Building a Galapagos Islands for Tech by Derrick Gut, CPA, CA, CFA OCTOBER 1 2021 In recent years, Canada has steadily bolstered its reputation as a global hub for tech talent, and we think things are just getting started. Tobi Lutke, the CEO/Founder of Shopify, has regularly referred to Canada as a Galapagos Islands for technology, and we think this analogy is apt. Canadian residents benefit from a reasonable cost of living, long-term medical coverage, a stable government and access to affordable, high quality education. For the more entrepreneurial minded, Canada also provides a government that values and invests in innovation and allows losses to be carried forward to future ventures. When Charles Darwin visited the Galapagos Islands he was struck by the tremendous vitality and adaptability of wildlife on the island, and his observations led him to formulate his Theory of Natural Selection. The Galapagos provided an environment for wildlife to rapidly evolve and develop the characteristics necessary to compete and flourish. In many ways, Canada is providing the same type of environment for tech talent, giving creative technology workers the resources and conditions they need to thrive, evolve, take chances and build a new generation of leading Canadian technology firms. At Jarislowsky Fraser, we believe Canada is still in the early days of a long transition away from a legacy resource-based economy to a more stable and secularly growing model, driven by information technology and other high-skill professions. To support this transition, Canada has developed policies to make it a beacon for highly skilled global talent. Immigration rates have typically been amongst the highest in the world at around 0.9% of the population per year, and a remarkable 58%¹ of immigrants fall into the “economic” category, bringing valuable resources, education and skills to the country. In recent years, this highly skilled pool of immigrants has accounted for over 80% of Canada’s population growth. By comparison, immigration in the U.S. has typically been only 0.3-0.4% of the population per year, and it is heavily driven by family sponsorship (68.8% of immigrants in 2019) rather than employment based factors (13.5%)². The result is that on a per capita basis, Canada is admitting multiples more skilled workers than the U.S. every year. We have been following how Canada stacks up relative to other countries in attracting talent, and these numbers have been tilting in Canada’s favor for quite some time. In a report from the OECD on the attractiveness of OECD countries for potential migrants (May 2019), Canada ranks high relative to the 38 other OECD countries as a destination for highly educated workers, entrepreneurs, and university students. Canada ranks in the Top 8 for each category and stands out as the most attractive developed country in the world for entrepreneurs. There is no doubt that Canada’s friendly world image, strong social safety net, excellent educational system, and significant policy incentives for entrepreneurs all play a significant role in bolstering this global perception. For example, Google recently announced new offices in Montreal, Kitchener, Waterloo and Toronto where 5,000 employees will be added to their workforce. These moves are being mimicked by other tech companies seeking to benefit from Canada’s growing pool of IT talent and its geographic and cultural proximity to the US. CBRE Research recently issued the findings of a study where they analysed tech talent pools across 30 North American cities; Toronto came in fourth, behind only San Francisco, New York and Washington. It also ranked third when it came to quality of talent across various metrics. In addition to having a large, high quality pool of labour, Canadian cities also consistently rank amongst the lowest in terms of labour costs for engineers, with Montreal, Ottawa, Toronto and Vancouver having the lowest salary scales in all of North America by a significant margin. In investor parlance, this is high quality at a great price – it’s no wonder we find compelling value in this sector. It’s also no surprise that in an increasingly virtual, work-from-home world, American companies are looking to establish a presence north of the border. As these companies immigrate, the ecosystem only becomes stronger. Canada also ranks first among OECD members for graduates starting companies within four years of entering a bachelor of science program. This figure clearly illustrates the country’s entrepreneurial spirit and also its attractiveness as a home for entrepreneurs. It’s also a function of Canada’s rapidly growing interest in tech-related fields of study which have seen enrollments growing 3-4% faster per year than any other field. The most prominent of these immigrant entrepreneurs is Shopify’s Tobi Lutke who came to Canada in the early 2000s and started the online snowboard retailer SnowDevil, which morphed into the Shopify we know today. Canada’s policies are designed to foster more success stories like Tobi Lutke’s. As artificial intelligence, augmented reality and data science proliferate as essential business tools in a modern economy, we expect the demand for tech talent to grow for decades to come. By building a supportive environment for innovation and cultivating an IT workforce through strong immigration and educational systems, Canada is positioning itself to compete on a global stage in the economy of the future. The rapid ascent of Shopify to the ranks of global tech leaders and even Montreal’s growing position as a hub for artificial intelligence and augmented reality research provide tangible evidence of this progress. Canada’s environment is breeding evolution, natural selection is breeding leaders, and success is breeding success. This is exciting for Canada’s long-term growth prospects, and equally exciting for us as long-term investors looking for Canada’s rising global champions. Evolution in Canada’s IT Sector Canada now has more software companies with global operations and wide addressable markets than at any other point in its history. The market capitalization of the sector flipped from being dominated by hardware and semiconductor companies during the tech bubble to more capital light and service based software companies today. Our investable universe has come a long way from the days of Nortel and RIM, which operated in competitive hardware segments and were quickly disrupted as competition intensified. In contrast, most software companies have much higher barriers to entry, more scalability, and greater customer loyalty, resulting in more durable competitive positions. We now own over a dozen Canadian tech companies across all market capitalizations in our portfolio, and the opportunity set continues to grow. Canada now has a pool of over 150 listed securities in the Technology sector all attacking their own niches in the IT landscape. This is a far cry from the 30 names that dominated the index two decades ago. Valuing Complex & Evolving Opportunities Truth be told there is no precise way to value the equity of high growth companies with large global addressable markets, evolving ecosystems and long runways for growth. They are truly complex adaptive systems in their purest forms, and applying static multiples to near-term earnings estimates both fails to capture long-term growth opportunities and suffers from distortion from elevated investment spending, predominantly on intangibles. Investors typically make the simplistic delineation between growth and value stocks based on near-term multiples, but in reality growth is usually the most essential source of value for the high quality companies we invest in. Shopify provides one of the clearest examples of this dynamic. It looks wildly expensive on next year’s estimates, but these multiples ascribe no value to the company’s extraordinary growth, impressive funda-mentals, essential services to customers and latent earnings power. When we look forward 5 to 10 years, and today’s investments (i.e. expenses) become tomorrow’s opportunities, the pendulum swings and value becomes more evident. Our process for investing in such high growth companies looks far beyond the next year or two of earnings. We examine the company’s current path across all addressable markets and think about how it can leverage its resources to pull additional growth levers and capitalize on adjacent opportunities. For a company like Shopify, we look to the end of the decade and estimate how big its core business can be and then add in the various verticals we expect to join the Shopify flywheel. We ultimately determine a value by looking at a sensitivity of margins these businesses can maintain at scale and discounting this value back to today using a conservative rate. We then layer on a qualitative assessment of where we can be both wrong to the downside and surprised to the upside to better define the risk/return profile. This exercise is perhaps easier described than executed. The critical element of the process comes from deeply understanding what a company offers to clients and how these relationships can strengthen and expand over time. Insights come from extensive discussions with the company, its suppliers, its customers and competitors, and they help us formulate our view on what a company is likely to become. This process has challenges, but it is the truest application of art within the investment process. The investment style at Jarislowsky Fraser fully embodies this marriage of long-term thinking with deep strategic and fundamental analysis. In our view, this remains one of the few edges left in active investment management as this combination of a long-term view with critical fundamental analysis is the best way to reveal hidden value in today’s overly short-sighted markets. While we carefully watch the short term, we look for value in the long term and invest accordingly. While Shopify is optically expensive, so was Amazon in its early days. Even in 2006 when it first launched Amazon Web Services, it was hard to envision the Amazon of today with over 200 million Prime subscribers, audio and video streaming services, a budding advertising business, Whole Foods and numerous other verticals. All of these businesses have altered Amazon’s path and created significant long-term value for shareholders, but never showed up in analyst forecasts in the mid-2000s. What Amazon did have at the time was a rapidly glowing ecosystem, fiercely loyal customer base and fanatical leadership with a growing track record of innovation and entrepreneurship. We obviously see many parallels with today’s Shopify and think similar long-term value creation is possible. Another way to describe these complex adaptive systems is that they operate under a power law distribution of non-linear outcomes. These non-linear outcomes stem from the compounding of network effects and converging business models across scalable verticals which combine to yield more output than would normally be assumed (1+1 = >2). The power of these network effects is easily overlooked when focusing too much on the short term and relying on static models and frameworks that fail to capture the potential of complex adaptive systems and the value added by visionary entrepreneurs. While it is important to avoid “drinking the Kool-Aid” when investing in high growth businesses, tremendous value can be found investing alongside talented entrepreneurs creating essential businesses with natural and realizable network effects. When these stars align, it can set investors up for Charlie Munger’s famed Lollapalooza effect. When it comes to Canada and technology investing, we firmly believe it is still early days. The ecosystem is in place, the talent pool is growing, and Canada’s budding IT leaders will continue to evolve, thrive and multiply. Shopify is leading the way, but impressive businesses like Kinaxis, Tecsys, Descartes, Enghouse, Altus and many more are also carrying the torch. At Jarislowsky Fraser, we continue to apply deep strategic and fundamental analysis to our long-term view to identify these opportunities and capitalize on the increasingly bright future for Canada’s technology sector and its emerging leaders. ¹ Canada immigration data: 2020 Annual Report to Parliament on Immigration: https://www.canada.ca/content/dam/ircc/migration/ircc/english/pdf/pub/annual-report-2020-en.pdf ² US immigration data: https://www.dhs.gov/sites/default/files/publications/immigration-statistics/yearbook/2019/lawful_permanent_ residents_2019.pdf Published: October 2021. This publication is provided for information purposes only. All opinions and estimates contained in this report constitute JFL’s judgment as of the time of writing and are provided in good faith. All data, facts and opinions presented in this publication may change without notification. No use of the Jarislowsky, Fraser Limited name or any information contained in this report may be copied or redistributed without prior written approval. About Institutional Private Wealth Global Research News & Insights Contact Client Portal Careers Privacy & Legal Accessibility CONTACT US © 2021 Jarislowsky, Fraser Limited. Canada - English Canada - Français United States - English International - English International - Español