The technology crash served as a reminder that investing in the Aim market is not for the faint-hearted but there are attractive opportunities for the stock-specific investor
The technology boom and bust rollercoaster of recent years has provided a challenging time for all investors, with market volatility and declining valuations constant themes in 2001.
Technology stocks continued to suffer through the third quarter of last year, hit by both the global economic slowdown and then by the terrorist atrocities of 11 September. Increased risk aversion led investors to shun the sector, which had all too visible detrimental knock-on effects.
However, the US Federal Reserve's aggressive monetary easing policy post-11 September appears to have alleviated fears of a full-blown recession. In turn, this has partially revived the allure of many established technology companies, potentially some of the greatest beneficiaries of an economic upturn.
The experience of the Aim market has broadly mirrored this scenario ' we have certainly been kept reasonably busy with new issues and re-financings. That said, there are still many heavily bruised stocks suffering in the doldrums as a result of poor business plans and weak investor support. This has served as a somewhat cliched reminder that Aim investments are for neither the fainthearted nor novice investor and should be viewed as long-term opportunities.
Excepting this caveat, the ISIS Aim Growth Fund launched in September 2001 and should be attractive to investors who are willing to accept a higher level of risk in return for the prospect of better performance. Our objective is to provide long-term capital growth by investing in a balanced portfolio of predominantly Aim companies.
The investment process is predominantly bottom up, with an emphasis on selecting companies that exhibit excellent growth potential over the medium term. While we expect many of our investments to benefit from an involvement in technology or technology-related industries, the fund's technology-specific stocks reflect our generic focus on growth.
The diversified nature of the portfolio also helps to spread risk and prevent other growth opportunities from being missed, while ensuring that the fund is measured against valuations in the Aim market as a whole. Such benchmarking means we are less likely to get caught up in either positive euphoria or negative sentiment surrounding specific tech stories. As a result we have been, and seek to remain, selective buyers and sellers of any stock at the right price.
In spite of recent market conditions for technology investment, we have not been encouraged to change our investment strategy.
Not only are we looking for good quality companies with sensible business plans for growth but we will also only invest when the valuation is in our favour.
This discipline is particularly important with regards to tech investments. During the recent bubble, the valuations placed on tech stocks rocketed. At this time, the long-term forecasts for such stocks were frequently, in our opinion, way too optimistic. Sales figures projecting growth of 40% to 50%a year over the next decade were quite common.
These in turn were often used in discounted cashflow (DCF) valuation models with equally unrealistic valuations being produced at the other end.
To put this in context and understand just how overcooked the whole sector had become, it is useful to bear in mind that Microsoft's revenues grew at a compound rate of just under 40% a year between 1985 and 2001. And this is a company that achieved true global domination across a wide swathe of the software sector. While something of a sweeping statement, pre-1999, many stocks traded within a limited price to earnings range.
This was a reflection that, historically, valuations broadly paralleled fundamental performance and that investment returns were realised as companies delivered. The trouble with the DCF models that were commonplace eighteen months ago is that too much of the to be delivered was already priced in.
A further problem we often encountered in these models was that the discount rates used were often squeezed to such an extent that they no longer reflected the levels of risk inherent in the companies. This point can be very important at flotation (when we might first invest, as the business case presented by a company can all too often prove, with the benefit of hindsight, to have been the best case scenario.
In our opinion, it is also a farce to have a model that stretches out 10 years with a cashflow that is growing at a rate higher than the discount rate. This then means that, in the valuation, year ten is worth more than year nine, which is worth more than year eight and so on.
As small-cap fund managers, this is too much for us to swallow. We can subscribe to the view that year three might be worth more than year two, and occasionally that year four is worth more than year three ' but that is about as far as it goes.
But please don't take this the wrong way. DCF is a valuable tool when used appropriately. However one chooses to value a company, it is important to apply a sanity check to the numbers used. For example, how many units must the company sell and at what price to achieve the projected turnover figures? Are its sales and distribution channels set-up to achieve this?
In looking at the risks associated with a company and its business plans, we split them into those related to management, financial, technology and market aspects. At the stages we typically invest (late-stage private equity, IPO and post-flotation), the balance of risk varies by company and, most notably, by sector.
With technology stocks for instance, the balance of risk often lies in the company getting the product to market. There is usually a product (hardware or software) that we can either play with or watch being demonstrated. Yes, it will almost certainly benefit from further development and fine-tuning but the main call we are making is whether there is a market for the product.
Conversely, with biotech companies the market for a particular drug or medical device tends to be reasonably well understood. The balance of risk lies on the technology side. The bet this time is that the company will develop its product to the point that it will successfully pass through the different clinical trials and be approved for market launch.
Our ongoing monitoring process of investee companies has enabled us to glean a better understanding of such risks and also the ability of different management teams to implement their business plans.
Looking ahead, and again in keeping with our fundamental style, we continue to look for evidence of positive earnings around two to three years out in our new investments. In spite of the recent volatility experienced by many of our technology holdings, we are confident that the underlying company fundamentals remain attractive.
At the time of writing, we are particularly excited by a number of opportunities in the personal and corporate security sectors, which for obvious reasons post last September, have moved rapidly up many government and corporate agendas. These include surveillance and monitoring equipment developers, which are currently being heavily courted.
Coming full circle, the market risk of the sector has been dramatically reduced in our eyes as security is no longer perceived as optional.
During the technology bubble, long-term forecasts on stocks were frequently far too optimistic.
The Federal Reserve's rate cutting post-11 September has alleviated fears of a full-blown recession.
With tech stocks, the balance of risk often lies in getting the product to market.
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