TMT Model Portfolio: Cutting Down on Volatility

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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psagawa@ / apylak@ssrllc.com

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@PaulSagawaSSR

April 18, 2017

TMT Model Portfolio: Cutting Down on Volatility

With an average beta of 1.29, our TMT model portfolio is inherently volatile and vulnerable to downdrafts in the broader market sentiment. While we feel that these 15 stocks are unusually well positioned to prosper from the paradigm shifts (e.g. AI, cloud, digital media, 5G wireless, etc.) that we believe will dominate the next era of TMT, many investors ask for stock selections that might mitigate the risk. We assessed 46 US TMT names with market cap >$3B and beta <1.0 for their strategic positioning and cash flow yields. This pool is skewed toward a handful of categories, some (cable, media, commodity data security, the telecom duopoly) that are structurally disadvantaged, but others (telecom challengers, wireless equipment, payments, SaaS apps) that have promise. Of the 16 names in these more attractive categories, TMUS, V, NATI, OTEX, and TEAM stand out for their positioning and FCF yields. We believe that these stocks would be excellent choices to hedge volatility risk in a thematically focused TMT portfolio.

  • Our model portfolio focuses on paradigm shift winners. Our model portfolio is intended as a vehicle to highlight specific TMT stocks that we feel are best positioned to benefit from the sea change paradigm shifts that we see remaking the sector for the next era. We recently reviewed our portfolio (http://ssrllc.com/publication/the-tmt-model-portfolio-15-well-positioned-stocks/), laying out the themes (AI/cloud operators and components, SaaS consolidation, digital media, and wireless competition), along with detailed investment theses for the 15 constituents.
  • Model portfolio performance has been good, but volatile. In 2013, we shifted our portfolio approach to an exclusive focus on selecting long term strategic winners, no longer balancing across the range of TMT subsectors or hedging risk. Since December 2012, performance has been excellent – beating the S&P500 by 2786bp and the tech elements of that index (our benchmark) by 53bp. Still, volatility has been predictably high – the average 2-year beta for our constituents is a hefty 1.29. TMUS, with a 0.684 beta, is the only stock below the 1.0 market average, while WDAY sports a vertigo inducing 1.91. While we are confident that this group will show excellent long term performance, many investors require balanced risks.
  • 46 low beta TMT names concentrated in a few categories. The TMT sector is volatile relative to the rest of the market. Of 225 TMT stocks with market cap greater than $3B, only about 20% have 2-year betas lower than the 1.0 market average. Those 46 names are mostly found in a few specific subsectors – cable operators, traditional media, basic data security, telecom operators, wireless equipment/testing, payments, and SaaS apps. We see some of these categories – cable, media, security, and telecom leaders – as structurally disadvantaged by the paradigmatic changes that are remaking the sector.
  • 16 low beta stocks are well positioned for change. After eliminating stocks that we believe will likely suffer from the thematic shifts detailed in our research, we find 16 low beta candidates. The two lowest beta names, are telecom operators – fiber CLEC consolidator ZAYO and portfolio constituent TMUS. Another 3 – UBNT, MSI and NATI – provide wireless equipment and testing. FIS, FISV, and V are well known payments companies, while 5 offer SaaS applications – BR, TEAM, OTEX, AZPN, and ANSS. Two offer electronic design testing, vital for semiconductor manufacturing: SNPS and CDNS. Security camera maker FLIR is the oddball of the group. All of these stocks would be good choices for muting portfolio volatility without exposure to the downside of thematic change.
  • TMUS, V, OTEX, NATI, and TEAM favored. We selected 5 of the 16 well positioned low beta large cap TMT stocks for their positioning, their cash flows and valuations that reflected low long term expectations. TMUS is already a constituent of our model portfolio. V is widely owned, growing quickly and we believe that the potential threats from future shifts in the payment industry are years away. OTEX and TEAM are well positioned SaaS applications players with the potential to be acquired, while NATI is a wireless testing equipment name with positive exposure to the coming deployment of the 5G standard.

A Bustle in Your Hedgerow

When we launched our 15-stock large cap TMT model portfolio in February 2011, our objectives included balancing our selections across as wide a range of subsectors as practical and hedging against volatility risk. However, in a such a concentrated portfolio and given our quarterly update schedule, the approach quickly became unwieldy and our portfolio performance lagged our benchmark of the tech constituents of the S&P500. In 2013, we adopted a more focused strategy, looking to identify a list of names particularly advantaged by the change themes that were exploring in our research. Since the end of 2012, our performance has been substantially better, beating the broader market by 2786bp and the tech constituents by 53bp in total.

Exh 1: Relative Performance of SSR’s TMT Model Portfolio versus Benchmarks

Today, our 15 constituents reflect 5 specific paradigmatic change themes that we have explored in our research: 1. AI/Cloud leaders, 2. AI/Cloud components, 3. SaaS consolidation, 4. Digital Media, and 5. Rising Wireless competitors. While the portfolio had a difficult quarter in 1Q17, much of the underperformance can be mapped to our unfortunate bet on TWTR – a circumstance that we rectified by replacing it with IBM in the most recent update.

Exh 2: The SSR TMT Model Portfolio

Exh 3: SSR’s 5 Key Investment Themes for TMT in 2017

Over longer periods, our performance has been consistently strong, but exhibiting considerable short term volatility, much of which can be seen in the portfolio’s average beta of 1.29. Obviously then, we will show outperformance during upward market swings and underperformance during downturns. Many investors are uncomfortable with such a large degree of market risk. As such, we have decided to assess opportunities amongst the universe of lower beta TMT names.

46 of 225

Excluding firms whose operations are substantially focused on less developed non-US markets (and thus, largely outside the scope of our thematic research), there are 225 US traded TMT stocks with market caps greater than $3B. Of these, just 46, a bit over 20%, have 2-year beta statistics below 1, definitionally, the broader market average. By its nature, the TMT sector is more at risk to market volatility than most other sectors of the economy (Exhibits 4-6).

Those 46 low beta TMT names are skewed to very specific subsectors. 10 of them are application software companies, some pursuing the SaaS approach that we see as strategically on point. Another 7 are traditional media stocks, including TV network owners, advertising agencies and movie theater operators. 6 are involved in payments – largely transactions processing and other credit services. 5 are IT outsourcers. 4 are telecommunications service providers, including the big two former RBOCs T and VZ. 4 others sell security products, mostly data security appliances, but also FLIR and its high-tech cameras. There are 3 cable operators, 3 wireless equipment vendors, and 2 semiconductor design and manufacturing suppliers. Finally, there is fuse maker LFUS, the only component manufacturer on the list.

Some of these categories are positioned poorly against the thematic changes that we see playing out. We believe traditional media companies and cable operators will face substantial pressure from deteriorating audiences for linear TV and the obvious threat to TV advertising from increasingly sophisticated digital advertising alternatives. Classic IT outsourcing is becoming outmoded, with greater cost savings likely available from SaaS cloud applications. We are not keen on the largely commoditized security appliance market, but are at least a little intrigued by FLIR’s infrared camera technology. Telecom operators are a bit of a mixed bag – we see competition from smaller operators threatening the hegemony (and wide cash flow margins) of the market leading duopoly, particularly with the coming transition to 5G which will lessen the spectrum advantages that the top firms have exploited. Thus, we like TMUS and ZAYO and dislike T and VZ. While payments are fundamentally threatened by the cloud/AI future (imagine a world without significant credit fraud), the barriers to change are still substantial, putting the risks for most of the low-beta names on the roster many years away. The wireless equipment names are intriguing, particularly with a transition to 5G on the docket. The two semiconductor tech suppliers are famously cyclical and LFUS’s decidedly low tech product list seems orthogonal to our expected market shifts – we don’t have a value-added take on either.

Exh 4: Industry Sector Average 2-Year Betas

Exh 5: Industry Group Average 2-Year Betas

Exh 6: The TMT Low Beta Screen

Exh 7: The TMT Low Beta Sweet 16

5 of 16

Using a subjective review to rule out investments counter to our projection of major thematic change leaves 16 stocks – 5 SaaS application companies, 3 payments companies, 3 wireless equipment suppliers, two rising telecom stocks, two semiconductor tech suppliers, and FLIR – that appear well suited to the sea changes that we expect to play out over the next 5 years (Exhibits 7-8). We screened these names for their 5-year projected cash flow growth, and the 5th year terminal value implied by those cash flow projections as a percentage of market cap, a framework that we have used in the past to identify stocks with valuations inconsistent with their consensus expectations. We also considered free cash flow yields, a metric that has shown to be the best predictor of performance in TMT stocks in our prior work.

In that context, we see TMUS, V, NATI, OTEX and AZPN as the best positioned stocks with attractive valuations from the group. TMUS is a long-standing constituent in our model portfolio, having returned 125% since being added in October of 2014. A strong record of market share gains is joined with improving margins to drive double digit growth in both sales and profits. Given the classic game theory problem faced by VZ and T as the contemplate reacting to TMUS’s aggressive moves without pressuring their 5% dividend yields, we believe TMUS can continue to harvest market share for the foreseeable future. New spectrum, acquired in the recently completed FCC auction, position TMUS to be equally aggressive in pushing 5G services that could open significant new markets – including residential broadband and IoT connectivity – for the company. This strategic strength and record of growth is particularly impressive given that its beta is one of very lowest in TMT.

Exh 8: SSR TMT Valuation Framework – The TMT Low Beta Sweet 16

We also see V as a strong option for reducing market risk. It is obviously a popular stock, and while we acknowledge several long-term threats to the company from the coming cloud/AI era, we believe that V’s penetration to merchants and powerful consumer brand are important barriers that will push the realization of those threats well into the next decade. Meanwhile, international expansion and the general domination of credit card based payments in developed markets remain powerful drivers for the business. We suspect many TMT investors are already using V as hedge against the volatility of their mega-cap tech holdings, a strategy with which we concur.

Of the three telecom equipment names, NATI, with its network testing product line, is the most directly connected to the coming roll out of 5G services. The company is thinly covered for its $4B market cap, and expectations for 20%+ earnings growth over the next two years belie the pessimistic long term prospects suggested by its modest implied terminal value. We see it as an excellent low beta play.

OTEX has been on a roll. Sales growth in the most recent quarter topped 35% YoY, and its shares are up about 40% over the same period. Despite the appreciation, and expectations for 20%+ growth in the year ahead, the forward P/E is just 13.5, and our calculation suggests an implied 5th year terminal value of less than 80% of the market cap, one of the lowest figures in the group. OTEX’s primary business of document management is targeted at small and medium businesses, and could be attractive to several possible acquirers. As such, it is an interesting low beta option.

Finally, TEAM provides SaaS-based collaboration tools that have become a near standard amongst web-development engineering groups. This is driving nearly 40% YoY top-line growth as the company rapidly approaches profitability. TEAM’s product line makes it an extremely tempting acquisition target for any of the IaaS cloud operators or SaaS productivity software players (MSFT comes to mind immediately). Given very high growth expectations, the valuation is hardly excessive – the implied terminal value is less than 75% of the total market cap. Of course, it is surprising that TEAM’s beta is so low – most other companies with similar profiles are unusually volatile. As such, the past lack of volatility may not be a harbinger of future trading.

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