Today, on the Market Call Show, we dive into smarter tech investing, I paint a vivid picture of the current tech sector, likening it to overfished rivers where investors crowd around large-cap stocks, inflating prices and squeezing out value.
We come up with a fresh approach: focusing on smaller tech companies and early-stage private equity to achieve better diversification and risk reduction.
We explore the valuation landscape as of October 22, 2024, shedding light on the significance of return on invested capital for predicting returns. We reveal that only a small fraction of U.S. tech companies achieve over 10% in return on invested capital, while high cash flow ratios make even profitable companies seem overvalued.
Tune in to hear why I believe looking beyond the usual tech giants can open doors to sustainable growth in this crowded market.
SHOW HIGHLIGHTS
- I explore hidden investment opportunities in the tech sector with Luis Llanes, emphasizing the value of looking beyond large-cap stocks.
- Louis uses the metaphor of overfished rivers to describe the crowded and overvalued large-cap tech market, suggesting a shift towards small tech companies and early-stage private equity.
- We discuss the current valuation landscape of the U.S. tech sector, highlighting that only a small percentage of companies achieve a return on invested capital above 10%.
- Louis notes the median price to cash flow ratio for profitable tech companies is 25, indicating high valuations even among successful firms.
- We analyze the tech sector's high median price to book ratio of 5.11 and its implications for investors.
- The conversation touches on the challenges of navigating the crowded index world and the benefits of a bottom-up investment approach.
- Louis discusses the impact of artificial intelligence on the tech sector, drawing parallels to the dot-com bubble and the need for risk management.
- We consider the advantages of targeting small tech companies with strong fundamentals, profitability, and growth potential.
- The episode emphasizes the importance of a diversified investment strategy, combining both indexing and active equity management.
- Throughout the discussion, we encourage listeners to assess investments based on fundamentals and to be prepared for potential market volatility.
PLUS: Whenever you're ready... here are three ways I can help you prepare for retirement:
1. Listen to the Market Call Show Podcast or Watch on Youtube
One of my favorite things to do is to talk with smart people about investing, financial planning, and how to live a full life. I share this on my podcast the Market Call Show. To watch on Youtube – Click here
2. Read the Financial Freedom Blueprint: 7 Steps to Accelerate Your Path to Prosperity
If you’re ready to accelerate your path to prosperity, the Financial Freedom Blueprint lays out a proven system for planning and investing to secure your financial independence. You can get a personalized signed hardcover copy – Click here
3. Work with me one-on-one
If you would like to talk with me about planning and investing for your future. – Click here
TRANSCRIPT
(AI transcript provided as supporting material and may contain errors)
Louis:Hi, this is Louis Llanes for the Market Call Show. Today I'm going to be talking about fishing for less crowded technology stocks and it's really a suggestion to help you reduce risk and diversify your portfolio. So I live in the beautiful state of Colorado, which offers excellent fly fishing for trout, and when I first moved here I learned that the fish on the Blue River in Silverthorne. You had to be a really good fisherman. The fish was. There was a lot of fish there. The rivers were full of trout, but it was located behind a popular outlet mall and it drew a lot of tourists to that mall. So there was a lot of men out there who would leave their wives to go shopping and they'd head down to the river and it to that mall. So there was a lot of men out there who would leave their wives to go shopping and they'd head down to the river and it made the river really crowded and you could see the trout everywhere. They were all over the place. The water was very clear and you could perfectly present your fly because we were fly fishing, you could perfectly present that fly and you could even be bumping them on the nose with the perfect fly and they would still not bite. They would just leave it alone, and that's what happens when an area is overfished.
That's what I'm feeling the tech sector feels like. The tech sector feels real similar, because there's tons of money that has been chasing these tech stocks and in the market where the large cap tech stocks dominate and the IPO market has dried up, it makes more sense to seek opportunities in less obvious places, in my opinion, like select small tech companies and early stage private equity. Instead of putting all your money into well known names that dominate the large portion of the S&P 500 that everybody's talking about, it's more logical to look for less crowded areas. In my opinion, there's way too much money chasing the same indexes and that's also pushing up those tech stocks, because the tech stocks represent almost a third or, depending on how you categorize tech stocks, it represents over a third even of the S&P 500. So here's the valuation picture today, and today is October 22nd 2024.
To put things in perspective, I ran some numbers on the US technology sector using the GIX standards. The GIX is a it's basically it's a standard for categorizing tech stocks, or really all the stocks. Now there's 638 companies that are in the technology sector in the United States, but only 21.2% have a return on invested capital above 10%. So I like to buy companies that are profitable, that have good returns on capital, because that is a big determinant of expected returns. So most companies in the tech sector right now have a negative return on invested capital.
For those with a reasonably good return on invested capital, the median price to cash flow ratio is 25.26 and the median return on invested capital is 19 in just in the tech sector. So these companies trade at a median price to book ratio of 5.11. So, based on using a multi-stage fair value calculation, which a lot of analysts would do for companies that are growing fast and then they start slowing their growth and then go into more of a steady state, if you just use reasonable expectations for companies in the tech sector, you find out that you generally rarely would be in a situation where your price to cash flow ratio is above 20. Yet the median right now is 25. So for even the most profitable tech companies they're very expensive. So, if you know, take a look at them in terms of percentile. You'll see that. You know the vast majority of the tech companies are really below the line and a lot of them are significantly below the line, like at the 10th percentile in return on invested capital. The average return on capital invested capital is like negative 27% negative 27% and even when you go to the most profitable, if you look at the decile, the top 10% of return on invested capital in the tech sector, the average return on capital is 21%. So you know, I mean we're in a situation. My main point, I guess, is that we're expensive right now.
So finding opportunity and better rivers is really what we want to do. We want to look at areas where there's a bigger return potential and maybe smaller companies are a better place to look, companies that have higher returns on capital and strong business models with smaller allocations to maybe early stage private equity, things like that, because in the index world today it's overcrowded, like we talked about. And, to make matters worse, a lot of the brokerage firms and a lot of advisors are indexing right now and a lot of people are offering a lot of like. Investment advisors are offering direct indexing, where you're able to buy the stocks directly in an index, and many RIAs or registered investment advisors they're adopting this. Registered investment advisors, they're adopting this.
I see a lot of advisors who are, you know, maybe not quite as experienced, out there looking at how well indexing has done recently and kind of extrapolating that's how indexes are gonna do in the future and they're making that assumption. So they're choosing to go this way and this is really in their minds makes them feel like, hey, indexing is a no brainer and I'm not anti-indexing and I think a proportion of portfolios could be indexed. In fact, we have strategies that are a core plus, where there's some indexing and then some active. But if I look at things kind of more the investment landscape, more from a rational standpoint in terms of expected return based on fundamentals, I think you have to kind of be prepared for either a melt-up or a melt-down situation, and you hear this a lot. There's certain research firms that will talk about this melt-up concept where you have stocks running up really rapidly because we're printing money and there's money is trying to find a place to go and that's probably gonna go into stocks, and then other people say, hey, this is just the opposite. Inflation's going to get high, interest rates are going to go up and then we can have like a meltdown. So the truth of the matter is we don't know exactly which direction this is going to go, and that the best way to invest really is to have more of a bottom-up approach, where you're looking at individual businesses based on fundamentals and, like I, always talk about the quality, et cetera, et cetera. So I want to be prepared for either scenario and that means just going bottom up. Now this type of environment is kind of more ripe for volatility spikes. In fact, I've heard some analysts are expecting volatility to increase after the election. So, but volatility spikes can catch investors off guard.
In my view, it's prudent to incorporate active equity management with indexes like the core plus year bound that invests in both indexing as well as active strategies that concentrate their holdings in the active strategies. Concentrate their holdings on those stocks that have the best fundamentals and I think if investors do that, it puts you in a better position. If the market heats up, then you'll have a sensible allocation to the indexes and then you also have a fundamental approach and that blend. I would expect to have better risk-adjusted returns over time. This approach is really often what I tend to take with high net worth investors. In the active equity portion of the portfolio, I like to target companies with strong fundamentals, like I mentioned, and a real chance to outperform the index, and you don't want to have too many stocks in there because you want to have some level of concentration in that portion, and it's a great example of diversification. You could go all into one strategy, but why limit yourself? You're better off having a blend, in my opinion.
Now, all the buzz right now in tech has to do with artificial intelligence, and to me that kind of echoes the dot-com bubble, and I know that history rhymes and it's not always exactly the same, but there are some corollaries. Artificial intelligence is heavily and it's clearly going to change the world. That we know. That's an easy conclusion to come to. But what's harder to know is which companies are going to be the ones who are going to be the winners, which will thrive and which will literally disappear. We have to make some educated guesses and apply risk management when dealing with artificial intelligence. So if you kind of look at the dot-com bubble, that's exactly what we saw. We knew the internet was going to be transforming everything, and here we are looking back and we say, yeah, that's exactly what happened. Yet most of those companies that had the huge valuations ended up collapsing over time and a few did very well, but overall the business became more efficient across the economy. So that increase in efficiency using the Internet boosted the entire economy in a lot of different ways and it led to a lot of new industries. And I think that's likely what's going to happen with artificial intelligence. I think AI will follow a similar path.
I have charted what it looks like with the market cap as a percentage of the S&P 500. And if you look at the kind of the graph of that percentage, so basically how much concentration does tech represent in the S&P 500,? And we're near the peaks that we saw at the dot-com era. So we're not quite up there as we were. We pulled back a little bit from there, but we're pretty close. So in history you could make an argument that we're, you know, we have to be somewhat careful, you would think. So small tech companies on the positive side that meet my criteria, I think is a good way to go.
I like to invest in these smaller companies that exhibit certain characteristics and I modify them somewhat for the smaller companies. But I really am looking at three categories and the first category is sentiment, which involves the shift in the brokerage firm's recommendations, the shift in the earnings. You know how well we want to see you know the estimates moving up. The company is doing better. The revenue is moving higher. There's growth in the smaller companies. We're looking for them to be moving up the market cap rank, moving from a smaller company to a larger company.
The second category I like to focus in, obviously, is quality, which includes how profitable they are. What are the returns? What are the return on invested capital and the strength of their balance sheet? And, lastly, I like to look at the valuation assessing the company's metrics compared to free cash flow, asset sales and earnings per share. You know how much are you paying for those metrics of cash flow and assets. So there's a few companies out there right now that we own. Now, in investing in these strategies, it's definitely more dynamic, and so companies can fall in and out depending on how they rank on these issues, because we're trying to focus our capital in those companies that are doing well. So there are a few companies.
I don't want to necessarily mention tickers, because these are smaller companies and I don't really want to have that out there right now, but that is, and so I like to have some money there and another way to fish in kind of less crowded streams is to you know you don't want to, instead of focusing where everybody knows I'm looking for under a great like mid caps and private equity.
So I'm underweighted large cap tech names right now, and these are the names that mostly everybody knows about. They're kind of priced to perfection. So I'd like to think I'd like to hear more about what your thoughts are about this. I am bullish on technology, I'm bullish on a, I'm bullish on the United States and I'm bullish on our overall future. I think it's just a matter of saying what price, or I should say asking ourselves what price are we paying for these investments and does it make sense? So that's all for now. I hope you got some value out of this. Feel free to contact us if you have any questions about any type of investment strategies. I'm Luis Llanos, market Call Show signing out. Have a great day.
Outro Sequence
For the latest episode of the Market Call Show. Make sure to like, subscribe and follow us on X, formerly known as Twitter, and YouTube. Go to wwwmarketcallshowcom for all our past episodes and sign up to get alerts. If you enjoy the content of this episode, please share it and comment. The information in this podcast is general in nature and does not take into consideration the listener's personal circumstances. Therefore, it is not intended to be a substitute for specific, individualized financial, legal or tax advice. To determine which strategies or investments may be suitable for you, consult the appropriately qualified professional prior to making a final decision.