The bursting of the dotcom bubble produced a strange dichotomy – many investors had their fingers badly burnt when they stopped paying attention to traditional valuation metrics and began to focus more on the fact that tech stocks “were going to change the world”.
However, had those same investors learnt their lesson and taken a back-to-basics approach to valuations, they would have missed out on the FAANG and BAT stocks that have driven much of the growth in world markets over the past decade – and very likely invested in one of the many value traps being disrupted by the tech sector instead.
So how can you accurately value a stock that relies heavily on technology? This is a question that is as vital now as it was 20 years ago, according to Lucy MacDonald, manager of the Brunner Investment Trust, who points to research indicating that despite the enormous technological advances of recent years, most industries are only one-third of the way through the process of digitalisation.
MacDonald – who is also chief investment officer for global equities at Allianz Global Investors – said the first step is to recognise the declining significance of balance sheets when analysing a company, pointing to a research paper called ‘The End of Accounting’ by Baruch Lev and Feng Gu.
“They looked through thousands of accounts to see how useful the information is now in accounting and then they regressed it against market values, and when you look at a picture of book value, it is getting less and less useful,” she explained.
Her co-manager Matthew Tillett added: “If you went back to the 1950s, most of the money was invested in companies that were capital intensive in traditional industrial sectors.
“What you saw on the balance sheet reflected the economic reality because every time a company like that makes a capital investment it goes on that balance sheet and gets depreciated.
"That’s why the market value has more of an approximation with the book value. Fast forward to today, those kinds of companies, although they still exist, are a much smaller chunk of the economy.”
MacDonald said the problem now is that so many businesses are built around intangible assets, which by their definition are harder to define and measure. And while if a company buys an asset such as a brand or some intellectual property, this will show up on the balance sheet, if it creates this value internally – which MacDonald said is preferable – it won’t.
She said there are some financial models that can help, such as discounted cash flows, while company visits also remain important, to a certain extent – Tillett said the problem with these are that company directors will often give you biased views “telling you what you want to hear”, making it important to double-check any findings with other industry sources.
However, MacDonald said that what is most important is listening to the views of people who see the world differently.
“You need to have analysts who can be open-minded, thoughtful and curious,” she explained. “And keen to try different things, which is not something you always want from an analyst. You would usually want people who are extremely precise and diligent – yes, thoughtful, but not necessarily so creative. And I think in fact being creative would usually be quite dangerous.”
“But, also, you need them to do it in sectors where it hasn’t historically been done,” added Tillett. “The tech analysts have always done this but now we need our retail analysts and media analysts to start getting their brains around this.”
One example of a tech stock that has given MacDonald some difficulty is fintech payments company Wirecard. This had such a huge differential between its market cap and a book value “of practically zero” that she began to wonder whether something fraudulent might be going on, so she asked one of Brunner’s tech analysts to investigate.
“Her view is that it is not fraudulent, but it’s really not very transparent, and she really thinks that some of the practices they are using are a little bit too creative,” MacDonald continued.
“And her conclusion on this one is that it is an interesting business, but she doesn’t think the valuation is right, it is overvalued, there is a big gap and the underlying assets are not anywhere close to what the market has been putting on them.
“So that’s the sort of work we are doing, she’s a tech analyst from a fintech company, but she’s had to think really quite differently about it and put aside some of the previous mental models when she was looking at it. Thankfully she is someone who can do that, but not many people can.”
It is not just experts that MacDonald talks to, either. Allianz has a division it calls Grassroots Research which aims to tap into the views of the end consumer to identify stock and sector trends before its competitors. This originated from employees of Allianz in San Francisco in the 1980s, who invested in Warner Communications based on the strength of the Atari games system. However, they got their sales forecasts completely wrong and the stock fell by 60 per cent.
“On the evening of the debacle when everyone was hiding, the head of research went home, almost incapable of speech, and eventually said to his family that he had had a terrible day at the office and told them why,” said MacDonald.
“At which point his son said, ‘I could have told you that – it is all about Nintendo’.
“The head of research said he was never going to let that happen again where his son or someone on the street had a better understanding of what was going on than the investors in their ivory towers.”
MacDonald said that this division has looked at the consumer reaction to every Apple product that has ever been launched, for example, while in healthcare if a new stent is released, they will discuss it with a cardiologist.
“And where it is really useful is in areas where the financial statements are even more dubious than what I have been talking about,” she finished.
Data from FE Analytics shows that Brunner Investment Trust has made 230.69 per cent since MacDonald took charge in July 2005, compared with 227.89 per cent from the IT Global sector and 192.5 per cent from its benchmark, split 70:30 between the FTSE World ex UK and FTSE All Share.
Performance of trust vs sector and benchmark over manager tenure
Source: FE Analytics
It is trading at a discount of 11.3 per cent to net asset value (NAV) compared with 9.88 and 12.88 per cent from its one- and three-year averages. The trust has ongoing charges of 0.73 per cent and is yielding 2.49 per cent. It is not currently geared.