Is the "Tech" Sector Hot? - 10 ways to find out

Recent coverage of the public market listings for online companies such as LinkedIn and Groupon have reignited a familiar flame – are such companies always worth the high valuations that are placed upon them? 

In the early 1980s when technology companies started to come to market with the IPOs of Apple, Sun Microsystems and others, no-one questioned whether these IPOs were a manifestation of a "tech bubble".  These companies, like businesses in other sectors, were built on the principles of consistent improvement of revenues and profits.  Although scalable, the limitations on distribution for the products they offered meant growth mirrored the value creation in other more traditional industries.

But the internet radically changed the financial landscape for the technology business.  A global market was delivered "gift-wrapped".  With this opportunity came the real prospect of the start-up company becoming a worldwide business and global brand in just a few years.  Google, e-bay, Facebook and Twitter all grabbed this opportunity.

Success fuels success.  When investors see companies like LinkedIn trading at over 500 times earnings, Twitter valued at $7 bn, and Facebook supposedly worth £50 bn (staggeringly as much as Ford), they naturally want a piece of the action.  As investments in those businesses are not generally available, investors look to find the new social network site, or the new Twitter.  It is around this point in the investment cycle that we start to hear talk of "hot stocks".  

Technology stocks with large valuations do not make a sector hot.  However, where many technology stocks with expensive valuations draw in significant amounts of private or institutional money then be scared - the sector is now "hot".  At this point please take a careful look at the risk-reward barometer.

From experience my suggested list of 10 tell-tale signs for a "hot sector" are:

1. The completion of an investment in a client's business plan which you thought had no prospect of being funded.
2. Investments being made without the benefit of an investment agreement, warranties, or protective corporate governance arrangements (and listed companies and investors forsaking the normal principles of good corporate governance).
3. Sector-focused funds being raised in a blind pool – see the proposed London IPO of Jellybook.
4. Listed cash shells raising funds – see the proposed £1.2 bn to be raised by cash shell Vallares backed by Nathaniel Rothschild and ex-BP boss Tony Hayward.
5. "Awards" dinners for ever more niche activities.
6. The use of the expression "light-touch" as in light touch regulation.
7. A new company or entrepreneur seeking to acquire a long-established business.
8. Significant investment funds being committed with deals closing within days.
9. The published track records in AIM Admission Documents or prospectuses of companies seeking to IPO being significantly less than three years.
10. Members of the public calling to see if they can be included in the next funding round for any technology company (and, yes, this does happen).

Sectors are not "hot" because valuations are high.  They only become hot when imitation takes hold and the wider investment public is tempted to put a finger in the flame.

Lawyers Tim Stocks