices.

Apparently not so. Market sentiment post the general weakness in September is now firmly focused on central banks slowing down the pace of rate hikes – a global trend that started with the RBA pre-Melbourne Cup day meeting.

Previous rallies in US equities have run out of puff once the 50 or 60 day moving average or the 200DMA came in sight, so investors will be keeping a close watch on what happens next over the weeks ahead.

Currently, the 60DMA, while trending downwards, seems only another positive day away while the 200DMA, also trending south, is below 4100 for the S&P500.

Headaches building for the largest companies on earth also lends credence to forecasts for the Aussie share market to outperform international peers, in particular US indices.

If investors were to assume Big Tech's marketweight is now reverting back to pre-pandemic level, this implies either Big Tech share prices must fall by a further -25% or other equities combined must outperform by some 33%, according to calculations published by Longview Economics.

Let us assume the actual outcome will be somewhere in the middle of those two scenarios. This still implies large US indices have a natural headwind to overcome, which the ASX200 doesn't have.

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This month's newfound vulnerability for the world's corporate giants also shines a light on current trends in corporate earnings; trends that equally affect businesses in Australia.

Even without disappointments from Meta et al, statistics and trends for corporate profits in the US had started to look bleaker in comparison with previous quarters this year. But despite a general expectation that analysts' forecasts for corporate profits remain too high, and estimates need to fall by -15%-20%, the outcome thus far is less unified, much more polarised.

In simple terms: companies that were badly hit by covid, and are currently enjoying the re-opening recovery, seem to be performing better-than-expected. Others are facing emerging headwinds from inflation, rising rates and bond yields, and from down-shifting consumer spending.

Companies like Alphabet and Meta, for example, are essentially offering an insight into global trends in paid advertising. With economic recessions on the horizon for the UK, Europe and elsewhere, who should be surprised businesses are spending less on promoting products and attracting fresh customers?

Australia has the added benefit of a relatively oversized skew to miners, energy producers and financials. In particular the latter two sectors have witnessed positive revisions to earnings forecasts recently, which is in stark contrast to this year's overall trend, and again makes the Australian market a positive stand-out on the global platform.

Australia doesn't have a quarterly results season, but this year's AGMs, quarterly updates and out-of-season reporters combined fulfill a similar function for local investors. Macquarie, upon checking 76 AGMs to date, concludes the underlying balance has shifted in favour of downgrades and "misses".

More worryingly, perhaps, is that market responses to any negative updates have become a lot larger too – a phenomenon that is equally visible in the US. Could this be a direct result from lower liquidity on the back of central banks' tightening and companies no longer buying in their own stock?

On Macquarie's assessment, earnings disappointments in Australia are mostly blamed on high freight and energy costs, the weak Aussie dollar and bad weather. And while 74% of companies to date have stuck with their guidance for FY23, it is also Macquarie's view that it's too early yet, both into the new financial year and into the global economic slowdown, for a true and accurate assessment of what lays ahead.

Meanwhile, the polarisation between covid-winners and -losers is also taking shape in Australia.

The recent weeks have seen sharp contrasts in market updates from Qantas Airways ((QAN)), the recently renamed EVT Ltd ((EVT)), Auckland International Airport ((AIA)), as well as from Super Retail ((SUL)), JB Hi-Fi ((JBH)) and Unibail-Rodamco-Westfield ((URW)) against disappointments from Coles Group ((COL)), Endeavour Group ((EDV)), Woolworths Group ((WOW)), as well as from Australian Clinical Labs ((ACL)), Healius ((HLS)) and Sigma Healthcare ((SIG)).

Market updates by CSL ((CSL)), ResMed ((RMD)) and Macquarie Group ((MQG)) have resulted in slightly lower price targets.

In contrast, banks, energy producers Santos ((STO)) and Woodside Energy ((WDS)), and local coal producers are enjoying positive market updates and upgrades this month. Though, it has to be pointed out, smaller cap mining companies equally delivered their share of disappointments and misses, as have the likes of Adbri ((ABC)), ARB Corp ((ARB)), Codan ((CDA)), Reliance Worldwide ((RWC)), and Step One Clothing ((STP)).

Following on from current trends, maybe extra caution seems but appropriate ahead of upcoming market updates from the likes of Boral ((BLD)), CSR ((CSR)), Domino's Pizza ((DMP)), James Hardie ((JHX)) and Downer EDI ((DOW)) – at least for the short term.

On the same logic, maybe companies including Best & Less Group ((BST)), Flight Centre ((FLT)), Monash IVF ((MVF)), Lovisa Holdings ((LOV)), and Universal Store Holdings ((UNI)) are in the short term poised to perform better-than-expected?

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If investors are ready to rethink their exposure to Big Tech in the USA, this could potentially have negative consequences for the sector locally, even if direct comparisons look rather spurious and manufactured.

Sure, a direct link exists between less advertisements for Google and Meta and services required from Appen ((APX)), but virtually nothing links with Audinate Group ((AD8)), Carsales ((CAR)), Life360 ((360)), Pro Medicus ((PME)), Seek ((SEK)), TechnologyOne ((TNE)) or WiseTech Global ((WTC)).

Yet, during the good times of the pre-2022 bull market, often no such questions were being asked as local share prices simply attracted buyers in the slipstream of gains made in the US.

In similar vein, investors who witnessed the aftermath following the Nasdaq meltdown in 2000 will still remember there was no more appetite left for anything online, technology or telecom – worldwide, for years.

Within this context, recent price action for local stalwarts including Altium ((ALU)), Audinate Group, Pro Medicus, TechnologyOne and WiseTech Global should be very encouraging for investors in Australia as it signals that local companies can break free from general market sentiment on the strength of their specific qualities and outlook.

I do note also that when UBS recently selected its ten stocks for the decade ahead, WiseTech was included.

The team of technology sector analysts at Morgan Stanley is equally positive about WiseTech, arguing the company is increasingly trending towards the broker's bull case scenario for the years ahead.

Morgan Stanley also decided to add ten more local technology companies to its coverage, which makes for some interesting reading, to say the least.

First conclusion: only few companies in the sector possess a sustainable competitive advantage. Even fewer are profitable and/or scalable into new markets.

The team ultimately decided to prefer Hansen Technologies ((HSN)), Megaport ((MP1)), and Pexa Group ((PXA)) – none are free of risks or criticism.

Megaport might be building global domination on the back of technological leadership, but the cash register is still bleeding, there are no profits and more than one growth hiccup has shown up in recent market updates; which is also why the share price has been so volatile.

Pexa, partially owned by very troubled Link Administration ((LNK)), operates from an extremely solid market position in most of Australia, but housing activity is expected to slow down and the fresh expansion into the UK will be a costly drag in the short term.

Hansen Technologies has just about been every analysts favourite throughout the past two decades, until realisation sinks in that loyal clients do not guarantee wealth creation for shareholders.

Investors only have to look back over the past decades, both through financial metrics like profits and dividends as through the share price to see this company relies on acquisitions to decisively move the dial.

Hansen has made 30 acquisitions in 30 years.

Key reasons as to why analysts tend to like this company include sticky customers (Hansen does billing software, churn is less than 2% annually), strong cash conversion of stable revenues, and family and senior management ownership.

Morgan Stanley's research and projections confirm my own observations and scepticism, with only minimal organic revenue growth expected, unless more acquisitions follow. Also, after all those years, and 30 acquisitions, annual revenues are still only expected to reach $300m this year.

Call me biased, but another software provider on the ASX, TechnologyOne ((TNE)) has an even lower customer-churn but it grows without the need for acquisitions, the past two decades showcasing one of the most consistent and resilient track records on the ASX (possibly worldwide).

Morgan Stanley's gripe is that TechnologyOne's ERP software is not that special, while it competes with larger multinationals including Workday, SAP and Oracle. Also, TechOne's business approach is very much based on strong relationships in Australia; a model that doesn't scale up when entering additional markets, such as the UK.

However, the analysts do concede if management achieves its targets in the years ahead, including $500m Annual Recurring Revenues (ARR) by FY26 at a 35% gross profit margin, the share market will likely re-rate the stock.

Morgan Stanley analysts are equally positive on oOh!media ((OML)) and hipages Group ((HPG)), but cannot get excited because of too much competition and no clear moat.

Four fresh initiations all received a negative Underweight rating (essentially an Avoid) as Morgan Stanley sees too many vulnerabilities and risks on the horizon for Appen, AirTasker ((ART)), Aussie Broadband ((ABB)) and Macquarie Telecom ((MAQ)).

I think the key message to take away from all of the above is that the Great Party is over for young gun Growth and Technology stocks.

Successful investing in these companies is now dependent on the same characteristics and requirements that have been necessary in other segments of the market throughout time and cycles; cashflows, dependable revenues, defendable moats, not too much debt, and successful execution.

Questions will be asked and narratives put to the test as economies slow down or face recession. Next year will separate the pretenders from the deliverers.

As for US Big Tech, there's a valid argument this is simply the end of a cycle, but with exact fall-out as yet unknown.

Conviction Calls

UBS equity strategists Richard Schellbach and Akash Biradar have outlined a number of reasons as to why the Australian share market might possibly be poised for relative outperformance vis-a-vis international equities throughout the decade ahead.

Reasons to support that premise are the faster population growth, the concentrated industry structure (supporting higher profit margins), the world-beating dividend yield and the fact most companies in Australia sell to local customers, which to an extent insulates them from troubles and headwinds elsewhere.

Once upon a time in the 1990s foreign investors used to make up 55% of ownership of ASX-listed companies, but this has been replaced with percentages fluctuating between 35%-40% in the past two decades. UBS predicts if the above thesis proves correct, that percentage of foreign ownership might be poised for a revival in the years ahead.

An important part of the thesis is based upon the prediction the world shall return to a low-growth environment and Australian equities, also carried by the resources industry, should be able to shine in such an environment, including when inflation sticks around for longer.

The duo has also selected its ten best ideas for the next ten years, or in their own words: "ten stocks to put in the bottom drawer for the next ten years".

The selection will raise a few eyebrows, no doubt about it: BHP Group ((BHP)), CommBank ((CBA)), IDP Education ((IEL)), REA Group ((REA)), Suncorp Group ((SUN)), Transurban ((TCL)), The Lottery Corp ((TLC)), Wesfarmers ((WES)), Worley ((WOR)), and WiseTech Global.

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Strategists at Wilsons prefer to remain cautious on equities as far as the next six months or so are concerned, mainly because inflation is not yet deflating and central bankers thus feel the need to continue tightening.

They also believe Australian equities might outperform on the international stage over the year ahead.

Specific opportunities identified include Aristocrat Leisure ((ALL)), Santos, Insurance Australia Group ((IAG)), Macquarie Group, National Australia Bank ((NAB)), Cleanaway Waste Management ((CWY)), Qantas Airways, Allkem ((AKE)), and Goodman Group ((GMG)).

Elsewhere, Wilsons' Research Ideas have identified the following opportunities: OFX Group ((OFX)), Aroa Biosurgery ((ARX)), Nanosonics ((NAN)), Select Harvests ((SHV)), Collins Foods ((CKF)), Ridley Corp ((RIC)), Nick Scali ((NCK)), ReadyTech Holdings ((RDY)), PeopleIn ((PPE)), Pro Medicus, and Immutep ((IMM)).

Still at Wilsons, the Model Portfolio made the following changes in September/October: adding Nine Entertainment ((NEC)) and NextDC ((NXT)) while buying more of ResMed while selling out of Judo Capital ((JDO)) and News Corp ((NWS)) and reducing exposure to BHP Group.

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Retail sector analysts at Jarden remain cautious on consumer-oriented companies in general. Investors are advised to look for companies with a clear value proposition, pricing power and scale.

Thus Woolworths Group, Metcash ((MTS)), Treasury Wine ((TWE)) and Costa Group ((CGC)) are preferred for their "defensive" business model, while Flight Centre ((FLT)) and Premier Investments ((PMV)) are preferred for their growing return on invested capital (ROIC).

The likes of Universal Store Holdings ((UNI)), Accent Group ((AX1)) and Premier Investments are favoured because of their defensive consumer clientele, with Treasury Wine shining in the premium section.

Three retailers are looked favourably upon for their 'value' proposition; The Reject Shop ((TRS)), Domino's Pizza, and Collins Foods.

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JP Morgan's monthly insights into positioning and sentiment among local institutions becomes available at one month's delay, but the September update still contains a few snippets that provide us mere mortals with some useful insights.

For starters, sentiment remains downbeat, which also feeds into unchanged high levels of cash holdings. September saw the return of staples becoming the defensive asset to own and JP Morgan reports Coles Group in particular enjoyed the come-back of institutional flows.

Overall exposure to the energy sector has been wound back, but just about everyone continues to favour Santos over Woodside Energy.

Macquarie Group fell out of favour in September. The other remarkable insight is that while retail investors continue to embrace ownership of local bank shares, domestic and offshore institutions are now markedly underweight the sector.

At least such was the situation in September.

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As mentioned above, Morgan Stanley has tried to spice up its coverage of ASX-listed technology stocks with the addition of ten new names, but only three start a with fresh Overweight rating: Pexa Group, Megaport and Hansen Technologies.

The decision to slap an Underweight rating (let's call them an Avoid/Sell) on four others has been inspired by intense pressure from competition and no obvious moat or defence against it. Stocks starting off on a negative note are Appen, Aussie Broadband, Macquarie Telecom and AirTasker.

Three companies sit in the middle with an Equal-weight rating: oOh!media, TechnologyOne and hipages Group Holdings.

Research To Download

Research as a service (RaaS) on:

-Millennial Services ((MIL)): https://www.fnarena.com/downloadfile.php?p=w&n=B4DEF51F-0CFB-844E-7A1CCFFBE4136EBF

-X2M Connect ((X2M)): https://www.fnarena.com/downloadfile.php?p=w&n=B4E20607-E608-2DF0-D2CEE652615F40EB

-Kinatico ((KYP)): https://www.fnarena.com/downloadfile.php?p=w&n=B4DC1EF2-C1CF-71D7-C6F4E137CF908E59

(This story was written on Monday, 31 October, 2022. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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