Sector Screener: two UK tech stocks with long-term investment appeal

Technology stocks are currently the darlings of the investment world. Investors are seemingly falling over themselves to purchase companies within the sector, especially those with links to artificial intelligence (AI), which has pushed their valuations to extremely high levels.

This has resulted in the information technology sector now accounting for around 30% of the S&P 500 index by market capitalisation. This figure rises to roughly 39% when communication services companies are included.

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Clearly, technology firms offer the potential for rapid earnings growth over the long run. Their capacity to improve employee productivity, reduce costs across a wide range of industries and appeal to consumers via new products and services means their financial performance as a whole is likely to improve in the coming years.

When the prospect of falling interest rates in the US and elsewhere is factored in, thereby potentially raising the net present value of their future cash flows, it is unsurprising that the industry is becoming increasingly popular among investors.

Growth at a reasonable price

However, any investor contemplating the purchase of technology stocks must try to ensure they do not overpay for them. While the dotcom bubble burst over two decades ago, it remains a cautionary tale for anyone assuming that AI, or any other form of new technology, is guaranteed to quickly become a success.

Although the internet has ultimately had a huge impact on almost every industry across the globe, it proved to be an evolution rather than a revolution. This meant that valuations across the technology sector in the late 1990s proved to be vastly excessive.

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Therefore, investors who buy technology stocks must ensure that they avoid overpaying for the growth potential on offer. This can be achieved by applying the same valuation discipline as that used when investing in companies from other industries.

For example, demanding a margin of safety in case highly optimistic earnings forecasts fail to come to fruition is a sensible approach. Similarly, requiring a company to have a proven track record of revenue and profit growth before buying it can help avoid the most unfavourable risk/reward opportunities in the sector.

Source SharePad. Data as at 15 April 2024. Past performance is not a guide to future performance.

Source SharePad. Data as at 15 April 2024. Past performance is not a guide to future performance.

Unearthing high-quality companies

Indeed, investors should not suddenly disregard their investment process when purchasing technology stocks. Although a large part of their valuation is derived from future sales and earnings growth potential, while excitement about their future prospects may be high, investors should still ensure that any company they purchase is financially sound and enjoys a strong competitive position.

Financial strength is likely to be best assessed by focusing on a company’s balance sheet, rather than its income statement, due to the potential for fast-paced profit growth that prompts interest cover to rapidly expand. The net debt-to-equity ratio, calculated by dividing net debt by net assets, is likely to be a good starting point.

Meanwhile, calculating a company’s average return on equity over the past three or five years provides a relatively reliable guide as to the strength of its competitive position. If return on equity, calculated by dividing net profit by average net assets, is relatively low, investors may want to wait for at least some of a company’s profit growth potential to be delivered before buying it. After all, a good story or outlook does not necessarily equate to a sound investment.

Of course, the share prices of technology companies are inherently volatile. Investors who are averse to wild fluctuations in the market values of their holdings may be better off buying shares from more predictable sectors.

A small but attractive industry

While the US has a plethora of technology stocks, the UK stock market is somewhat lacking. In the FTSE 100 index, for instance, the technology industry group has just two members. Together, they account for less than 1% of the index’s total market capitalisation.

However, this does not mean the industry lacks appeal. There may be a degree of scarcity value among the FTSE 100’s two technology companies, Auto Trader Group (LSE:AUTO) and Sage Group (The) (LSE:SGE), which are both members of the Software & Computer Services sector.

Their share prices have risen by 13% and 51%, respectively, over the past year in contrast to a 2% gain for the FTSE 100 index. And since they offer long-term earnings growth potential at a reasonable price, they could generate continued index-beating share price performances over the coming years.

Source SharePad. Data as at 15 April 2024. Past performance is not a guide to future performance.

Auto Trader

Auto Trader Group (LSE:AUTO)’s latest half-year results showed it is performing well despite a challenging operating environment. The online automotive marketplace recorded sales growth of 12%, while operating profits moved 10% higher.

Crucially, the company maintained its dominant market position, with over 75% of all minutes spent on automotive sites being on its website. This provides it with significant pricing power, since motor traders have limited opportunities to advertise their vehicles to a large audience elsewhere.

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Indeed, average revenue per retailer rose by 12% in the first half of the current financial year. And with continued investment in innovative new products that make the firm’s offering increasingly valuable to its customers, it is likely to maintain its competitive advantage over sector peers.

Its strong competitive position is further evidenced by an average return on equity figure of 47% over the past three years. And with a net gearing ratio of around 9%, it has a solid financial position through which to overcome a period of economic weakness.

Falling inflation and upcoming interest rate cuts should mean that demand for new and used cars increases over the coming years. As a result, Auto Trader is currently forecast to deliver an annualised increase in earnings per share of 13% over the next two financial years.

Given that it trades on a forward price/earnings (PE) ratio of around 24, its shares are by no means cheap relative to other FTSE 100 index peers. However, with a solid balance sheet, a strong track record of financial performance and a dominant market position, the stock offers a favourable risk/reward opportunity for long-term investors.

Sage

Sector peer Sage Group (The) (LSE:SGE) also has a bright long-term future. The company offers a range of accounting and payroll technology services to small and medium-sized businesses, with its latest trading update showing that revenue rose across all three of its geographical regions.

It increased by a total of 10%, with the firm on track to meet financial guidance for the full year. This is despite tough operating conditions for many of its customers.

Indeed, the company has an excellent market position, as highlighted by return on equity averaging 21% over the last three years. This has been achieved despite modest debt levels, with the firm’s net gearing ratio currently amounting to 40%. This shows it has a solid financial platform from which to grow.

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The proportion of the company’s sales that are recurring has risen over recent years so that it now stands at around 97%. This equates to a relatively stable outlook for the firm, with its customers highly reliant on its wide range of products and services. In turn, significant switching costs mean Sage has substantial pricing power that, alongside an improving economic outlook, are likely to act as catalysts on its top and bottom lines.

The firm is forecast to produce an annualised earnings growth rate of 13% over the next two financial years. Although it trades on a PE ratio of around 33, which is significantly higher than that of many FTSE 100 stocks, the company’s strong competitive position, high proportion of recurring revenue and improving outlook mean it offers further capital growth potential.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.