What should an investor look for in a Canadian tech company?

First published in Financial Post: FP Answers on January 26, 2024

Question: In 2023 investment returns were primarily driven by the “Magnificent Seven”, U.S.-based, high-tech stocks. What about Canadian high-tech? What should investors look for in a Canada-based high-tech company? – Marisa.

Answer: FOMO was alive and well through 2023 with the so-called “Magnificent Seven” attracting the bulk of investors’ capital. (The seven mega cap tech stocks were up 71 per cent as of late-November.) By any measure, these companies that drove the performance returns in the S&P 500 last year are, as the saying goes, “priced for perfection.”

As the Magnificent Seven pulled focus (and capital), other sectors have been, in our opinion, unjustly overlooked. One of these is the Canadian technology industry where many high-quality companies are trading near trough valuations. The Canadian tech industry is not as broad as the U.S.; the S&P/TSX Capped Information Technology Index has only 23 constituents. It was up a not-too-shabby 50.45 per cent last year (to December 11).

Other than a few of large companies, such as Shopify, Constellation Software, and CGI, it 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 selloffs. Despite the current lack of investor interest, technology is of growing importance to Canada’s current and future economy. According to Deloitte Canada, the average three-year growth of the 50 fastest growing Canadian tech companies was 2,213 per cent.

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 the Canadian technology space, the challenges of the past few years have presented a silver lining. The historically low valuations offer the rare opportunity to cycle capital into higher-quality 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 5-10 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 companies, next generation companies in AI, 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 M&A activity. Last year, several Canadian technology companies were acquired by financial or strategic buyers: Magnet Forensics, Absolute Software, Dialogue Health Technologies, are a few of these names. The outsize strength of the U.S. dollar made shopping in Canada a relative bargain for foreign capital and serial acquirers such as Thoma Bravo, the U.S-based private equity and growth capital firm that bought Magnet Forensics for US$1.3 billion. In addition, companies that did successful IPOs during 2020, have now adjusted their valuation expectations in light of a difficult couple of years of capital raising. In some cases, their management and board of directors are more amenable to overtures from outside investors looking for acquisitions.

When searching for the subset of Canadian tech companies which may be acquisition targets, investors should look for businesses 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 the elimination 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 as 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 their fundamentals or seek trusted professionals with a proven track record of investing in Canadian small-to-mid-cap technology companies through all market cycles.

Sharon Wang is a senior equity analyst at PenderFund Capital Management Ltd.