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

For investors in Canadian tech, the challenges of the past few years have presented a silver lining

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By Julie Cazzin with Sharon Wang

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

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FP Answers: The fear of missing out (FOMO) was alive and well through 2023 with the so-called Magnificent Seven attracting the bulk of investors’ capital. The seven megacap tech stocks were up an average of 104.7% 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.”

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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 selloffs.

Despite the current lack of investor interest, technology is of growing importance to Canada’s current and future economy. The average three-year 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.

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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 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 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.

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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.

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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.

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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-mid-cap technology companies through all market cycles.

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

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