Emma Wall: Hello, and welcome to the Morningstar Series 'Why Should I Invest with You?' I am Emma Wall and I am joined today by Ali Unwin, manager of the Neptune Global Technology Fund.
Hi, Ali.
Ali Unwin: Good Morning.
Wall: So, the thing with tech, the thing that everyone wants to know is all of these valuations sustainable? Why the tech stocks demand such high prices?
Unwin: Well, tech has had a fantastic run, up 25% year-to-date in sterling, so valuations also are a little harder than they were. The reason that we believe that tech companies enjoy these high valuations is actually quite often because they are better businesses, and there are sort of statistical measures of that. For example, the operating margin of median tech company is about twice that of the median S&P Company.
But more importantly, particularly in the bigger names which is where we get a lot of pushback on valuation. The FANGs if you like. Those companies have something quite specific about them which in our mind means that they are worth more and that's they enjoy network effects. The network effects something that people talk about a lot and hear bandied around and it's a sort of a little bit of a throw a line, but there is actually quite a rich and full academic literature on them what is a network effect and how they work.
Essentially, if you think of in an industrial economy, you have supply side economies of scale, so the bigger you are, the cheaper you can make in inequitable unit. The way it worked in a digital economy, or what we call a zero-margin cost economy, is that companies have demand side economies of scale. All this really means is that every single person who joins the network or every developer who develops an app on Apple's platform, for example, they make the platform or the network or the service more valuable for everyone. So, your service gets more valuable, the more people use it.
It's actually quite interesting if you go back to the history of this, AT&T were the first people to realise this and they were looking at their phone network in sort of 1908 or 1909 and usually with an asset you build this and then you'd appreciate it over time. And what AT&T realised is that the more people they got to use the assets are either harder they were sweating it, the more people willing to pay for the assets which has obviously completely different characteristics to a traditional industry if you like model of how the economy in the world works. So, we think companies are able to benefit from these and ultimately, they are given the realistic price over a long period of time.
Wall: And you also run a U.S. equity fund, does that mean that when you're looking at rest of market versus tech stocks, you're valuing stocks in a completely different way?
Unwin: I wouldn't say we're still ultimately valuing on what are the free cash flows that can be produced by this company. So, it's all the different methodology in that sense. But we're willing to if you like use a lower fade rate on the tech companies and actually there is lot of evidence to back this up.
So, of the top decile of companies in the S&P if you rank them all by the return on invested capital, tech companies obviously score very, very highly on that. But what's been interesting is since 2000 the top decile of companies return on invested capital has actually increased quite dramatically, it's up near a 100% now.
Now, traditionally, obviously if the company is getting a 100% return on invested capital they should attract a lot of competition and this is where the sustainability of those net back effects as we see with the Facebook (FB), with the Microsoft (MSFT) to some extent, with an Amazon (AMZN), with a Google (GOOGL), that's where we see their ability to keep generating these super normal returns, that are in our minds are actually not necessarily super normal.
Wall: Well, that implies then that you think that these prices can keep rising and that this actually these stocks despite being highly valued on certain metrics could actually grow their share price even greater.
Unwin: It's certainly very possible and if you – the most extraordinary thing at all has been the law of large numbers which was taken as a law and since sort of demonstrated not to be, which was that as you get bigger, obviously, you're growing of the larger base it just becomes harder to grow. But we've actually seen companies like Google, like Facebook growing quicker now than they were three or four years ago. So, the law of large numbers for these companies at least appears to work in reverse.
Wall: Ali, thank you very much.
Unwin: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
