A review of global equity value

When we think technology stocks we invariably are led to the Nasdaq and its checkered history of boom, crash and now recovery. The dot com bubble of 2000 was a period when speculators (not investors) valued companies based on eye-balls or clicks enjoyed by websites. The inevitable crash came when the laws of finance brought on an unpleasant awakening. Share valuations were once again based on profit and Return on Equity (ROE) rather than hope.
Now, fifteen years later, the index has just exceeded its 2000 peak. Business models of the survivors have matured. Some of the dreams of 2000 have become business realities. Today there are new dreams being considered and executed – such is capitalism.

But is there value today in the sector’s best names?    

Figure 1. NASDAQ composite
Source. Thomson Reuters Datastream
The impact of technology has continuously changed and improved all human endeavours throughout history. The twentieth century industrial revolution was a slow moving event relative to the remarkable last couple of decades. The breathtaking pace of the ‘digitisation of everything’ has seemingly affected the ability of humans to see and acknowledge many remarkable advancements.
Today we have two generations of people differentiated by their experience of life during two industrial revolutions. There are the baby boomers – the generation that was paid in cash, paid for things with cash, wrote letters by hand, used fax machines and telephones that had wires attached to them and phone books.
The baby boomers’ children are living through remarkable change but they are unaware of what the world is changing from.
Looking back over twenty years, technological change has created corporate winners and losers. The capitalist system exerts its magnificent trait of rewarding the winners and diverting capital to them. The losers are capital starved, devalued and their businesses ultimately disappear (unless they reinvent themselves).
Below we have identified 20 significant technology stocks to watch and possibly consider for investment. The first 15 have achieved remarkable accomplishments over the last twenty years. The last five on the list are our picks for the disruptors most likely to be successful over the next five years.

Company Name Stock Code Opportunity today?
Apple Inc AAPL.OQ No
Google Inc GOOGLE.OQ No
Microsoft Corporation MSFT.OQ No
International Business Machines (IBM) Corp. IBM.N Yes
Samsung Electronics 005930.KS No
Facebook FB.OQ No
Intel Corporation INTC.OQ No
Accenture PLC ACN.N Yes
Hitachi Limited 6501.T No
Western Digital Corp WDC.OQ Yes
Seagate Technology PLC STX.OQ Yes
Qualcomm Inc QCOM.OQ Yes
NVIDIA Corporation NVDA.OQ No
eBay Inc EBAY.OQ No
OMRON Corporation 6645.T No
Tesla Motors Inc TSLA.OQ For the risk tolerant
Netflix Inc NFLX.OQ No
Regeneron Pharmaceuticals Inc REGN.OQ For the risk tolerant
Baidu Inc (ADR) BIDU.OQ For the risk tolerant
iRobot Corporation IRBT.OQ No

The giants – Apple, Google, Microsoft and IBM- need little introduction. Each of these display remarkable pedigree, and formidable product and service offerings.
The most innovative is perhaps Apple which continuously enhances its revolutionary product offerings. It will be interesting to observe if Apple’s new watch offering can achieve market expectations of sales of 20m units. In our view much of Apple’s potential is factored into its share price.
IBM is undergoing some significant change and is certainly the most unloved of this group. Today it boasts Warren Buffett as a big supporter and we think there is value in IBM. IBM trades at 10 times the current year’s earnings and due to significant buybacks over recent years (greater than $70bn), it has reduced its equity base and created a very high profitability level. If one was conservative on projected ROE (assuming a reduction in future profitability) and used a moderate required return (RR) of 10%, the intrinsic value of IBM is above $200 (against a current price of $165). We expect low single digit revenue and profit growth driven by IBM leveraging its cloud investments and expanding in security and mobility offerings. This profit growth and buybacks (80% of free cash-flow) will drive high single digit EPS growth and increase value by a similar quantum over the medium term. We find the 20% discount attractive and more than discounting the earnings headwind of a rising $US.
Accenture, a cyclical global consulting and outsourcing powerhouse, displays the rock solid fundamentals that one would expect from a superior service business. Today it is trading at a small discount to intrinsic value and is offering an opportunity for those with a constructive view on the outlook for the global economy.
Western Digital, Seagate and Hitachi are the leading names in digital storage. It is remarkable that it was only in 1996 that IBM estimated that it was more cost effective to store data digitally rather than on paper. When one considers that every minute of every day, users of youtube.com upload some 300 hours of content, much of this in high definition, one can start to get a feel for the explosive growth in the demand for storage. We are only part way through the ‘digitisation of everything’ movement that will likely continue to grow for another decade or two. While the industry growth rates are impressive, the challenge for Western Digital, Seagate and Hitachi is that the key products these names offer are commodities in nature. Many but not all consumers shop for hard drives based on specifications rather than brand names. Over time, this will act to keep a lid on margins enjoyed by the industry. The strong industry tailwinds and acceptable margin performance today make Western Digital and Seagate attractive opportunities. Hitachi is engaged in several different industries and its share price is caught up in the Japanese equity optimism created by massive QE. We suggest caution in looking at Japanese companies but acknowledge that QE has a long period to play out.
Qualcomm is one of the world’s largest semiconductor players and the world’s leading supplier of mobile device chipsets. Reviewing this company exposes the evolution of 5G cellular networks and suggests that Australia’s roll out of the NBN needs to be properly considered. With projected speeds approaching 1GB/s there is the likelihood of connection with mobile sensors and monitors in places that will surprise most of us.
For instance, Tesla is now updating the software in its cars via direct internet downloads; this theme will likely lead the industry to change over time. The demand for mobile chipsets looks remarkably strong for the foreseeable future and Qualcomm is the gorilla in the space. Its board has recently announced a buyback plan ($10bn of stock in the next 12 months) and an increase of the quarterly dividend by 14%. Adding the buyback to the dividend, we calculate that the cash flow back to shareholders is approaching 9% of the current share price. Qualcomm has been a steady performer based on ROE and cash generation. It has no debt and a high quality rating score – a very healthy 89% Clime Quality Rating (CQR). The outlook for profitability is not dissimilar to the past, which adds to our assessment of the valuation of $73 growing at around 6% per annum. The current share price of $70 places this name at a discount, but for cautious investors perhaps slightly more of a discount is required. The key risk factors are a slowdown in global growth and/or the loss of a key customer such as Apple or Samsung.
At the more exciting end of the spectrum are our five picks for the “disruptors” that have the potential to change their industries and create new markets over the next 5-10 years. Each has remarkable upside potential but entails considerable risk. Baidu looks the cheapest and Tesla the most interesting. These names suite the enterprising but risk tolerant investor.
After considerable research of over one hundred annual reports – your correspondent, an avid tech consumer – perceives continued uncertainty across the IT sector. There will be no slowdown in technological change and the creation of low customer switching costs makes the landscape even more unpredictable. The network effects, first mover advantages and sheer growth in markets may favor many for the short to medium term, but no business has a certain future when we look out past a decade.
From a financial perspective, there is little certainty as to how many developments will transform into revenue or profit. Then there is the disruption that eventuates as capitalism fosters new sub-industries and destroys established players with the combination of a ‘new idea’, an entrepreneur and a little venture capital.
One may lean toward the majors with their enormous cash war chests and expect them to consume the disruptors (will Apple consume Tesla?). Alternatively, one could focus on the integrators who are agnostic about the particular technology and solve clients’ problems by using the best product/service of the day. Accenture and IBM fit the bill here. Apple presents a strong enduring position leveraging their ecosystem and creativeness. Is this insurmountable in the next few years? No. But in the next decade? Probably Yes! Creative destruction risk is higher in this sector than any other and investors should be alert to prices that become disconnected from fundamentals.

Investment Conclusion

The best way to minimise risk and the likelihood of poor investment returns is to focus on undervalued opportunities. Today, global value continues to be elusive on a broad basis as equity continues to be well bid in an environment of benign fiscal policy and remarkably stimulatory monetary policy across major markets.
Shareholder returns come from three sources: dividends, earnings growth and the speculative return or the change in the market’s pricing of the underlying profitability. Over the longer term (10 years+), the speculative return ends up being zero as prices inevitably find their way back toward value. In the short term, all manner of things can occur to separate price and value, monetary madness being the flavour of today.
Recently, earnings per share growth estimates have tracked lower in most developed markets. MSCI countries with significant materials and energy components such as Canada (33%), Australia (20%) and the UK (23%) are facing EPS growth headwinds with all three falling meaningfully over the last three months or so. As such, it is challenging to see much value growth for these three countries in the near term.

Figure 2. Earning Growth Rates – 12 months forward
Source. Thomson Reuters Datastream
Nevertheless, prospects in the US and in Germany are looking better than they have been for some time. In the US, the housing market has staged a significant recovery and consumer confidence has risen in line with the improvement in employment conditions. In Germany, a cyclical upturn and weaker euro have led to a sharp rise in business conditions and expectations. Indeed, business sentiment across the auto sector in Germany is now at an all-time high based on data going back to 2001.
Sensible investors will take advantage of opportunities to invest in high quality, world class companies at times when uncertainty has kept share prices at attractive levels. While uncertainty in the IT sector is a constant, there are some wonderful companies that seem destined to succeed over the decades ahead, a few of which are priced at reasonable levels. As always, the prudent advice is to be appropriately diversified across stocks, sectors and geographies. Without the benefit of the elusive “crystal ball,” we suggest sensible exposure to some of the leading names in technology may be a rewarding endeavour.

Source. Daily Reckoning, 21 March 2015