By Michael Brush
Sentiment in the stock market is so dark, it’s time to rummage through the hard-hit technology sector to pick up potential long-term winners.
For help, let’s turn to tech expert Chris Armbruster, the co-portfolio manager of the Virtus KAR Mid-Cap Growth Fund /zigman2/quotes/206751673/realtime PHSKX +3.78% . He’s worth listening to because his fund has such a great record. The fund beats its Morningstar Direct mid-cap growth category and U.S. mid-cap index by over 13 percentage points, annualized, over the past five years. That’s impressive, and not only because so many fund managers regularly lag behind the market.
‘ Grow right through’ rate increases
Tech companies are down in large part because of worries about rising interest rates. That increases the discount rate in valuation models, which lowers estimated net present values. Armbruster acknowledges the challenge, but downplays it as a meaningful issue for tech over the medium term.
“Whether the fed funds rate is 1% or 2.5% is not going to affect their ability to grow unless it slows down the economy,” he says. “We have had interest rate hike cycles in the past and the very best tech companies grow right through them.”
The key is to be in the right tech companies, and this is where things get complicated. Fortunately for us, Armbruster took the time recently to share with us the key qualities he looks for in tech and other sectors, below.
Big picture, you want to be in companies that have competitive strengths to fend off rivals and maintain their long-term growth potential.
This will remain a source of doubt among many investors looking at tech for two reasons, beyond interest rates.
1. The pandemic pulled forward a lot of demand. That will hurt the cadence of growth over the next couple of quarters, and that will make investors nervous.
2. The best tech companies will continue to invest in their businesses, as they should. This creates uncertainty about their path to profitability. “These uncertainties are going to weigh on the multiples until we get a trend line of growth that people can model.” But they aren’t long-term issues.
The bottom line: Take advantage of the confusion to pick up the companies that look like winners because they have the following characteristics.
The five most important characteristics
Armbruster says buying names with the following five qualities has helped him build his record of outperformance. Besides tech, the list includes companies from other sectors, as examples, but most of them are in tech. You can consider picking some of these up on your own, or just buying Armbruster’s fund for broader exposure to these qualities.
1. High switching costs: This helps investors because it locks in customers and revenue. This quality is often found in software companies. “Once you go through the process of implementing the software, especially at the enterprise level, the inertia is very high, as long as the product is still good,” says Armbruster.
For this to really pay off in software, the company has to have upgrades and additional add-on modules and products to sell to customers. He cites Workday /zigman2/quotes/201157610/composite WDAY +6.93% in human resources and finance cloud apps, and Datadog /zigman2/quotes/214127379/composite DDOG +6.84% in security monitoring and analytics, as examples in his portfolio. Another example is Okta /zigman2/quotes/210420951/composite OKTA +8.42% in identity management software. Once it’s part of all of a customers’ apps, it’s a headache to switch.
High switching costs can crop up in a lot of sectors. For instance, you can look for situations where a service is embedded in a business process. Here he cites the credit score company Equifax /zigman2/quotes/208789454/composite EFX +1.37% , from his holdings. “The credit score is engrained into the credit decision process,” he says. You can also find switching costs in industry, when a company’s product gets designed in to its customer’s product. Since a redesign can be expensive, switching costs are elevated. Amphenol /zigman2/quotes/207999687/composite APH +2.84% in electronic and fiber optic connectors and cables is an example.
2. Scale advantage: Bigger is better if it brings down costs and enhances clout. An obvious example is Amazon.com /zigman2/quotes/210331248/composite AMZN +3.58% , which has built a huge competitive advantage in its extensive fulfillment network. “The secret sauce has always been fulfillment and the scale advantage here,” says Armbruster.