Over the past 10-20 years, essentially since the recovery from the dotcom crash started to take hold in 2002, stock market growth on Wall Street has been in large part driven by technology stocks. The influence of technology stocks on the American stock market has been even more pronounced over the past decade.
The ascendance of technology stocks, particularly the FAANG group, fuelled the record-beating bull run that remained in place from early 2009, right up to the coronavirus sell-off in March of this year.
But the extent of the rise in the value of U.S.-listed technology stocks, and how unmoored from hard revenue and profit figures many have become, has seen investors start to seriously ask if we aren’t in a new dotcom bubble. Valuations are based on the perceived potential of tech companies to dominate their industries for years ahead. Tesla becoming the most valuable car manufacturer in the world despite sales and profits that are a fraction of those of established competitors being a prime example.
Perceived future potential for revenue growth is always somehow built into the market’s valuation of public companies. But, at least in theory, an optimistic outlook should add a premium to a valuation based on current realities. There’s an argument why that premium might occasionally be stretched in the case of a young, quickly growing company developing ‘disruptive’ products or services.
But the current valuations of many tech companies seem to go way beyond this kind of risky but understandable premium. They don’t seem to take any account of the risk factor that companies may not, in fact, be as profitable as hoped five or ten years later.
Not only does the fact that potential does not equate to reality seem to be missing in how many tech stocks are currently valued. They seem to be based on the most optimistic reading of that potential. Without pricing in any kind of risk that the most optimistic outcome may not, actually, eventuate for any number of reasons.
That all sounds very much like the dictionary definition of a stock market bubble. And yet it is only recently that the possibility that we might be in a dotcom bubble version 2.0 has begun to be treated seriously. And it is still far from the dominant view of technology stocks. There are many highly competent and successful analysts and investors such as multi-billion fund managers who believe current tech valuations don’t obviously represent a bubble.
Let’s look at both sides of the argument in some more detail.
Technology Stocks Dominate The Fortunes Of The World’s Dominant Stock Market
The S&P 500’s total value has increased by a staggering $6 trillion (£4.8 trillion) since early 2015. That represents a total gain of over 57%, even after the March sell-off this year that saw the value of the benchmark index crash by over 37% between late February and the market’s bottom on March 23rd. Since then most of those losses have been recovered, despite fears a post coronavirus-lockdown economic tsunami is about to hit the world.
$4 trillion of the $6 trillion gain in value over the past 5 and a something years comes from the increase in value of just six giant technology stocks – Microsoft, Apple, Amazon, Alphabet (Google), Facebook and Netflix. That’s the so-called FAANG stocks, plus Microsoft. Together, those six companies represent almost 25% of the total value of the U.S. stock market. If they were to form their own mini stock market, it would be worth more than any other in the world excluding those of the rest of the USA and China.
What Are The Huge Valuations Of The Biggest Technology Stocks Based On?
A public company’s valuation is often qualified as multiple of earnings. When assessing value, investors typically look for companies whose valuation is a lower multiple on their earnings than the average for either their sector, or the market as a whole, if the sector itself is generally considered undervalued.
Currently, the average earnings multiple for an S&P 500 company is 21. That’s still historically high, compared to the average mean and medium S&P 500 PE ratios of 15.8 and 14.8 respectively. But the companies that form the technology-centric Nasdaq index trade at an even more aggressive average multiple of 31 times earnings. Microsoft’s valuation meets that average, with its $1.6 trillion market capitalisation 31 times more than its projected future earnings. Amazon, however, has a valuation that represents a multiple of 125 times its forecast future earnings.
Tesla, considered a tech stock, last week saw its value surge ahead of Toyota by $3 billion to make it the most valuable automaker in the world, worth around $206 billion. The electric car maker’s p/e ratio currently sits at over 300. Toyota’s p/e ratio is less than 9.
Do The Current Valuations Of Technology Stocks Resemble Those Ahead Of The Dotcom Crash?
It’s almost exactly 20 years since the dotcom bubble burst, sending global stock markets crashing. There are more than a few parallels to be drawn between the period before the crash and now. Ahead of 2000, the US Federal Reserve was also injecting large amounts of liquidity into market. That was to combat the 1998 collapse of the Long-Term Capital Management hedge fund, which had come close to catalysing a stock market crash.
The internet age and digital economy was only just getting going and the river of cheap money flowing into financial markets fuelled speculative investment in online and tech companies. When monetary policy started to be tightened, the bubble burst.
In 2008 liquidity was again the response to a financial markets crash. That cheap money has again fuelled the rise in value of today’s tech giants. They are much more mature than those of the dotcom bubble and several, Apple, Amazon, Alphabet and Microsoft are in fact its survivors.
In 2020, these companies do earn consistently huge revenues and they have largely managed to keep those revenues growing by branching into new products and services, often creating entirely new markets, such as cloud computing and content streaming. But that doesn’t detract from the fact their valuations are spectacular multiples of even those huge revenue and profit figures.
There are signs big investors are beginning to grow concerned. This month Polar Capital restricted the amount of new capital being accepted by its impressively-performing Global Technology fund. Over three months it had grown by £1.6 billion to £4.5 billion as investors moved to ‘buy the crash’ of March’s sell-off. It’s a process termed ‘soft closure’ and is unusual for a fund that is doing well. It hints that Polar Capital is concerned its fund has been contributing towards the expansion of a bubble.
However, despite the similarities, there are also significant differences between technology stocks in 2020 and technology stocks in 2000. The most important is that the big boys now have proven business models and are hugely profitable. 20 years ago most had unproven models and were burning huge amounts of cash on advertising.
There are certainly plenty of tech stocks today that could still fit that latter description. Uber and the big food delivery start-ups such as Grubhub spring immediately to mind. Tesla, despite now having achieved four consecutive quarters of profit, has also burned through vast sums of money to get to the stage it has. But those contributing most to the value of U.S. stock markets are now profitable cash cows that are diversified and have global reach.
Another difference is the number of new technology IPOs coming to market. In 1999, ahead of the dotcom bubble bursting, there were 486 floats. Last year there were 159. Small private investors are also far less influential today than they were 20 years ago, when they were pouring money into many of the freshly-listed internet companies. Funds are today the far more influential investors driving valuations.
There is an argument that the biggest tech stocks are today so profitable and so diversified that they deserve to trade at historically unprecedented premiums. They are also companies of historically unprecedented diversified market share, reach and wealth. They are not capital intensive with their value mainly held in intellectual property and their businesses have proven robust in the face of the coronavirus pandemic.
With the exception of Netflix, the biggest tech companies all have strong balance sheets and are sitting on mountains of cash. The net cash pile of the U.S. tech giants is around $212 billion – a figure that has remained relatively constant since 2014 despite $450 billion having been spent on dividends and share buybacks since then. Profit margins averaged 17.7% in 2019 and free cash flow since 2014 totals $485 billion.
These are not companies that look vulnerable to unexpected shocks to the wider system or their own markets. Other than, again, Netflix, none also look particularly vulnerable to agile new competitors. They have established huge barriers to entry for anyone who might dare to compete. Their only real threat in different product and service verticals, such as cloud computing, e-commerce, content streaming and driverless technology, is each other.
Are Tech Stocks Still Overvalued?
All of the above doesn’t mean tech stocks aren’t currently still overvalued. But their revenues continue to grow. In 2021, the revenues of the major tech stocks are expected to increase by 27%. And by another 18% in 2022. That’s very high growth and would bring current price to earnings ratios down to 23.5 within two years. If valuations don’t also keep on marching north.
The tech giants have also so successfully made their products and services central to business and personal life that it’s difficult to see how that would change in the short to medium term at least. Some analysts believe this makes the way big tech is run more like a utility than a growth stock. The Covid-19 pandemic has also accelerated digital transformation in a way the biggest technology companies stand to benefit from the most.
What Are The Dangers For The Technology Giants?
The biggest threat to the continued growth of the largest tech companies doesn’t appear to be the free market and competition. They are already too dominant to have much to fear from new competition. But that is also perhaps where danger does lie.
Regulators and governments have become wary of the economic might and influence of big tech. Even other companies are starting to move to diversify their reliance on advertising on big tech platforms such as Google and Facebook. Amazon is to be forced to explain to Congress how it uses data. Anti-trust regulators, tax authorities and privacy campaigners are all gunning for big tech.
Is Big Tech The New Nifty Fifty?
Back in the 1970s, 50 big American blue chips dubbed the ‘Nifty Fifty’, were seen as a safe harbour whenever markets saw turbulence. Much like the position big tech has occupied for the past several years. But their valuations plunged with the rest of the market in 1973-74.
Just six giant technology stocks making up a quarter of the value of the S&P 500 also seems risky. If they do take a major hit at some point and fail to recover in the way they have over the past few months, the reverberations would echo across the global economy.
Investors should be cautious of over exposure to big tech. If invested in mainstream funds, they will have plenty of exposure anyway. That can be balanced by not pouring additional capital into specialist tech funds or individual tech stocks.
If the dotcom bubble of 2000 might see a repeat is more of a complex call than simply looking at extremely aggressive tech stock valuations on a simple p/e metric. But the higher valuations are, the less room for error. If growth rates do stall or anti-trust regulators move seriously to clip the wings of the biggest technology companies, valuations could drop quickly.
It makes sense for investors to diversify enough that they will gain from big tech’s march continuing but not be overly exposed to a major correction. Or a crash in tech valuations reminiscent of that of 2000.