Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 209

Tech stocks: balancing realism and evangelism

Just as it is dangerous for anyone to argue “It’s different this time”, it is similarly risky for technology sceptics to doubt what may seem like absurd ideas. For example, should anyone laugh at Elon Musk’s latest claim that Teslas get better with age as software upgrades improve the car’s functionality?

This battle between reality and hope, with the realists often looking as silly as the evangelists, is a constant in technology and technology investing. Technology has changed the world and created substantial value. Yet, tech history remains littered with the likes of Blackberry, Nokia and Geocities. The latest (modest) sell-off in technology is a good time to reflect on the value created by technology and where we currently stand.

Technology has supported much of the improvement in equities from 2009. The S&P 500 Information Technology index has risen 301% since March 2009, compared to 202% for the broad S&P500 index. In the last 12 months, returns in technology of 30% were double those in the index to the end of May.

Performance of US tech stocks vs. the US market

Source: Bloomberg, weekly data, index = 100 @ 31 Mar 1997 to 19 Jun 2017

The evangelist and the realist

The balance between realism and evangelism is the combination of valuation and earnings. Fortunately, we have a benchmark for extreme evangelisation, the dot-com boom of the late nineties. From a valuation perspective, today in no way matches the experience of 1999. Yes, valuations have risen recently, but for both Price to Earnings and Price to Sales, the increase is barely noticeable by comparison. The Price to Earnings for the S&P500 Information Technology peaked at 80x and the Price to Sales peaked at a little over 7x around the year 2000. By contrast, today, the index is at 24x earnings and 4x sales.

Valuations of Tech stocks now (green line) vs. pre-2000 (blue line)

Source: Bloomberg, CFSGAM, valuations to Mar 2000 peak vs. valuations to 31 May 2017

So it is not a bubble. Indeed, it is possible, depending on your earnings view, to say that valuations in the expansion from 2005-2007 were slightly higher (with earnings higher than in 2000) than they are today.

But not being a bubble does not mean valuations are cheap. Much more important are earnings and their trajectory, and it’s useful to look at four leaders from 2000 against two from today’s FANG (Facebook, Amazon, Netflix and Google).

It is not clear from this analysis that the big constituents of 2000 were not as profitable as Facebook and Google are today. Gross margins were a little volatile around 2000 but future margins, which matter to long-term investors, have maintained high levels and greater stability. The ongoing profitability of Microsoft, Cisco, Oracle, and Intel (MCOI) is remarkable.

The evangelism of 2000 was misplaced yet the scepticism of 2010 and 2011 when valuations were at their lowest, was similarly misplaced. Oh, to have bought Facebook in September 2012!

Gross margins of the major tech companies from the year 2000 to now

Source: Bloomberg, MCOI vs. Facebook & Google, quarterly data (%), Mar 1997 - Present

The fundamental evangelist: Facebook, Adobe and Nvidia/Micron

The profitability of the industry as a whole reflects two consistent themes across a variety of sub-sectors: strong demand for products and services with increasing utility and high margin business models. For example, four companies across three sectors include Facebook on the Internet, Adobe for enterprise software and Nvidia/Micron in semiconductors.

Facebook

Facebook is a dominant player in contributing to substantial productivity improvements generated from the sharing of information and commerce.

“But the kids don’t like Facebook anymore”. This standard view misses the essential value of Facebook to its users, shareholders and the broader economy. To go all evangelist, Facebook is the social network or, alternatively, social infrastructure, creating value as users’ bulletin board. These interactions provide Facebook with the ability to offer advertising that is extremely well targeted, with businesses receiving high, measurable Returns on Investment. Many of these advertisers are new advertisers looking to advertise to a customer base that is geographically close. Facebook is changing the world, but more importantly, it is changing your neighbourhood.

The resulting profitability, particularly in the US, is astounding. Each user in the US attracted $67 in advertising in the 12 months to March 2017.

Facebook’s profitability growth depends on finding new use cases and building a sales infrastructure. The monetisation of Facebook Messenger is a good example of new use cases. The forced adoption of Facebook Messenger has been the fastest adoption cycle in internet history. It allows Facebook to drive transactions in ways similar to WeChat in China. For instance, the e-gaming company Activision used a chat bot to engage with users via Facebook Messenger. In the first 24 hours, the chat bot had six million interactions. Similarly, tools that improve the quality of advertising enable smaller and smaller businesses to have a professional online presence.

Adobe

Enterprise software is a key productivity theme in the technology sector. Firms are continually looking for ways to improve their business processes to focus on and invest in the things that matter: product development, product marketing and customer service. Adobe not only improves efficiency in many marketing functions, it also adds value to the process.

Demand for Adobe’s product comes from increasing online content, especially as the demand for professional content rises similarly. Adobe delivers that content. It uses a Software as a Service (SaaS) business model where it charges users an annual subscription for access to its Creative Cloud. Since 2014, revenue from the Creative Cloud has risen 75% on a gross margin of greater than 65%.

The use of the Cloud to drive growth for Adobe highlights two key points: new use cases and the explosion in data creation. Adobe now uses Machine Learning to help improve searches of its stock photo gallery, which in turn requires greater data storage and computing power.

Adobe Digital Creative revenues

Source: Adobe, Bloomberg, rolling four quarters (USD million), Nov 2014 - Jun 2017

Semiconductors: Nvidia and Micron

Semiconductors are the ‘picks and shovels’ of information technology. As the uses of the internet, software and computing power expand, they drive an increasing requirement for data. At the heart of data processing is the chip.

In early 2016, the market expected stable to lower demand for semiconductors over the next two years. The price of DRAM and 3D Nand had collapsed, and smartphone demand seemed to be tailing. Instead, growth has improved as new use cases for semiconductors have emerged. It started with Nvidia’s new chips for gaming but has morphed into cars, data centres, machine learning, a doubling in the memory on a standard smartphone, increasing use of sensors in industrial processes and payments. It has also emerged in demand for crypto-currency mining.

Importantly, it has also occurred at a time when the industry is as under-invested as it has been in some time. Semi-conductor companies have entered a period of demand with limited plans for capacity growth. For once, the industry seems capable of benefiting from a demand upswing.

Conclusion

Technology evangelism has been a formidable strategy over time. Amazon was $107 at the peak of the dot-com boom in March 2000, and it hit $1,000 in June 2017. That is a 13% CAGR for 17 years. And, if you bought at the bottom, the CAGR is 39%. But there have been other disasters, and every so often, a little realism does not hurt.

 

James White is a Portfolio Manager with Colonial First State Global Asset Management.

 


 

Leave a Comment:

RELATED ARTICLES

Are expectations for the Magnificent Seven too high?

banner

Most viewed in recent weeks

How much do you need to retire comfortably?

Two commonly asked questions are: 'How much do I need to retire' and 'How much can I afford to spend in retirement'? This is a guide to help you come up with your own numbers to suit your goals and needs.

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

The secrets of Australia’s Berkshire Hathaway

Washington H. Soul Pattinson is an ASX top 50 stock with one of the best investment track records this country has seen. Yet, most Australians haven’t heard of it, and the company seems to prefer it that way.

How long will you live?

We are often quoted life expectancy at birth but what matters most is how long we should live as we grow older. It is surprising how short this can be for people born last century, so make the most of it.

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Latest Updates

Investment strategies

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

Economy

A pullback in Australian consumer spending could last years

Australian consumers have held up remarkably well amid rising interest rates and inflation. Yet, there are increasing signs that this is turning, and the weakness in consumer spending may last years, not months.

Investment strategies

The 9 most important things I've learned about investing over 40 years

The nine lessons include there is always a cycle, the crowd gets it wrong at extremes, what you pay for an investment matters a lot, markets don’t learn, and you need to know yourself to be a good investor.

Shares

Tax-loss selling creates opportunities in these 3 ASX stocks

It's that time of year when investors sell underperforming stocks at a loss to offset capital gains from profitable investments. This tax-loss selling is creating opportunities in three quality ASX stocks.

Economy

The global baby bust

Across the globe, leaders are concerned about the fallout from declining birth rates and shrinking populations. Australia, though attractive to migrants, mirrors global birth rate declines, and faces its own challenges.

Economy

Hidden card fees and why cash should make a comeback

Australians are paying almost two billion dollars in credit and debit card fees each year and the RBA wil now probe the whole payment system. What changes are needed to ensure the system is fair and transparent?

Investment strategies

Investment bonds should be considered for retirement planning

Many Australians neglect key retirement planning tools. Investment bonds are increasingly valuable as they facilitate intergenerational wealth transfer and offer strategic tax advantages, thereby enhancing financial security.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.