Quality growth – the recipe for success
2023 has been a challenging year for stock markets, when we commenced in January we launched with a bang, with strong market returns occurring across the globe. By the time February approached volatility had set in and we find ourselves in a situation where like tropical weather, the forecast can change at a moment’s notice.
Having said that when we started the year and reflected on 2022, no matter the quality, the earnings resilience, or the outlook, Growth was a dirty word and in the market’s eyes growth companies were far from popular. For example Alphabet fell -38 per cent, Apple -29 per cent and Microsoft -29 per cent over the 2022 calendar year.
Now that we have moved some months into 2023 much to many investors surprise the NASDAQ has been one of the best performing indices in the market currently up 20 per cent for the calendar year of 2023.
We have seen the U.S. market being led by mega cap, quality, growth companies. These businesses have attracted the market’s attention in recent times for a number of factors:
- We would argue they were oversold in 2022
- They have high quality and resilient earnings profiles
- They are far less rate sensitive than their cyclical counterparts
We have seen this in companies such as Apple Inc which is up 37 per cent year to date. Looking further we have Microsoft 31 per cent, Amazon 34 per cent, Netflix 20 per cent, and Alphabet up 37 per cent.
This turn of fortune then raises the question, what does it mean for the Australian Share Market and Aussie investors?
The first part of this question is answered by considering the thematics and business models these mega cap tech growth stocks have. They are all innovative leaders with attractive business models and structural tailwinds. As we’ve mentioned in the past, we believe innovation lives in smaller companies in Australia and many of these companies are being propelled along by the same global thematics and mega trends such as cloud computing, software as a service (SaaS’s Businesses), and various forms of E commerce.
Many of our long-term followers and investors are also aware that we categorise our growth company investments from Tier 1 (the rock stars), to Tier 3 (an early lifecycle opportunity with bright prospects).
Fortunately, as small cap investors, we have access to invest in high quality businesses that allow us to gain exposure to the above global megatrends and also enjoy the share price performance that can be associated with this type of investment.
Why we like TechnologyOne (ASX:TNE)
If we look at TechnologyOne, headquartered in Brisbane we have a local business that offers a similar technology solution to the likes of SAP and Oracle, but in niche market segments and at a much cheaper price point.
TechnologyOne sell what is called an ERP software which stands for Enterprise Resource Planning. It is a software programme that allows an organisation to streamline things like procurement, accounting, project management and compliance. We’re also seeing these systems incorporate artificial intelligence and machine learning to better improve their productivity and efficiency when dealing with repetitive tasks.
TechnologyOne has also been able to transition its technology from a programme delivered on a CD with regular updates to a cloud-based software service or SaaS business.
Furthermore, through their evolution we have seen TechnologyOne work to form a client base that consists of local governments and universities. This client base provides revenue that is less economically sensitive and more consistent in its nature. They have also carved out a niche market where the participants represent a significant customer for TechnologyOne, but don’t have the scale to attract the attention of the likes of SAP or Oracle (where a far more significant technology budget would be required to fully implement their systems).
We’ve also seen TechnologyOne embark upon an expansion plan into the UK. The move to the UK has now begun to bear fruit and is producing positive earnings for TechnologyOne. It has allowed them to gain access to a far larger total addressable market and has materially improved their outlook for revenue and earnings growth in the medium term.
Their recent results demonstrate firstly the resilience of their earnings as well as the future growth potential of the company. TechnologyOne saw Revenue growth of 17 per cent Year on Year with Profit before Tax up 22 per cent. With earnings expected to grow conservatively by 10-15 per cent over the next 2-3 years the outlook for TechnologyOne is quite strong.
This is particularly interesting when you consider the broader economic outlook in the near term. We have pressure forming in households from higher interest rates and the increasing cost of living which will have an impact on consumption and certain cyclical stocks. Furthermore, the reopening in China hasn’t been as strong as the market initially anticipated, which hasn’t translated into the expected increase in overall demand for commodities.
We certainly aren’t back in a world where the market will pay anything for any growth; far from it. We are however in an environment where the market is prepared to reward quality businesses with resilient earnings and what it believes to be a sustainable growth outlook. And growth companies have listened to the market – long gone are the days of growth at any cost, burning through huge chunks of capital in a land grab free for all. Capital markets closed and growth companies have been forced to cut costs and manage cash burn. This newfound operating discipline should support investment sentiment towards the sector, particularly in an uncertain macro environment.
We have seen this in the global mega caps and we are seeing this stocks like TechnologyOne which has rallied 21 per cent this calendar year to date.
The Montgomery Small Companies Fund own shares in TechnologyOne. This article was prepared 30 May 2023 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade TechnologyOne you should seek financial advice.