SIF Folio: Hunting for tech stocks to buy

My simple and perhaps old-fashioned valuation criteria rule out stocks with nose-bleed valuations. So I haven’t had a chance to buy into the UK’s largest tech play, food delivery service Just Eat Takeaway. 

I can’t say I’m sorry. JET required a global pandemic to make it profitable and currently trades on 95 times 2021 forecast earnings. I’m not sure how much upside is left, as the evidence this year suggests that people will return to dining out just as soon as they’re allowed to. 

For my money, Stocko’s classification of JET as a Momentum Trap is spot on. However, I can recognise the structural growth potential inherent in many businesses in this sector. Luckily, UK tech stocks have been left behind somewhat by their US rivals this year. As a result, I think there is some value on offer elsewhere in the UK tech sector. 

I’ve been hoping to find an opportunity to add some tech exposure to SIF, which currently has none.

I think I may have found an opportunity that could tick all the boxes. FTSE 250 precision measurement firm Spectris (LON:SXS) is a new arrival in my stock-buying screen. This £3.2bn business is the ninth largest stock in the UK technology sector. Happily, Spectris also has some old-fashioned fundamental attractions for nervous types like me.

For one, it makes money and has done for many years. Stockopedia shows a six-year average operating margin of 13%, with a matching return on equity. Spectris generates cash, pays dividends and maintains a strong balance sheet. The valuation doesn’t require a leap of faith and Spectris’s customer base includes all major sectors and geographies:

Source: Spectris 2019 fact sheet

Spectris has four operating subsidiaries which sell directly to clients, building lasting relationships. The group sells measuring instruments and sensor technology, along with related software and services. 

I believe demand for such products should be underwritten by structural growth for many years to come. Consider the global market for sensors and related software, for example. Apart from short-term cyclical dips, I can’t really see any scenario where demand for data capture and operational monitoring is likely to decline.

I should have kept the shares in 2019

As it happens, I’ve bought Spectris before for SIF. I last sold the shares at the start of 2019. With hindsight this was a bad decision, as the stock has risen by around 25% since then. 

Perhaps under my new selling system I’d have kept the stock. I don’t know. But I’m hoping to see the group move into a new phase of growth after a period of consolidation:

Stockopedia’s algorithms also have a favourable view of Spectris. The shares’ StockRank has risen to 77 over the last 30 days, thanks to a notable improvement in momentum factors:

Let’s take a closer look at the stock’s individual factor scores to see how the numbers shape up.

Value: look closely

A ValueRank of 46 does not suggest an obvious bargain. Certainly, Spectris’s trailing 12-month valuation metrics do not look especially cheap:

However, there are a couple of measures which convince me this business is probably quite reasonably valued.

Earnings yield: One of the main measures of valuation I use is earnings yield, which I calculate as EBIT/EV. Spectris currently has an earnings yield of 8.9%, above my threshold of 8%. Looked at a different way, the entire business is currently valued at a multiple of 11 times operating profit. I don’t think that’s expensive for a company which generated a return on capital employed of 19% last year.

Net cash: One reason for the relatively high earnings yield is that Spectris reported a net cash position of £60m at the end of September. This means that its enterprise value (market cap plus net debt) is actually smaller than its market cap. For now at least, debt is not diluting the return available to equity holders.

Quality: precision profits

For industrial and technology stocks, I generally view quality metrics as a good proxy for measuring barriers to entry, customer loyalty and cash generation. Engineering businesses which lack these attributes are more likely, in my experience, to be vulnerable to pricing pressure and perhaps dependent on a small number of customers. 

I’m relieved to see that Spectris scores highly here, with a QualityRank of 94. I believe this score support my view that this is a business with attractive technology and enduring customer relationships:

Cash generation also appears to be excellent. In the screenshot below, I’ve compared earnings per share with free cash flow. The close relationship between the two suggests that the business converts profits into cash with great consistency. 

Note how dividends are always covered by free cash flow:

I don’t have any concerns about the quality of this business. What I do need is some hope that near-term growth will justify the stock’s rolling forecast P/E of 22. 

Momentum: a new uptrend?

Last month’s vaccine news was the rising tide that lifted all ships. But even before this, Spectris had reported improved revenue trends. Third-quarter LFL sales were down by 9%, versus a drop of 18% during the second quarter. North America and China were both said to have rebounded strongly.

Although MomentumRank is fairly low, at 55, hovering my mouse over the green arrow next to this score tells me that MomentumRank has risen by 16 over the last 30 days of trading. This suggests a notable improvement in the outlook.

October’s trading update did seem fairly positive to me, but my feeling is that Spectris’s improved momentum is mostly due to recent buying activity. Increased buying volumes have lifted the stock close to its 52-week high:

So far at least, upgrades to earnings forecasts have been more modest:

However, even without further upgrades, a 28% increase in earnings is pencilled in for next year. I think that’s enough – for now – to support the 2021 forecast P/E of 21. The shares also offer a useful 2.4% dividend yield. I expect this payout will continue to be supported by strong cash generation.

My decision

I didn’t start out with a strong conviction that I’d want to buy Spectris for SIF. But having reviewed the numbers and narrative from the group, I feel fairly positive about this business. I’m also comfortable that the stock passes all of my SIF screening tests.

On balance, I think Spectris looks reasonably valued and could add useful diversity and growth potential to SIF. Although I don’t expect fireworks, I think the firm should benefit if we do see a broad economic recovery next year. If not, then I believe the company’s diverse client base and strong balance sheet should provide some protection for shareholders.

I’m going to buy Spectric for the SIF folio and my own holdings this week. As always, I’ll make the trades after this piece has been published.

Stockopedia