Over the past 10 years, investing in technology companies has been a great way to make money. And when we think about investing in tech, it’s almost natural to think about the world conquering US technology behemoths, the likes of Nvidia, Apple, Microsoft, Meta, Google and Amazon.

The US’s NASDAQ Composite index has become synonymous with tech investing, and USD100,000 invested there 10 years ago would now be worth more than USD$430,000.

Or at a stretch you might think about the Asian tech giants, the likes of Baidu, Alibaba, Tencent and Xiaomi out of China, or even Korea’s Samsung and Taiwan’s TSMC.

It’s less likely when you think about investing in tech companies that Australia comes to mind, after all, that’s where you go for some of the world’s biggest resources companies, or reliable dividend payers like the financials, which between them account for more than half the total market. Given the S&P/ASX Information Technology index accounts for just 3 per cent of the market, it’s easy to see how it can be overlooked.

However, the same peculiarities with the way the US tech index is constructed that stops Meta (Facebook), Amazon and Google from being included as “tech”, are applied to some companies that would seem obvious inclusions for the Australian index, such as REA Group, Pro Medicus and CAR Group, and they happen to be some of the best performing too.

Whilst Australia’s tech sector is relatively small, it boasts some high-quality companies that come with decades of history which have produced outstanding returns. To illustrate, we can take full advantage of the benefit of hindsight to see how a portfolio of a selection of Australian tech-oriented companies would have performed compared to the market.

The portfolio is comprised of seven of the best known tech companies from the ASX 200 ranging in market cap from $33 billion down to $2 billion: WiseTech (WTC), REA Group (REA), Xero (XRO), CAR Group (CAR), Pro Medicus (PME), TechnologyOne (TNE) and Megaport (MPT).

A portfolio equally weighted to each of the seven companies starting from the date that WiseTech listed on the ASX, 11 April 2016, would have returned an astonishing 1151 per cent to the end of May this year, against the Vanguard Australian Share (VAS) ETF’s total return (including dividends) of 117 per cent and the S&P/ASX Information Technology index’s 208 per cent – see chart 1.

That’s an incredible compounded annualised return of more than 36 per cent, which is more than double that of the NASDAQ Composite over the same period, and well over triple that of the broader Australian share market.

The catch is, however, this is a portfolio of “growth” companies, meaning their earnings growth is not so dependent on the economic cycle, and the market typically looks out years ahead when valuing them, and the higher the potential growth, the further out it will look. Consequently, just like their international tech peers, this portfolio of stocks comes with a high forecast price to earnings (PE) ratio for next year, with an average of 70x, compared to the ASX 200’s 17x.

A drawback of their high valuation multiples is that growth stocks are usually more volatile than the broader market. For example, during the COVID crash of 2020, this portfolio of stocks fell by 53 per cent, compared to the broader market’s 39 per cent; and in the market correction of 2022, it was a 51 per cent drop versus 28. So investors need to be sure they have the risk tolerance to see those corrections through in order to benefit from the long-term growth.

It is also unusual that high growth companies pay much of a dividend, if they pay one at all, because normally they are reinvesting earnings into their growth pipeline where they would expect to earn a high return on the equity invested. The average dividend yield on this portfolio is less than 1 per cent, so investors have to be resigned to returns being dependent on capital growth.

Obviously, the old proviso of past performance not being an indicator of future returns applies to this portfolio of tech stocks, but there has been an impressive degree of consistency. Whilst it might be a brave investor who would allocate a large portion of their portfolio to high growth companies, a smart investor should see the merit of some allocation.

At last month’s Portfolio Construction Forum summit in Sydney, almost every presenter – from economists to fund managers – was critical of central banks for “artificially inflating asset prices” with “excessive liquidity”, leaving financial markets “addicted to easy monetary policy”.

Indeed, US journalist Christopher Leonard recently published a book called The Lords of Easy Money: How the Federal Reserve Broke the US Economy, which “tells the shocking, riveting tale of how quantitative easing is imperilling the American economy”.

On the face of it, the numbers are confronting. Before the start of the COVID-19 crisis in February 2020, the US Federal Reserve’s balance sheet stood at $US4.4 trillion. Two years later, after a program of buying government bonds and mortgage-backed securities known as quantitative easing (popularly referred to as QE), it has more than doubled to $US8.9 trillion ($12.3 trillion).

Similarly, the Reserve Bank of Australia has also conducted its own QE program, expanding its balance sheet from $180 billion before the pandemic to about $650 billion.

It sounds intuitive and seductively simple: central banks print money; they’ve expanded their balance sheets by trillions of dollars; all that newly printed money has inflated asset prices. Unfortunately, it is dead wrong but, as is often the case in financial markets, it’s the prevailing narrative that’s been repeated so often that people believe it.

In his book, Leonard describes how, under the QE program, the Fed will buy bonds off a bank by crediting that bank’s “reserve account”, which, in simple terms, is a special account that only banks who transact directly with the central bank can have. He then claims those banks are free to use those reserves “to buy assets in the wider marketplace”.

That just isn’t how it works.

What really happens is far more complicated, and far less exciting. Those reserves, which in Australia are called exchange settlement reserves, are a special kind of currency that is only transacted between the central bank and other commercial banks to make sure the billions of transactions the banks undertake daily settle every day. Those reserves are not the same as the cash used in the real world.

Central banks will also buy bonds from other institutions that don’t have a special reserve account with them, in which case they do settle with normal cash. However, according to the Reserve Bank’s website, those institutions are all credit unions, smaller banks or insurance companies. If an institution like that is holding bonds in the first place, which are classified as a defensive, fixed income asset, it is pretty much guaranteed they are not going to take the money and punt it on cryptocurrencies.

So what caused financial markets to rebound so aggressively if it wasn’t central banks printing money? It was governments, by injecting trillions of dollars, pounds, euros, yen and other currencies into economies to support them during the COVID-19 crisis.

That money was created out of thin air and is still circulating around their respective economies. In fact, governments create money in a keystroke via fiscal policy every day, with things like social security payments or any other spending program.

Many will argue it was central bank QE programs that allowed governments to run deficits – but this is not true either. Just like before QE, it’s the government spending money into existence that provides the cash for banks and others to buy the bonds. Central banks are not required to do anything other than conduct their normal daily monetary operations of targeting interest rates.

That the central bank QE programs did not drive the share market means the tapering of QE, or allowing their balance sheets to shrink, does not necessarily have a negative impact on the share market.

Chris Bedingfield, a portfolio manager at Quay Global Investors, points out that in the first three QE programs, the S&P 500 went up by an average of 2.2 per cent in the month after a QE “event”, be that the commencement, announcement of tapering, or conclusion of QE. On average, regardless of whether the announcement indicated an easing or tightening of central bank policy, a month later US equities were higher.

That does not mean share markets cannot fall – but if they do, it will have more to do with other factors, like valuations, fear, geopolitics or even inflation rather than central bank actions.

The most commonly used valuation measure for share investors is the price to earnings ratio, which is typically referred to as the PE. It’s the price of a company’s share divided by the earnings per share the company either has, or is expected to generate, and it tells you how many years of earnings it would take to repay your investment.

The higher the PE, the more faith investors are placing in a company that it will perform well into the future. Another way of saying that is the higher the PE, the more expensive are the shares.

The PE, and variations on it such as the CAPE ratio (which uses rolling 10 years of real earnings) are constantly referred to by analysts and strategists as the benchmark of determining whether a particular share, or the market overall, is fairly valued or not.

However, the PE ratio suffers some shortcomings as a valuation tool. First, it is heavily influenced by sentiment, both positive and negative, plus it can be affected by inflation. Another problem is that while the P part is indisputable, the E part can be subject to the peculiarities and interpretation of accounting rules, which can make an enormous difference and render the PE all but meaningless.

Legendary analyst, Michael Mauboussin, Head of Consilient Research on Counterpoint Global at Morgan Stanley Investment Management, argues in his new book Expectations Investing, that the PE ratio is pretty much useless.

One of the critical reasons behind that surprisingly robust assertion is the rise and rise of ‘intangible assets’ on company balance sheets, especially in the US.

Tangible assets are things you can touch, like buildings and machinery. They are entered onto a company’s balance sheet as a capital item and treated as an asset.

Intangible assets are things that you can’t touch but are nevertheless an asset to the company, such as patents, trademarks or goodwill. Notwithstanding these can be the most valuable assets a company holds, the spending that goes into building them, like R&D, or marketing, or paying up for talented staff, is treated as an expense to the company and therefore reduces reported profits, which in turn reduces the reported earnings per share.

In 1975, the US share market was dominated by companies like General Electric, Ford, GM and oil companies, and intangible assets accounted for only 17 per cent of total S&P 500 assets. By 2020 the biggest companies were Apple, Microsoft, Amazon, Facebook and Google and intangibles had grown to be 90 per cent of assets.

In their book The End of Accounting, the authors, Lev and Gu, argue centuries old accounting principles are inappropriate for intangible-rich companies and concluded the ability of reported earnings and book value (the anchor for two of the most widely used ratios, the PE and price to book value) to explain share market values declined by an incredible 6 per cent per year between 1950 and 2014.

As Mauboussin points out, at the end of the day, what matters most is how much cash a company produces, not earnings. What this means is that when you see a tech company trading on what looks like an outlandish PE, it could simply mean the market is looking way beyond the reported earnings and instead is factoring in how much cash it thinks that company’s intangible assets are going to generate.

Kai Wu, principal of Sparkline Capital in the US, argues that if investors want to understand the value of intangible assets, they need to move beyond the limited information available in financial statements. On their analysis tangible assets make up less than 45 per cent of total value in six of the eleven sectors that make up the S&P 500, with things like network effects, brand equity, human capital and intellectual property making up the balance but not even rating a mention in financial statements.

Sparkline uses AI to analyse the mountains of data companies produce that reflect their intangible assets and incorporate the results into their valuations. The results are impressive, with backtests producing annualised returns more than 30 per cent higher than the S&P 500 over the past 25 years.

When you hear or read market commentators saying the PE ratio is way out of whack compared to its long-term average, the smart investor should first ask why that might be, not necessarily to rationalise it, but to understand it.