The last couple of weeks have seen a lot of positive news from US tech companies as they report their earnings. Many are surpassing expectations, including the giants: Facebook, Amazon, Apple, Google etc. While there is quite a bit of commentary about how technology companies are leading the US stock market rally and parallels drawn to the dot.com bubble, valuations and prospects look pretty promising to me. After buying Alphabet last week, I decided to increase my US exposure with Apple and another couple of purchases of US stocks.
I sold FDM and Ted Baker for very modest profits in order to fund these purchases. FDM has been falling in price over the last month and showing signs of breaking its uptrend. It is also quite highly valued and was the weakest ranked share on in my portfolio spreadsheet. Ted Baker was also starting to show signs of share price weakness.
US technology stocks are looking very promising at the moment. Earnings have outpaced expectations across the whole tech sector, valuations are reasonable given growth prospects and the possibility of substantial tax cuts in the US may allow businesses like Apple to repatriate their huge piles of cash. From the perspective of a UK investor another possible tailwind may be the exchange rate: the US now looks to be on a somewhat faster trajectory of interest rate rises, which may further strengthen the dollar against the pound. Don’t quote me on that though!
As well as Apple, I bought Mastercard and IPG Photonics, a company that makes laser devices.
Apple is the largest listed company in the world and is something of a blend between a technology business and a luxury consumer product business, earnings most of its profits from sales made directly to consumers, unlike a lot of other technology businesses. It’s a business I would have bought shares in several years ago had I been more open to the idea of owning foreign-listed shares. It looked stonkingly cheap at the time and surprisingly it still looks cheap, despite the share price rising significantly since then.
Apple is a high quality business:
- Business economics: Apple is very profitable, making high margins and returns on capital (consistently above 20% but declining somewhat over recent years). It generates a lot of cash, with free cash flow consistently substantially above profits for the last few years.
- Track record: Apple has been successful in growing revenues and profits for the past few years. However, it has been a little inconsistent, occasionally facing issues with certain products or finding it more difficult to expand in China than expected.
- Competitive advantage: Apple has a formidable ‘moat’. The main source of Apple’s competitive advantage is the quality of its product design, which also allows it to get away with charging a significant premium for its products (most importantly the iPhone on which I’m writing this at the moment). It has been able to generate this competitive advantage whilst also generating loyalty among its customer base, and even to some extent locking them in through limiting the compatibility of its devices with related products (e.g. apps and other media bought on the iPhone). The smartphone then also provides a platform through which many other services can be delivered. Apple can charge for this access or has an advantage in providing these services itself.
- Growth prospects: as the largest listed company in the world, and supplying a durable product, it is natural to presuppose that Apple’s prospects for further growth must be limited. However, the more I’ve thought about it the more bullish I’ve become on Apple’s prospects for further growth. Smartphones are likely to continue to evolve and grow in importance in technology and Apple is the clear market leader here. I can’t see any imminent respite in the introduction of increasingly technologically advanced models. Adoption of the smartphone is still low in many parts of the world, giving plenty of scope for growth here too. Due to the iPhone’s role as a platform, Apple also has an advantage in providing other technologies, for example such as payment systems. Apple may also have the opportunity to extract valuable data from its customers. Its dominance means Apple probably faces some regulatory risk, but this seems less present compared to the other tech giants, Facebook and Google.
Momentum in the share price is very strong with the share price breaking out to new highs in advance of its recent earnings statement. The earnings statement itself was very good, both substantially beating expectations for the third quarter and being very bullish about future prospects. The shares are also strikingly cheap given the growth prospects.
Mastercard is another huge US listed business that almost everyone will have heard of. Originally set up by the banks, it provides payment systems used to clear transactions between consumers, businesses and their respective banks.
- Business economics: Mastercard is a hugely profitable business. It makes operating margins and returns on capital of above 50%. It also manages to turn almost all of its profits into cash. It has relatively little need to invest into continually developing its payment system (though it does so to some extent) so most of its growth in revenues falls straight through to the bottom line and ultimately to the pockets of the shareholders.
- Track record: Mastercard has a stunningly consistent record of double digit growth in revenues and profits. The share price has risen in a more or less straight line for a number of years, with the financial crisis now looking like a fairly minor blip in its long term trajectory.
- Competitive advantage: Mastercard’s competitive advantage arises from the fact that it has developed the infrastructure for the fastest type of payment system (which means it can be used for processing consumer transactions instantly) and that it operates in a two-sided market, with the consumer and its bank on one side and the merchant (retailer) and its bank on the other. Mastercard sets an interchange fee that the merchant side bank pays to the consumer side bank every time a transaction is made. As the choice of payment system is determined by the consumer side bank when it issues the credit card rather than the merchant side, it (perversely) benefits from the interchange fee being set higher rather than lower, also allowing Mastercard to take a greater cut. Due to the prevalence of Mastercard credit and debit cards, the merchant side is forced to accept the interchange fee or risk losing the transaction to a competiting retailer who does accept the card. This means that Mastercard faces little competition, despite effectively being in a duopoly with Visa. Rather than competition, the more pressing risk that Mastercard and Visa face is from regulators who are now seeking to regulate interchange fees.
- Growth prospects: Mastercard benefits from the long term trend in consumers shifting away from cash to electronic payments.
Momentum is good, with the share price continually making all time highs for many years. Mastercard issued earnings beating expectations just before I bought. The valuation appears reasonable given the growth prospects.
IPG Photonics makes lasers for use in materials processing, communications and medical applications.
- Business economics: IPG Photonics makes huge margins of almost 40% and consistently high returns on capital of around 25%. It does invest quite a bit of capital expenditure into R&D but still has a reasonable rate of cash flow conversion.
- Track record: IPG has grown revenues and profits at a fast rate consistently since the financial crisis in 2008. The share price has correspondingly steadily appreciated.
- Competitive advantage: IPG competes in an oligopoly but appears to be the market leader at producing its laser products and has been steadily growing its market share. While I lack the expertise to judge this, its annual report and other market commentary suggests that it is some way in terms of functionality and cost. Its competitive position is protected by a large number of patents.
- Growth prospects: demand for laser products is likely to continue to grow over the longer term, though IPG’s growth rate may moderate as its share of the market increases. One drawback is that demand for laser equipment arises from capital expenditure and so is likely to be quite cyclical. Revenues and profits fell significantly in the 2008 recession.
IPG has excellent momentum, with the price in a firm uptrend and recently beating expectations. The valuation seems reasonable given the growth prospects.