National Post

WHAT SHOULD INVESTORS BE LOOKING FOR IN A CANADIAN TECH COMPANY?

- Julie Cazzin with Sharon wang Sharon Wang is a senior equity analyst at Penderfund Capital Management.

Q Investment returns in 2023 were primarily driven by the Magnificen­t Seven. What should investors look for in a Canada-based hightech company? — Marisa

A The fear of missing out (FOMO) was alive and well through 2023 with the socalled Magnificen­t Seven attracting the bulk of investors’ capital. The seven megacap tech stocks were up an average of 104.7 per cent for 2023, accounting for more than 62 per cent of the S&P’S performanc­e. By any measure, these companies that drove the S&P 500 last year are, as the saying goes, “priced for perfection.”

As the Magnificen­t Seven pulled in the focus (and capital), other sectors have been unjustly overlooked. One of these is the Canadian technology industry, where many high-quality companies are trading near their trough valuations. The Canadian tech industry is not as broad as that in the United States; the S&P/TSX capped informatio­n technology index only has 23 constituen­ts. It was up a not-too-shabby 69.2 per cent in 2023.

Other than a few large companies, such as Shopify Inc., Constellat­ion Software Inc. and CGI Inc., the Canadian sector is more of a small-to-mid-cap universe. As bond yields rose last year, investors’ risk appetite diminished for companies with smaller capitaliza­tions, and this led to indiscrimi­nate sell-offs.

Despite the current lack of investor interest, technology is of growing importance to Canada’s current and future economy. The average threeyear growth of the 50 fastest-growing Canadian tech companies was 2,213 per cent, according to Deloitte Canada.

Hence, we expect a regime change and a re-rating in valuation multiples for some of these Canadian companies that are emerging stronger than ever, having withstood the volatility of 2022 and 2023.

For investors in Canadian tech, the challenges of the past few years have presented a silver lining. The historical­ly low valuations offer a rare opportunit­y to cycle capital into higherqual­ity companies.

This period reminds us of the early 2000s. After rapid price appreciati­on in dot-com stocks and a narrow market leadership, the dot-com crash brought valuations down to earth. Among the wreckage, smaller companies that demonstrat­ed they could deliver profitable growth emerged as long-term winners over the next five to 10 years, outperform­ing large caps by an average of 12 per cent annually.

There are several tailwinds to support higher valuations in the Canadian technology sector. Investors should focus on fundamenta­ls such as companies with good unit economics, a long runway for generating revenues and profits, a large addressabl­e market and incentiviz­ed management. Leading and next-generation companies in artificial intelligen­ce, data, clean tech, quantum computing and life sciences are counter-cyclical and relatively immune to rising interest rates.

Another very positive trend for Canadian tech companies is the uptick in merger-and-acquisitio­n (M&A) activity. Last year, several Canadian technology companies were acquired by financial or strategic buyers: Magnet Forensics Inc., Absolute Software Corp. and Dialogue Health Technologi­es Inc. are a few of these names.

The outsized strength of the U.S. dollar made shopping in Canada a relative bargain for foreign capital and serial acquirers such as Thoma Bravo LP, the Chicago-based private-equity and growth-capital firm that bought Magnet Forensics for US$1.3 billion.

In addition, companies that had successful IPOS during 2020 have now adjusted their valuation expectatio­ns in light of a difficult couple of years of raising capital. In some cases, their management and board of directors are more amenable to overtures from outside investors looking for acquisitio­ns.

Investors searching for the subset of Canadian tech companies that may be acquisitio­n targets should look for those that are competing in the same market as much larger companies. This increases the probabilit­y of shareholde­rs being offered a strategic premium by the larger enterprise looking for a tuck-in acquisitio­n or to eliminate a competitor.

In 2024, we may see more takeovers, and “takeunders,” where knowledgea­ble and sophistica­ted buyers take advantage of today’s discounted valuations to take a company private. In some cases, being acquired is the next logical step for a smaller company since it gives better access to capital to fuel the next stage of growth. For equity investors, a takeout permits them to recycle their capital gains into another investment.

As always, investors should thoroughly research companies based on their fundamenta­ls or seek trusted profession­als with a proven track record of investing in Canadian small-to-midcap technology companies through all market cycles.

 ?? CHRIS YOUNG / THE CANADIAN PRESS FILES ?? After rapid price appreciati­on in dot-com stocks, the dot-com crash brought valuations down to earth.
CHRIS YOUNG / THE CANADIAN PRESS FILES After rapid price appreciati­on in dot-com stocks, the dot-com crash brought valuations down to earth.

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