Valuations in the technology sector are high but probably justified
A handful of tech stocks are dominating global markets like it’s 1999. But this time could their lofty valuations be based on something more concrete?
Advances in the internet, artificial intelligence (AI) and automation are causing increasing disruption to established business models and creating new growth markets for innovative and agile companies. The technology sector has performed well, helped by its superior growth potential and investors shifting money into the perceived beneficiaries of structural change.
The US S&P 500 Technology Index delivered a total return of 39% over the first 11 months of 2017, compared with a 20% return for the wider S&P 500. Technology has outperformed over a longer time frame also, returning 65% over the past three years compared with 36% for the wider index. Although talk is emerging of a bubble in the technology sector, we believe the valuations are justified.
The five largest American companies are all technology stocks — collectively known as the FAAMGs (Facebook, Apple, Amazon, Microsoft and Google/Alphabet), a twist on the more widely known acronym of ‘FANGs’ (Facebook, Amazon, Netflix and Google/Alphabet), which refers to the four internet leaders. The FAAMGs all returned between 31% and 57% over the first 11 months of 2017.
Over the past year global investors have become increasingly familiar with a new acronym of BAT, which stands for Baidu, Alibaba and Tencent, the three dominant Chinese internet players. China has developed a strong set of internet champions, shielded in part by the effective blocking of Western internet services, such as Facebook, Google, Snapchat and Pinterest.
Baidu has emerged as a Chinese equivalent of Google. Alibaba with its Taobao and Tmall sites for unbranded and branded goods is a fierce competitor of Amazon. Tencent is a social media giant to rival Facebook, with 843 million monthly users of its QQ instant messaging service and 980 million users of its Weixin/WeChat service, which is similar to WhatsApp.
The Chinese internet companies used to be dismissed as merely copycats of their Western equivalents but are now threatening to surpass them. They benefit from a focus on the world’s most populous nation, and a benign operating environment where government interference is primarily concerned with political censorship rather than data privacy or consumer protection.
These companies have also been able to garner an unusual level of market dominance through ‘leapfrogging’. The Chinese middle class has grown rapidly over the past two decades and there has been much less development of bricks and mortar infrastructure, with which the internet companies would need to compete. This has meant less competition from incumbents for Alibaba in retail, and from Tencent in the sphere of media and games.
As a result, Alibaba represents more than 10% of China’s total retail sales — and 75% of online sales — and is seeing annual growth of more than 50%. This compares favourably with Amazon, which represented 38% of US online sales in 2016 and only 4% of total retail sales. Meanwhile, Tencent’s Weixin social media app has far greater penetration (more than 90%) and three times the average amount of user time spent per day than Facebook largely because it offers much more utility to its consumers — for example news content, games and payment applications. This means Tencent is much less reliant on advertising for its revenues, unlike its Western peers Facebook and Google. Advertising is likely to be a source of future upside for Tencent, which currently derives most of its revenue from games.
The Chinese internet players are well-established in growth areas such as cloud computing and payments, and have been deploying their cash flow to acquire a growing presence outside China. They are also investing heavily in AI, which is a key battleground for all the major global internet companies. That’s because it is required to solve a growing number of issues, perhaps most importantly stopping people posting inflammatory comments and videos on social media.
Developing AI requires large amounts of computing power, storage and volumes of data to analyse and learn from, all of which the internet companies have in abundance. However, the Chinese companies may have an inherent advantage in that they are less constrained than their Western peers by concerns about individual privacy.
Additionally, they are supported by a government that recognises how mastering AI could be key to global leadership in the twenty-first century — as embodied in its ‘Next Generation Artificial Intelligence Development Plan’ to 2030, launched in July 2017. The BAT-FAAMGs (or for that matter the BAT-FANGs) will be central to this new vital element of geo-strategic rivalry between East and West.
Figure 4: Key tech leaders
China's leading stock market index is even more dominated by the country's tech giants than the US stock market.
Source: datastream and Rathbones.
The performance of China’s internet companies has been even stronger than their US peers in 2017. Tencent and Alibaba both achieved a total return of 100%, while laggard Baidu has returned 43%. These three companies are now so large that they dominate their stock market, representing 34% of the MSCI China Index between them, and 10.7% of the wider MSCI Emerging Markets Index. This is a concerning level of index concentration in a small number of companies, which is even more acute than in the US, where the five FAAMG stocks represent 13% of the S&P 500.
In both the US and China, passive funds are exacerbating the situation because they blindly replicate the index, buying stocks when they go up and selling them when they go down. They are being forced to follow the Chinese and US indices in becoming more and more concentrated, which heightens the risks for their investors.
Sustained performance by a small group of internet leaders is causing some concern that we might be entering another period of mania similar to the dotcom boom of the late 1990s. Notably, there has been an increase in the prevalence of financial measures used to justify the lofty valuations that we would not typically use, such as cash flow, sales and profits.
One example is TAM (total addressable market), which gives an idea of how much scope there is for a firm’s revenue to grow from its current level. Another is MAU (monthly active users), which indicates the size of a firm’s user base and gives an idea of the positive network effects and the potential to monetise this user base. In Facebook’s case, it has 2.07 billion MAU, representing more than a quarter of the world’s population.
While we are alert to the potential risk of an emerging bubble, we remain fairly relaxed for a couple of reasons. First, these internet leaders are well-established with attractive business models rather than just ‘hope value’. They generate prodigious cash flow and most have no debt and are extremely profitable. For example, Facebook makes an operating profit margin of 50%, Alibaba 43% and Tencent 35%.
Second, these companies are not trading on ludicrous valuations. While their price/earnings ratios are certainly higher than average, most trade between 20 and 40 times annual earnings, which is partly justified by their superior growth rates. Amazon is an outlier trading on more than 100 times annual earnings but this is due to its tendency to reinvest profits into new ventures.
Typically, these companies trade on stretched but justifiable cash flow multiples and have cash surpluses on their balance sheets. Therefore, there is some fundamental value in the internet sector, unlike during the dotcom boom.