When we see clients, it is perfectly natural that they should ask us about the make-up of the portfolios we run on their behalf. Often this will involve questions about the industry sectors we hold and how our various weightings compare with those of our peers but, while this kind of shorthand approach to portfolio analysis is again perfectly natural, it also has the potential to be highly misleading.
A neat illustration of some of the dangers of judging investment portfolios on a sectoral basis are highlighted in a paper, The aging of the tech sector: The pricing divergence of young and old tech companies ) which was published as a blog earlier this year by New York-based finance professor Aswath Damodaran.
Focusing on the 2,816 companies – almost one third of all publicly traded stocks in, and 20% of, the US market – that as of this February were classified as technology businesses, Damodaran estimates their age to arrive at the chart below. As you can see, some two-fifths of US tech firms have been around for 25 years or more while a significant minority have existed for less than a decade.
Source: Aswath Damodaran 2015
Is that spread of ages significant? Damodaran concedes there are manufacturing and consumer products businesses that have been around a good deal longer but notes: “Tech companies age in dog years, as the life cycles tend to be more intense and compressed”. “Put differently,” he adds, “IBM may not be as old as Coca Cola in calendar time but it is a corporate Methuselah in tech years.”
Damodaran goes on to make the simple point that ‘young tech’ – companies less than 10-years-old – are much more richly valued than the ‘old tech’ pioneers set up more than 25 years ago. As you can see from his table below, for example, young tech trades on 4.34x revenues (based on enterprise value) compared with just 2.44x for old tech. The other metrics tell a similar story.
Source: Aswath Damodaran 2015
The only real exception is where no price/earnings (PE) comparison is possible but that is because the young tech firms that have grown from nothing to be significant fractions of the sector – the likes of Facebook and LinkedIn – have done so largely through a multiple expansion rather than on earnings. You would need to scour their profit and loss statements to find any number you could use as a divisor.
So there is a huge valuation dispersion between these two parts of the industry and there is a huge dispersion in revenue growth rates too – 33% over the past three years for young tech compared with just 1% for old tech. The very different valuations we saw earlier clearly demonstrate the market’s belief those recent growth rates will be reflected in the future.
That may or may not prove to be the case but what can be said with some certainty is that lumping young and old tech together to indicate an exposure to the sector is both misleading to investors and a poor way of judging a portfolio. Still, if you need further persuading, we can make a similar point with a single UK-listed business.
Telecoms giant Vodafone may be 100% listed in the UK but it certainly does not generate 100% of its revenues at home – indeed, the company’s revenues from just India and South Africa added together exceed those from the UK. So that UK exposure you thought you had through your investments – how sure of the number are you now?
Unpalatable as it may be for some, the truth is there is no short cut to a proper analysis of a fund’s process and the stocks it holds. Understanding individual businesses is tricky enough and yet understanding a fund as an aggregation of investments in individual businesses is, in some respects, trickier still. On the surface you have less information to go on and so you just have to dig deeper.