One of the first rules you learn when you enter the sell side of the investment industry like stockbroking/private banking/financial planning is that "all news is good news".
So for instance when interest rates go down that's good news because shares will be worth more theoretically and of course it makes bonds look less attractive.
No problems if interest rates go up because that means the economy must be getting stronger which is good for shares too. The one area that presents something of a problem is when shares go down but rather than state the obvious like "your shares have gone down" most good news advocates describe a fall in stock prices as shares being "volatile".
The implication here is that the shares have gone down but don't worry they will be up again soon. It's obfuscation along the lines of "it's just a paper loss".
Currently one of the most "volatile" sectors on the stockmarket is that plague of technology stocks which floated in the last year or so.
Forty percent of last year's IPOs were technology stocks, we have had at least four so far this year and there are apparently at least another four wanting to sell their shares before the end of the year.
The academics tell us that IPO's generally are bad news but these local tech stocks are something else. Check out the table attached. The trend this year has been down. Look at GeoOp shares - floated to investors at $1.00, hit $4.49 but now trading at $0.65, down 86 per cent from the high. Lots of volatility" there.
SELECTED TECHNOLOGY STOCK RETURNS
Why so volatile? Finance 101 says that a company is worth the net present value of its future cash flows but working out those cash flows is hard enough for your average company making profits today.
To try and estimate the worth of a company which may or may not become profitable in two, three or four years' time is extremely difficult. Furthermore the impact of changes in discount rates are greater when the cash flows occur further out. That is why loss-making tech stocks tend to be particularly volatile - soaring when people are optimistic and plummeting when they are not.
That is the buyer's perspective of technology IPO's - from a seller's perspective tech represents an entrepreneur's dream requiring little in the way of capital, no hard assets, just some software, and a good story. Technology IPO's are therefore a modern version of old world alchemy - turning water into wine.
Gentrack's interim report as at 31 March, prior to its listing, showed that its equity was around $30m however this included $40m of goodwill and $21m of intangibles. Its net assets, excluding these two items, was -$31m. Since then Gentrack listed on the NZX and received gross proceeds of $36m which it has used to repay bank debt of $33m. The way to reconcile the lack of assets with a high stockmarket value is that the market believes that the business plan can convert sales to a profit stream.
Some tech stocks will certainly deliver but those that do not will get hammered. The Financial Times recently reported that the share price of one newly listed tech stock fell by 50 per cent in a day when it reported disappointing earnings.
This month Gentrack in a stock exchange announcement updated its profit forecast for the September 2014 year and stated that earnings would be some 30 per cent less than the forecast made two months earlier when it listed on the NZX. The market reacted immediately and marked the stock down by 14 per cent.
What was behind the stockmarket enthusiasm for tech IPOs?
There were three reasons.
Firstly tech was all the rage in the US and some of that exuberance has spilled over into our market.
Secondly tech stock Xero has been the best performing stock on the NZ stockmarket in the last three years, returning 1100 per cent, despite making no profits. Regret is a powerful emotion and many locals missed the boat on Xero and are thus determined not to miss the next one. Good luck with that strategy!
Whilst Xero has been great we shouldn't lose too much sleep if we didn't buy it before its great run indeed you have to wonder how many people have actually participated in its success. History suggests many get in too late. Three years ago Xero had 2379 shareholders. When its shareprice peaked at $45.99 on 6th March 2014 it had 7056 shareholders. Xero has been a great performer and may well convert sales to profits but many of its newest shareholders will be losing money today.
The third reason is fees which seem to have been quite high in the tech offers. For example Serko raised $22 million and offer costs were $2.1 million. That's a 10 per cent fee. Nice work if you can get it.
Given the volatility of technology and the lack of hard assets the question must be asked of the investment banking sector as to whether it is reasonable to float all these small technology companies with no profits.
Institutional investors can cope with "volatility" because they strictly manage their exposure to speculative areas but anecdotal evidence suggests that some mum and dad investors will have weightings in individual tech stocks hugely disproportionate to the tech stocks weighting in the overall index. And herein lies the fundamental problem with having investment banking and retail banking under the same roof - when push comes to shove we see who prevails and it ain't retail banking. With many of the regulators and politicians having a background in investment banking don't expect an NZ version of Glass-Stegall any time soon but that is arguably the end game for the banking sector - it will just need a few more crises and bailouts to move things along
Anyway everything might eventually turn out well. Certainly if you believe the efficient market hypothesis then the high share prices simply reflect the likelihood of an appropriate level of profitability further down the track. Local and overseas fund managers are heavily into our tech sector so you would have to assume their spreadsheets are modelling reality.
Having said that I am reminded of a story I did on global technology for the Herald in 2000. The Business Editor asked me to write something on this hot sector so I obtained research from one of the world's largest stockbrokers which showed that the elevated valuations were entirely appropriate. Oops. Let's hope it really is different this time.
Either way it is going to be very interesting watching the progress.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have a financial interest in the companies mentioned in this article.