There is no doubt that the world's annual $120 trillion economy increasingly depends on just six mega-tech businesses - Facebook, Alphabet (Google), Microsoft, Amazon, Tencent and Alibaba - to function properly. You would think they would continue to all be obvious inclusions in portfolios. But investors today have a menu of reasons to avoid or even sell mega-tech investments.

After a strong 2020, many investors are worried all the "easy money has been made" - a commonly used phrase we hear in our industry (which also suffers from acute hindsight bias). They're also worried inflation will drive interest rates higher and compress the earnings multiples of higher-growth businesses. Mega-tech investments also seem boring now - a surprisingly strong criterion some investors seek to avoid. And, of course, there are the never-ending headlines pointing to regulatory pressures across the sector.

Yet our analysis shows that mega-tech stocks not only offer some of the best growth opportunities, but also offer some of the best 'value' opportunities in the market today. We see material upside in all six of these mega technology businesses. Given the combination of strong and growing advantages, enormous growth opportunities, and material undervaluation today, we believe these names should form - or continue to form - the core of any global equities portfolio.

Investors shouldn't rotate out of mega-tech to value because mega-tech are value.

At Montaka, our investment philosophy is to own long-term winning businesses operating in the world's most attractive markets, without overpaying. These mega tech businesses meet these criteria in the strongest way we've seen and they form the core of our portfolio.

 Below we look at the top 3 reasons why mega-tech stocks are some of today's best value stocks.

1.            Mega-techs have the best businesses … ever?

The first reason is that the business quality of today's mega-techs is among the highest that humans have ever created. They dominate global data, benefit from enormous ecosystems, and have superior economics and scale. The huge cash flows and profits these businesses generate can be reinvested in new business opportunities, spurring fresh rounds of growth. These mega-techs all have a vast array of high-probability growth options in enormous new TAMs (total addressable markets).

Take Facebook, for example. More than 3 billion members log in and spend significant time each month on its platforms. It is unquestionably the world's best platform for marketers to reach customers. Facebook's revenues and earnings have been largely driven by the company monetising around 10 million businesses who pay for the company's digital marketing services. But approximately 200 million businesses use Facebook today, as well as another 200 million 'creators'.

Facebook is now investing heavily in its conversion and monetisation capabilities - particularly in eCommerce and creator monetisation tools - to unlock the enormous latent revenue opportunity of these currently non-paying businesses and creators. That gives us great confidence that Facebook's future revenue and earnings power will be multiples of its current levels.

Alphabet is also leveraging its advantages in data, talent and time to become a clear global leader in artificial intelligence (AI), which will not only strengthen its existing advantages in its core advertising, cloud and productivity businesses, but will also create brand new businesses, such as Verily - which is leveraging Alphabet's data advantages to solve problems in life sciences and healthcare.

And, of course, one of the biggest areas of future mega-tech growth is the cloud. Amazon, Microsoft and Alphabet, along with Alibaba and Tencent in China, dominate the cloud. Microsoft CEO, Satya Nadella, estimates there will be approximately $8 trillion in incremental IT spend each year globally by 2030, of which cloud-based services and applications will no doubt claim the lion's share. For the leading cloud providers, their advantages in scale, data and customer captivity will only continue to strengthen over time. Said another way, this is a space for which enormous growth is largely assured and for which the winners have already been defined today. This means that the future revenues and earnings power of these businesses will also be multiple of their current levels.

2.            Inflation concerns are overdone

The second reason mega-tech provides fantastic value is that investors are too worried about inflation and what that could mean for interest rates and valuations. Over the first six months of this year, equities in the technology sector have underperformed the broader market largely because investors feared rising rates would slash tech valuations.

But those fears - and the sell-off - we believe are overdone. While we note the same strong headline inflation numbers as everyone else, we struggle to see an extended acceleration in core inflation.

For a start, over the short-term, there remains significant slack in the labor markets relative to pre-pandemic levels, which should limit the acceleration in wage growth. Secondly, our analysis of Chinese credit growth shows a clear and substantial slowing, which is a strong leading indicator for cooling global commodities demand growth over the next 6-12 months. We also expect structural disinflationary forces - such as aging populations, labor-disrupting automation technologies and global corporate and government indebtedness - to persist for decades.

But something that has not yet been tested in any meaningful way is the pricing power of our mega-tech businesses. Should these businesses find it easy to increase their prices in an inflationary environment, then this goes some way to insulating investors from the negative effects of inflation. We believe the latent pricing power in these businesses is likely very strong - and in some cases, extraordinarily so. Take Microsoft 365, for example - arguably one of the most mission-critical software packages upon which many hundreds of millions of employees are reliant each day. This costs just US$32/month, vastly below any reasonable estimate for the value it adds, strongly supporting our latent pricing power hypothesis.

3.            Current valuations are way too conservative

The final reason that mega-tech stocks are great value is their attractive valuations. Our analysis shows that the expectations baked into the current stock prices of our big-tech names are far too conservative.

• In the case of three dominant US cloud providers, Amazon, Microsoft and Alphabet, for example, their implied collective annual cloud revenues by 2030 are in the order of just $650 billion higher than current levels, according to consensus estimates. This is a tiny fraction of the $8 trillion increment that Microsoft CEO Nadella expects to accrue to the tech space over the next decade. If Nadella's forecast above is even remotely accurate, then these cloud providers will see much higher revenues (and earnings) in 2030 than what is currently being implied by consensus estimates.

• Next, consider Tencent and Alibaba, the latter of which has of course suffered greatly from the Jack Ma saga, with the billionaire Alibaba founder's fintech Ant Group IPO pulled at the last minute and with Ma reportedly under serious pressure from Chinese regulators and Government. In both cases, despite owning some of the most valuable data ecosystems in China and South-East Asia - including being the two dominant cloud providers on the Mainland - their respective stock prices imply very conservative sets of expectations. Said another way, if revenue growth for these businesses were to fall from healthy-double-digits, to just single-digits by 2025, an investor today would still make money, based on Montaka's analysis.

• And finally, in the biggest head-scratcher of them all is Facebook, which is priced at a forward earnings multiple of just 14x. Some of the businesses trading at a higher multiple than this today include Australia's Wesfarmers, Scentre Group, and plumbing parts supplier, Reece. At the current stock price, the market is effectively giving investors all of the upside from eCommerce, the monetisation of the creator economy, WhatsApp, Messenger and Reels, as well as Facebook's growth in VR/AR for free!

Spectacular potential

As the global economy grows, we are all becoming even more dependent on the highest-quality mega-tech winners.

Today, the collective revenues of these six businesses account for just one percent of global GDP. By 2030, global GDP will probably be around $160 trillion per annum, and these businesses will account for a much larger share than today.

When you combine a growing share of a growing economy, the future upside of these mega-techs is spectacular. Yet the market is underestimating that.

For the patient investor who can look through the short-term noise, the rewards will be substantial, and we believe these businesses are very strong candidates to form the core of any global equities portfolio today.

At Montaka, we will continue to own these businesses in size while their prices make sense. Patiently owning the winning businesses in the world's most attractive industries without overpaying is the way Montaka believes in safely compounding capital over the long-term.

If investors cast their eyes back over the last two decades, it's obvious the stock market's massive winners and 10-baggers - the likes of Amazon, Google and Afterpay - have always looked overvalued and uninvestable based on conventional valuation methods. Many investors wielding traditional valuation tools shunned these stocks and missed out on staggering returns.

When investors value established companies, it is a relatively straightforward exercise guided by market capitalisation and earnings multiples, as well as some subjective elements. But it is much more difficult to value early-stage growth companies. Investors often lack these foundations and are forced to follow a process that looks quite different.

Small cap equity investors, particularly, must frequently value less mature companies with short revenue histories, zero profit, and that require significant external capital for growth. Without years of financial data to rely on, early-stage companies and their investors must employ more creative ways to substitute these inputs.

We are in a period of unprecedented innovation and disruption globally. Exciting new companies are emerging every day. If investors can better understand how to value young, fast-growing companies, they will be much better placed to identify - and ride - the next 10-bagger.

When DCF doesn't work

For investors to grasp the challenges in valuing early-stage growth companies, they must first understand the mechanics of Discounted Cash Flow (DCF), a valuation method that all analysts are taught.

A DCF financial model projects the expected cash flows of a business into the future. Those future cash flows are then brought back to a value today by applying a discount rate to adjust for the level of risk and uncertainty faced in achieving those cash flows.

The DCF methodology is relatively easy to implement when investors value mature business that have years of consistent earnings and stable margins. But it is much harder to value a business using DCF when its earnings streams become less predictable, such as in the case of an early stage, fast-growing company. This can lead to potentially extreme mispricing of equities over time, as we have seen with the likes of Amazon, Google and Afterpay that all appeared overvalued but recorded spectacular growth.

Useless metrics

As with DCF, many of the stock standard valuation metrics such as P/E (price/earnings) or PEG (price/earnings to growth) can be completely useless when analysing immature companies.

Their P/E or PEG ratios can look astronomical, and change wildly, because their current earnings may only be a tiny sliver of their potential earnings when they mature. To achieve scale, these companies are often heavily reinvesting in themselves with high R&D costs. Revenues may grow rapidly, but it could take years to deliver profits.

Why is Afterpay's 'value' so high?

A classic example investors ask us about is Afterpay. "How can it be valued so high when it doesn't make a profit?" they ask. By "valued" we assume they mean its market capitalisation.

Our answer is simple: Afterpay's valuation, such as its P/E, is so high because it is deliberately keeping the 'E' low to non-existent by reinvesting for future growth. Given Afterpay's superior offering, and the massive size of its potential markets, we would prefer that the company reinvest and realise that potential, rather than spit out profit today.

As we say with Afterpay, and at the risk of oversimplifying, you can have revenue growth or you can have profits now, but you can't have both.

Their Australian business is highly profitable, but they are using that excess cash flow to grow and take market share in new geographies - meaning they have little to no profit at a group level. The moment they stop reinvesting for growth to prioritise generating profits, at least in the short to medium term, this would likely represent to us a signal for exiting the business.

The corporate lifecycle

To illustrate what we have been talking about, the stylised example below paints a typical picture of a corporate's lifecycle. As you can see, many early-stage growth companies simply don't have any free cash flows that are used to value the worth of a share in a DCF model. So, investors and analysts must make assumptions about what these will look like in the future.

Corporate Life and Death - a stylised lifecycle

Source: Aswath Damodaran

Turning to qualitative factors

But how do you make those assumptions?

To evaluate young, high-growth companies, analysts must dive into the underlying business, and judge how long it will take to mature. They will need to refer less to financial ratios and income statements, and more to qualitative factors such as:

• Recurring revenue
• Scalability
• Competitive advantage
• Size of addressable market
• Best-in-class leadership
• Organisational culture
• Track-record of success
• Ability to create new revenue streams

Few of these traits can be meaningfully reflected in spreadsheets.

For legendary investors, such as Peter Lynch, Warren Buffett and Howard Marks, it is the quality of a company's growth that determines its value, not revenue or even earnings growth per se. When they analyse the broad range of factors outlined above, they can make informed judgements on which businesses are most likely to be long-term successes.

Focusing on four factors

More specifically, the study of early-stage companies will focus heavily on four key factors:

1. Identifying assets

Usually, the first thing to consider when formulating a valuation for an early-stage company is the balance sheet. You list the company's assets which could include proprietary software, products, cash flow, patents, customers/users, or partnerships. Although you may not be able to precisely determine (outside cash flows) the true market value of most of these assets, this list provides a helpful guide through comparing valuations of other, similarly young businesses.

2. Defining revenue KPIs

For many young companies, revenue is initially market validation of their product or service. Sales typically aren't enough to sustain the company's growth and allow it to capture its potential market share. Therefore, in addition to (or in place of) revenue, we look to identify the key progress indicators (KPIs) that will help justify the company's valuation. Some common KPIs include user growth rate (monthly or weekly), customer success rate, referral rate, and daily usage statistics. This exercise can require creativity, especially in the start-up/tech space.

3. Reinvestment assumptions

Value-creating growth only happens when a firm generates a return on capital greater than its cost of capital on its investments. So a key element in determining the quality of growth is assessing how much the firm reinvests to generate its growth. For young companies, reinvestment assumptions are particularly critical, given they allow investors to better estimate future growth in revenues and operating margins.

4. Changing circumstances

Circumstances can move or change quickly for early-stage companies. When a young company achieves significant milestones, such as successfully launching a new product or securing a critical strategic partnership, it can reduce the risk of the business, which in turn can have a big impact on its value. Significant underperformance can also result when competitive or regulatory forces move against a company.

Landing the next 10-bagger

At Ophir, we believe that the market should award the businesses with the greatest long-term potential premium valuations.

If you avoid early stage growth businesses simply because they have high valuation multiples compared to the market (such as P/Es), you will often miss the most exciting businesses and the next '10 bagger'.

That doesn't mean you should ignore valuation measures; they are a core part of our process. You can still overpay for high growth companies.

But when you analyse high-growth early-stage companies, you need to accept that the long-term potential of a business ultimately matters more than its valuation at any given time.