The roller-coast ride of tech stocks

17:00, Jul 26 2013

Technology stocks Xero and Diligent have lit up the NZX, showing just how lucrative - if risky - investing in shares can be.

While banks are paying annual interest rates of about 3 or 4 per cent on savings accounts, Xero's shares fell and then rose by 8 per cent during a single trading day last week.

It has become an increasingly breathless roller-coast ride for investors.

Anyone who bought $5000 of Xero shares five years ago and had the nerve to hang on, would now be sitting on a profit of more than $86,000. Diligent slumped after its initial listing but would have returned an almost equally staggering $74,000 as of a week ago.

Even news of the Financial Markets Authority's first market manipulation case against Diligent founder Brian Henry, which helped wipe 2.9 per cent off the share price on Wednesday dropping it to $6.31 as of Thursday morning, was barely enough to dent the gains of anyone who bought shares at 40c.

Is it worth non-professional investors dipping their toes into these choppy waters? Or should they perhaps wait for the next ship that comes along, as Xero's meteoric rise inspires other technology businesses to seek a mooring on the NZX?

There is probably no more divisive stock than accounting software company Xero.

Sceptics argue it is massively overvalued. With a market capitalisation of $2.1 billion it is worth more than Air New Zealand, despite posting a loss of $15 million on sales of only $39m in 2012.

Hindsight has a good reputation, but can be a terrible thing. Don Trow, emeritus professor of accounting at Victoria University, admits he persuaded someone to sell out of Xero when its share price was $2.

They haven't fallen out, but he says he wouldn't blame them for holding a grudge. "They look at me as though I must be a bit screwballed. It is a bit embarrassing, but even at that stage it looked to me well beyond what seemed an appropriate valuation."

Trow remains firm in his conviction that Xero would not be stock he would select as a "careful investor", except for "play money". With no sign of a profit on the horizon and the ratio between costs and revenues heading - temporarily at least - in the wrong direction, "you really are taking a considerable gamble", he says.

Xero's believers point to the fact that founder and chief executive Rod Drury hasn't put an obvious foot wrong pursuing his long-term vision of turning the company into a New Zealand-based multinational in the emerging world of cloud-computing.

Forsyth Barr analyst Andrew Harvey-Green emphasises that the way computing is consumed appears to be undergoing a massive transformation.

"[But] 'Mum and Dad' investors have to be pretty careful investing in these sorts of technology companies because of the risks and uncertainties.

There is only limited research available on NZX-listed technology stocks, he says. "That will improve over time, but at this point in time you would say it is not a particularly well-researched sector."

If the market did take a big turn for the worse, would savvy investors have time to read the signs and escape with their shirts?

"What happened with the dot-com bubble [late 1990s] was it all crashed very quickly and everyone got out at a great rate of knots and all the valuations crashed very quickly.

"Whether this is a bubble or not, who really knows? I expect gradual disappointments over time to be the more likely outcome [in the case of a downturn] but you can't rule out a significant correction."

Trow couches his doubts about Xero by noting he had "never heard anyone say an unfavourable thing about the quality of the product".

"Watching the new television show Selfridges I thought how wonderful it was someone with the confidence and vision got through, but everything was a gimmick. To some extent, IT companies are facing up to the same thing."

Something on which all experts agree is that there is nothing inherently different or special about technology stocks that means they shouldn't be valued in the same manner as shares in other sectors of the economy with the same underlying fundamentals, however.

While analysts may look at revenue growth to see whether start-ups have legs, like any asset, they will be ultimately be worth what they are able to return by way of future profits. In Xero's case that means investors would need to believe the value - in today's money - of its future profits will be at least $2.1b.

Like any investment, shareholders are buying into a "story" and into a management team they believe can deliver the happy ending.

With a compelling and well-told story like Xero's, the temptation may be to skip ahead a few pages and pay Chapter 10 prices for a Chapter Five investment.

In the technology industry, perhaps more than any other, investors will need to regularly check the plot that they bought into hasn't changed, and keep in mind the company they have invested in will merely be one of the protagonists.

Trow suspects many investors don't stop to regularly re-evaluate why they are holding a rising stock and will instead "just watch the price". He has no doubt the wave of enthusiasm for new technology listings can't be explained in any other way than by Xero's halo effect.

While the smattering of technology stocks on the NZX may rise and fall on the same tides of shifting sentiment, there is no reason to assume they will share a common destiny.


Product: Cloud-based accounting software for small businesses.

Market worth: $2.1b (based on $17.93 per share on Thursday)

What to watch for: Investors have been accepting of Xero's losses as it experiences strong sales growth, particularly in Australia. But the company's share price is likely to become increasingly sensitive to its rate of sales growth in the United States market. Keep a close eye on breakdowns of its regional performance in all future announcements, not just the headline numbers, and be prepared for a strong reaction to subtle signals as other investors try to read those tea leaves.

Blue sky potential: Certainly. Xero could make a new business or entrench any future dominant position in the accounting software market by helping its clients benchmark their financial data, and hence their business performance, against their peers. Ultimately, Xero's real value could be as a "data" company rather than as a software company. But benchmarking data becomes more valuable the more of it you can aggregate, so Xero first needs to become a big player in the accounting software market.

Product: Cloud-based software that lets company directors manage boardroom documents electronically.

Market worth: $521m (based on $6.22 per share on Thursday)

What to watch for: Ironically, given the business it is in, Diligent has had plenty of slip-ups in its own corporate governance, but so far these have so far just been a distraction for this stock. Its dividend policy and a decision on whether or not to list in the United States could affect its short term outlook. Diligent faces the opposite issue to Xero, with some indications it may be running out of room for growth in the US, so look to regional sales breakdowns to see if that is likely to put a dampener on overall growth.

Blue sky potential: Yes. Diligent's core expertise is in enabling the secure distribution of electronic documents. It is exploring opportunities to expand beyond its current niche of handling boardroom papers, which would seem an obvious growth strategy.

Product: Search tool for online businesses, such as retailers, that helps visitors find information on their sites.

Market worth: $145m (based on $2.50 per share on Thursday)

What to watch for: It is early days for this newly-listed technology stock which is likely to be judged initially, first and foremost, on its headline numbers. Gaining a meaningful understanding of where the company sits relative to its competition would be a big ask, so keep an eye open for any newly-published expert research and any information on churn levels, in addition to sales data.

Blue sky potential: Nothing obvious. But SLI Systems would have plenty of room for growth within its existing, expanding global niche, if it can win in the marketplace.

Product: Specialist business intelligence software designed for use by police forces, security services, financial services firms and similar.

Market worth: $114 million (based on $1.12 per share on Thursday).

What to watch for: This newly-listed business has operated as a division of Christchurch's Jade for several years. Of all the NZX-listed software firms, its product would have the longest sales and implementation cycle, so this is not a "get rich quick" stock. Individual contracts could be big enough to be price sensitive, so look for the deals it wins and try to also keep an eye open for those it might have wanted to, but didn't.

Blue sky potential: This stock should probably be valued on its price-to-earnings ratio and dividend yield. Consider also checking that its share market liquidity will be adequate over the medium term before diving in as a small investor.

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