When you hear other investors talking about a great technology company going places, do you:
1.Think, great, let's buy the shares because the next great frontier is technology or alternatively:
2.Mutter "God help us" - there goes another overpriced, overhyped shooting star that will come crashing back down to earth and is best avoided?
Most of us tend these days to fall into the second category - we're probably willing to buy the argument put by US financial journalist John Cassidy that the whole tech thing was just one big dot.con, or as he pithily subtitles his book of the same name, the Greatest Story Ever Sold.
But there is a rather odd species of investor who think that some technology shares are actually great value. These investors think the bearish disappointment of private investors after the dot.con meltdown of a few years back actually presents level-headed investors with a great opportunity – you can buy companies with great intellectual property at relatively cheap prices because investors don't really understand the true value of the technology or its potential to transform modern economies. One relatively famous stateside investor who has articulated this philosophy brilliantly is a certain Michael Murphy. Editor of a hugely successful investment newsletter, he's spelt out his strategy for finding bargain basement, cheap tech shares that are still going places - and it seems to work. Our sister publication, Stock-Screening News, has been running a version of his strategy for the past couple of years and the first portfolio of shares has already risen by over 50 per cent in just under two years. His core strategy is to focus in on the amount of money spent on R&D and compare it with both the growth rate in sales plus earnings, as well as the share price.
But Mr Murphy's not alone. Many traditional growth investors also reckon that the tech sector offers the perfect investment proposition - fast-growing companies, benefiting from structural changes in modern economies whose share price is reasonably priced. Run a traditional growth screen of the market using a filter such a the PEG ratio - which compares the estimate of earnings growth in the coming year against the current PE ratio - and you'll be inundated with tech stocks.
Even traditional contrarian value investors also reckon that there might be some value in the least-understood parts of the tech markets - they tend to focus in on bombed-out shares where growth prospects are still strong, where there’s strong intellectual property backing up the balance sheet and a share price that has taken a hammering in recent months.
Three ways to find bargain basement techs
The key point here is that there are many ways to find the ultimate bargain-basement tech stock - there's no one road to investing bliss in such a complex and risky sector. You have to be willing to use a number of different methods to track down good investments in this sector - we've used three simple strategies and built up a portfolio of six great tech stocks that we think are set to race ahead.
The most useful strategy for hunting down the elusive bargain-basement tech stock is to use Mr Murphy's ideas and apply them to the smaller UK tech markets. Mr Murphy contends that the global economy is undergoing a paradigm shift - a "once-in-a-century revolution" that is creating huge wealth as well as destroying whole sectors too slow to keep up. The result of this shift, says Mr Murphy, is that the technology sector is the fastest-growing sector of all and will quickly dominate most other sectors - as is painfully apparent in the US market where the net worth of tech companies such as Google, Microsoft and Cisco dwarfs whole industrial sectors. But how do you find these true technology gems? Mr Murphy suggests you look at five, key measures:
• Research and development (R&D). According to Mr Murphy the only reliable way to gauge whether a company really is involved in this technology 'paradigm shift' is to look at how much money it's spending on R&D. According to Mr Murphy, the most reliable way of doing this is to divide the company's earnings by its R&D spend. Mr Murphy says that a tech company should spend a minimum of 7 per cent of revenues on R&D.
• Return on equity (earnings divided by shareholders' equity) of 15 per cent or more. This measure indicates that a company is capable of financing its own growth without resorting to outside financings that dilute earnings.
• Are they producing new products? Does the company turn out a steady stream of new, successful products? Mr Murphy also suggests calling a prospective company and asking what percentage of revenues today come from products introduced in the past three years. If the company's research is productive, the answer should be over 50 per cent.
• Sales growth of at least 15 per cent a year. Mr Murphy regards this as a crucial test and suggests that companies failing this are not worth pursuing.
• Pre-tax profit margins (net income divided by revenues) of 15 per cent. Fast-growing sales, high spending on R&D and strong return on equity are great, but the net operating margin - the profit margin - needs to be chunky.
Mr Murphy's next challenge is to rethink how you value your shortlisted companies - traditional valuation approaches, such as the PE ratio, are misleading. R&D spending cuts directly into a company's current earnings, which means that the more a company spends on R&D the worse its earnings appear, which in turn will push up the PE ratio. But, from a shareholder's viewpoint, earnings invested for tomorrow in the form of R&D are as important as reported earnings today. Murphy deals with this problem by adding together the R&D spending per share [R&D spending divided by the number of shares outstanding] to the normal earnings per share to work out what he calls the company's "growth flow". The final step in the stock-picking process is to divide the current share price by this growth flow per share to provide what's called the price-to-growth-flow ratio. In Murphy's view, tech shares are 'fairly priced' when the price-to-growth-flow ratio is around 10 to 14; anything under 8 is cheap and below 5 is a real bargain; 16 and over is too expensive. We've run Mr Murphy's stock screen on the UK market and come up with four candidates, ranging from health sciences company Immunodiagnostic Systems Holdings through to software giant Sage.
Alternatives to the Murphy method
Mr Murphy's methodology tends to focus in on companies growing reasonably fast but who spend a shed load on R&D compared with their peers. That’'s a sensible strategy, but it's not the only way of finding cheap, solid tech stocks. We've also run two other, much simpler, screens on the UK market looking for undervalued tech shares. The first is a classic growth screen where we're looking for:
• A PEG of below 1. This implies that the forecast EPS growth rate next year is above that of the current PE ratio. If, for instance, the earnings per share is expected to grow at 20 per cent but the PE ratio is just 10, the PEG would be 0.5.
• We also looked for evidence of strong earnings growth of at least 10 per cent next year, plus sales growth.
• The operating margin, ie the net profit rate, must be at least 10 per cent.
Our second approach was to take similar ideas - where we're looking for a fast-growing, financially sound company - but add a contrarian take on it. In this last 'tech fallers' screen we looked for companies that pretty much ticked all the boxes in our classic growth screen above but where the share price had fallen markedly in the past six months - by at least 20 per cent.
These last two stock screens produced just two additional shares, which we've added to our portfolio of four shares produced using the Murphy method. This final lot of six shares, we think, is a cracking mini portfolio of fast-growing, technologically sophisticated companies with relatively lowly shares prices compared with their great growth prospects.
