The strength of technology stocks in 2020 is indisputable. The five largest companies – Google, Amazon, Apple, Facebook, Microsoft – are all in technology. Their dominance is increasing. Their market values make up more of the S&P 500 than their counterparts did at the dotcom bubble peak 20 years ago.
Yet such strength often precedes bubbles that end with painful crashes. History contains many examples – conglomerates in the 70s, thrifts and semiconductors in the 80s, “tiger” economies in Southeast Asia in the 90s, TMT in early 2000s, and financials before the GFC in 2008.
All bubbles begin as booms, but not all booms become bubbles. Sometimes a boom is deflated by timely contractionary policies or gradual loss of investor interest. The boom to worry about is the one with a self-reinforcing character. It starts with good fundamentals, leading to rising valuations, high investor interest, and pressure on companies to show improving fundamentals. Companies venture into less-profitable activities that are disguised as sound decisions to support valuations. Rising stock prices discourage investors from prudent due diligence and encourage them to use impractical assumptions to justify increasing valuations, which further increases pressure on companies. The self-reinforcing frenzy results in a bubble that would inevitably end after companies meet the limits of expansion and show deteriorating fundamentals.
History shows that two factors are essential for a boom to become a bubble:
- Excessive valuations
- Abundance of overly simplistic elements as key drivers of value
Is the boom in tech stocks actually a bubble?
1. The largest tech companies do not appear to be excessively valued relative to past bubbles and long-term interest rates.
The conglomerate bubble in the 70s involved the then-largest companies, while the dotcom bubble in 2000 involved TMT companies. These bubbles are used as proxies because they relate to the current largest tech companies in size and sector respectively.
The reader should also understand the concept of equity yield and its relation to long-term interest rates. The equity yield is the underlying company’s earnings and dividends relative to its stock price. Another way to put the equity yield in context is to view a stock as a bond. Earnings and dividends of a stock are akin to coupons of a bond (except that earnings are not distributed like coupons are, but are left for management to allocate).
Compared to the yield on treasury bonds, the equity yield of a stock should be higher. This is because a stock’s risk is higher than treasuries’ (ie risk-free), so it should almost always offer higher yields than treasuries to entice investors. Higher risk, higher yields; lower risk, lower yields.
During the 1970s, the conglomerate bubble saw large-cap stocks yielding less than 2%, while 10-year treasuries yield more than 6%. This discrepancy was evident of a bubble. Equity investors accepted yields lower than treasuries!
Put in a different way, investors accepted low yields that implied excessively high valuations (PE ratios range 70-80), and could had accepted higher yields in treasuries with much lower risk.
The tech bubble in 2000 saw even lower equity yields. The 100-200x PE ratios of Nasdaq stocks implied yields of 0.5-1.0%, which were much lower than the 6.5% yield on 10-year treasuries.
Today, with the exception of Amazon, the four large tech companies trade near 32x forward PE, which translates to 3.1% yield (inverse of 32). Only Microsoft and Apple in the group pay dividends in the 0.7-1.0% range. Hence 4.0% can be used as an appropriate proxy for the equity yield of the group.
Relative to 10-year treasuries yielding 0.7%, the group isn’t expensive. Even if the 10-year yielded 1%, PE ratios of the group have to triple to match.
This method shows that only Amazon is expensive relative to long-term rates. Amazon sports 108x forward pe, which translates to 0.9% yield, just slightly above the yield on the 10-year.
2. There is little evidence of overly simplistic elements as key drivers of valuations.
During the late 1960s and early 1970s, conglomerates relied on M&A for high growth rates that were rewarded with increasing multiples. Their success attracted imitators, which went on acquisition sprees. M&A activity eventually involved the most mundane businesses with stagnant or even contracting revenues, such as metal scrapping. At the peak of the bubble, companies were rewarded with high multiples as long as they promised fervent M&A.
In the late 1990s and early 2000s, any business related to the Internet, whether it be laying fiber-optic cables or selling pet products online, had high multiples based on projected revenues. No attention was paid to earning, cash flows, and other traditional indicators of the sustainability of business models.
As shown by history, bubbles are formed by the lack of investor discrimination.
Current trends favor SaaS (software-as-a-service), IaaS (infrastructure-as-a-service), and similar business models with strong customer loyalty, platforms with network effects, and subscription components that support recurring revenues. However, investors are selective about the quality of business models. Most importantly, they discriminate to an extent that a company cannot market itself as “something-as-a-service” to achieve high multiples.
Take Grubhub as an example. The company was once a high-flyer, whose stock increased 22% in a single session after Yum Brands (the parent of Taco Bell, KFC, and Pizza Hut) bought a small stake. The stock crumbled after competition from Uber, Postmates, and Amazon intensified (Amazon has shut down its food delivery business) and revealed that high margins were unsustainable because of expensive customer acquisition cost. As with airlines and autos, consolidation to achieve scale is the solution to the problem of costs outpacing revenue growth. Uber is merging with Postmates, and Just Eat Takeaway is acquiring Grubhub.
Another example is lesser-known Alteryx. The company pioneered data analytics SaaS, increased revenue by 12x in 6 years, and oversaw near 13-fold returns from its IPO. Despite its excellent history, AYX was punished with a 53% decline in its stock when it provided earnings and an outlook that missed expectations. Investors were unforgiving despite the SaaS nature of the business and the company’s excellent track record.
Even Intel faced the wrath of the market when it failed to deliver. After announcing a delay in its next-generation chips, the stock of the technology stalwart fell 23% in 3 days.
Investors are (still) careful, so the current tech boom is not a bubble (yet).
Despite the lack of a tech bubble, technology stocks are still prone to large and small declines. It is hard to tell what the market would focus on. At one moment, it is revenue growth rates, no matter the cost. At another, it is liquidity and cash flows., no matter the business model. The investor must be ready for the market to do anything, and has to prepare accordingly. Investors, especially those in technology, would do well to heed Ben Graham’s advice:
“You can get in more trouble with a sound premise than an unsound premise because you’ll just throw out the unsound premise” -Ben Graham, father of value investing and mentor to Warren Buffett