Tech is hot. So why do Canadian tech stocks suck right now?

M Partners technology analyst Ron Shuttleworth says a trend has developed in the Canadian markets. Many are looking to rotate their capital into technology from the mining sector. The money, however, is pouring into smaller speculative stocks not larger, more established names. Shuttleworth thinks he knows why this is the case…

At M Partners, we publish a monthly review of the small cap technology sector on the TSX and TSXV and compare it to the main S&P/TSX index. We also attempt to find trends within the sector. We happen to index the fundamentals of thirty small cap technology stocks covered by at least three analysts.

The large cash balances of technology companies discussed in this month’s issue of Cantech Letter are not anomalies. The M Partners RES 30 averages 19.7% of cash and, perhaps more impressive, 15.9% of net cash as a percentage of market cap. These companies are stuffed with cash, which should be a good thing for investors, but it’s not.

After benefiting greatly from the commodity bull market for the past several years, many generalist institutions are rediscovering the fundamentals of the tech sector, and are attempting to rotate into it. This is supported by dramatic increases in trading volumes over the past six months. Ironically, the heavy volume is, for the most part, not occurring among the stocks with strong fundamentals, but among riskier microcap “story” stocks with weaker fundamentals, and limited coverage.

This has created a strange dichotomy. The fundamentally sound companies with solid balance sheets and consistent earnings remain chronically undervalued and illiquid in comparison to peers on other exchanges and to the main S&P/TSX index. Despite better fundamentals than ever before, our RES 30 Tech Index has underperformed the S&P/TSX main index since the beginning of 2010 on an EV/EBITDA multiple. To put this into perspective, prior to the recession bottom of Q1 2009, the tech group consistently traded at a higher EV/EBITDA multiple than the S&P/TSX index. In the meantime, stocks with no history of earnings, weak balance sheets (1.4% of net cash as a percentage of market cap), and limited analyst coverage have soared. Why does this dichotomy exist?

In order to take new meaningful positions in small cap stocks, institutions have historically relied on participation in new equity issues. Institutions need deals. Among the tech companies with the best fundamentals, there are no deals. No easy way in. For the most part, these companies sailed through the recession and have been generating gobs of cash since, which means that they do not need to raise capital by selling equity. In fact, most are rewarding shareholders with dividends or share buy back programs.

Among many of the best stocks, It is difficult to build meaningful positions in the open market. The institutions that specialize in technology are already long and holding the good stories and are not getting out any time soon because the fundamentals are so solid (including cash position), so a generalist rotating into the sector can’t easily get into these stocks due to limited liquidity.

The alternative is for institutions to invest in the momentum of highly liquid “story” stocks like Intertainment Media (TSXV:INT), ISign Media (TSXV:ISD), Fireswirl (TSXV:FSW), Poynt (TSXV:PYN), and Counterpath (TSXV:CCV) with high share counts, retail concentration and limited institutional participation. But wait, there are still very few deals. And no meaningful M&A. Why?

Nobody wants to capitalize the speculative stocks that actually need cash to grow because the momentum-based valuations are too high and fragile for typical four-month hold paper, and larger undervalued companies with cash are not willing to pay-up for overvalued micro-caps that have traded up on speculation. Nothing is accretive, which means few deals.

The only companies that may be willing to pay-up are mega-caps like Qualcomm (NASD:QCOM), Microsoft (NASD:MSFT), Google (NASD:GOOG), and Cisco (NASD:CSCO), who don’t care about valuation for strategic purchases because they can usually pay right out of quarterly cash flow for most; right up to $10 billion. A good example is Microsoft buying Skype for $8.1 billion. That number is essentially a quarter of cash flow for Microsoft.

These companies, however, are unlikely to waste the internal M&A resources to acquire a $30M Canadian microcap. To put this into stark perspective, with cash-on-hand, Apple could acquire the entire TSX technology sector (including RIM) and still pay a 10% premium to shareholders.

So here is the bottom line: there is simply not enough product in the TSX/TSXV technology sector to accept the capital that wants to rotate into it. In mid-2008 there were over 220 technology companies listed by the TSX with market caps of over $5M. As of today, there are only 134 tech companies with market caps of between $5M and $500M and only 10 companies with market caps above that. Including the large caps, there are about 50 fundamentally solid technology companies with active coverage. And they are not doing deals.

We think that the market is screaming for new quality product in which to invest meaningfully. This could be an exceptional time for exceptional companies to go public right now. Interestingly, good quality private companies that would make excellent IPO candidates are hesitant to go public. The are already profitable with scale and don’t necessarily want the hassles of being public, nor do they want to contend with Canadian public market investors.

Now what about the micro-cap “story” stocks? Many of the these stories are actually compelling and they need appropriate capital to commercialize the stories into cash flow for shareholders. Are the institutions that have helped to drive up their valuations willing to support their need for equity capital? We hope so, because with only 134 stocks in the sector, failure is not an option.

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