The recent weakness among tech stocks did not go unnoticed, for the simple reason that all investors follow these star blue-chip stocks. Some investors monitor these stocks because they are invested in them, whereas others do so as they are aware that these blue-chips lead the equity market cycle.

Each market cycle is dominated by a particular theme and history shows that the end of the cycle is marked by the leading theme running out of steam. Many questions have therefore arisen recently as to whether these Nasdaq darlings harbour further upside potential in terms of valuation.

Consensus among investors appears not to consider their absolute valuations to be a major cause for concern, believing that there is no valuation bubble, and that the real debate is therefore over the potential growth upside with regard the size of these giants. How is it possible to sell more goods and services when the entire planet already uses them? Facebook has almost 2 billion users!

We have taken a slightly different analytical approach however. We consider valuation to be a major issue, as the valuation multiple of a stock can only be fully established if normative profitability is a known factor. The last two equity markets bubbles were not characterised by artificially inflated valuations (P/E bubbles) but were profit bubbles (E bubbles). For investors with short memories, European banking and mining stocks were trading on P/E multiples of around 11/12 x in 2007 which did not prevent these sectors from falling 60% over just a few months. The bubble was in the E, not in the P/E.

The P/E of the Nasdaq is therefore not that important, whereas its E is the key issue. Could Nasdaq profits fall by 30% over the next few quarters?

To provide some perspective on the dominance of these tech stocks in the current market, we have compared them with the star stocks of the 90s. We have divided them into two groups, made up of Google, Apple, Amazon and Facebook, on the one hand, and IBM, AT&T, Exxon Mobil, Walmart and General Electric on the other. The below chart illustrates their aggregated sales expressed as a percentage of nominal global GDP in dollars.

During the 90s, General Electric and Exxon Mobil became real behemoths. They were perceived as the star stocks in the market, which investors aspired to own, representing the big-is-beautiful theme, with both GE and Walmart trading on over 50 x realised profits at the end of the 90s. Today they are considered as fallen angels and a part of the old economy.

Aggregated sales generated by Google, Amazon, Facebook and Apple should represent 0.67% of global GDP this year.  Although this percentage is lower than the former glories of the 90s, the gap is closing. Furthermore, an analysis of operating margins reveals an exceptional level of profitability implying a unique, almost monopolistic, situation.  In terms of absolute profits, the new economy has already caught up with the old, with IBM, ATT & co generating USD 73.5bn vs. USD 99.0bn for Google, Apple & co according to the Bloomberg 2017 consensus.

This we consider to be the real issue at stake. Google and the other tech giants have become so dominant that the question of the sustainability of their leadership and their monopolistic revenues arises. Can they lose their place?

Monopolies imply high entry barriers. Although we are unable to judge whether this time around things will be different or not, there are previous examples of rising stars which disappeared as technological breakthroughs occurred, such as Palm, or due to rapid change in terms of consumer tastes, such as Nokia, which missed the clamshell mobile trend. Below are some of the memorable best-sellers in the mobiles market from the 90s and 2000s.

These mobiles were among the top sellers for several years (https://en.wikipedia.org/wiki/List_of_best-selling_mobile_phones). All of our readers aged over 35 will have owned at least one of the mobiles presented on the previous page. Motorola, Ericsson and Nokia were the leading sellers and formed an oligopoly. None of these companies is present in the mobile phone market today and they have all refocussed their business model on other activities.

Could Apple and its iPhone follow the same destiny as Nokia and its 3310, two decades later? This idea seems unimaginable today, in the same way as in the early 2000s it was inconceivable that Nokia could fall from its pedestal. The above chart demonstrates operating margins generated by the three leaders in the 90s and 2000s, which are far below the 27.6% achieved by Apple in 2016.

The conclusion is a simple one. Things will either be different this time around and Apple, Google, Amazon and Facebook therefore have no upside limit in terms of their share price, as their monopolistic profits are unlimited, or this time will not be different and history will repeat itself, like with Nokia, Eastman Kodak and Xerox.

This is a complex question as today’s leaders are involved in highly specific business lines:

  • service companies or group’s without manufacturing units and therefore very low capital intensity
  • exceedingly high entry barriers based on a strongest/leadership premium, reflecting consumer herd behaviour

The specific characteristic of these tech giants is their capacity to generate cash and their absence of gearing. This factor represents a major difference from the stars of the 90s, as illustrated in the chart below.

Their positive cash position enables these groups to remain competitive, given that any outside company considered as a threat can be immediately bought, as in the case of Google-Youtube and Facebook-What’s App. Lodging Google under the Alphabet holding company is also an emblematic move, meaning that Alphabet can now be perceived as an investment fund with massive firepower to invest in tomorrow’s companies. How will it be possible to resist against such might?

 

Tristan Abet

Senior Fund Manager




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