Ghosts of dotcom boom reappear in tech stock valuations

The four most dangerous words in investing are “this time it’s different” (Sir John Templeton).  The ghosts of the last tech boom, referred to as the dot-com bubble in 1999 seem to be restless, with some eerie similarities to today’s obsession with technology stocks and high valuations.

Douglas Isles (Investment Specialist, Platinum Asset Management) says “the current mania in technology stocks is not about the big names but about the breadth of companies trading on high valuations.”  This is seen in the table below which shows market capitalisation compared to GDP in the US share market, and compares the record level 170% to previous bubble episodes.  This valuation indicator has become popular thanks to Warren Buffett who in 2001 said “it is probably the best single measure of where valuations stand at any given moment”.

The cyclically adjusted price to earnings ratio, commonly known as CAPE, is another valuation measure applied to the US share market.  CAPE is defined as price divided by the average of ten years of earnings, adjusted for inflation. 

Isles says “the maths tells us in aggregate there will be considerable disappointment. But also, like 1999, the more interesting thing is the opportunity in companies that are not part of the mania. In 1999, the sectors being shunned were labelled the old economy.  Today the shunned sectors include emerging markets and cyclical stocks”.

There are of course differences in today’s technology stocks according to Nathan Bell (Head of Research, InvestSMART), who says “the dominant tech companies are perhaps the best businesses that we’ve ever seen and are extremely profitable.”  

Hugh Dive (Portfolio Manager, Atlas Funds Management) says that “Apple, Amazon, Facebook and Google are actually generating revenues and growing profits”.  He adds “what we haven’t seen in 2020 is the plethora of concept companies raising large amounts of capital solely based on having an idea that is similar to a hot theme”.

That said, the seven Buy Now Pay Later stocks trading on the ASX could arguably be described as an example of this phenomen.

Bell sees the flood of Initial Public Offerings (IPO’s) of untested business models where the business owners are selling heavily as a sign of a heated market.

Other ‘red flags’ that investors would be wise to consider include the record fund raising in the US into SPAC’s (Special Purpose Acquisition Company).  A SPAC is a company with no commercial operations that is formed to raise capital through an IPO for the purpose of acquiring an existing company.  Bell says SPAC’s are where investors essentially sign a blank cheque in the hope that management will find something useful to do with the money while Isles believes they look very much like the ‘cash boxes’ of the 1980’s.

Dive’s key red flag is “the re-emergence of novel valuation methods such as ‘price to revenue’ in order to value companies that are generating losses, and are expected to continue to generate losses for the near future before miraculously swinging into steep profit growth”.

Highlighting Dive’s point about the behaviour of investing into loss making companies, US investor Joel Greenblatt says “If you bought every company that lost money in 2019 that had a market cap of over $1 billion, and so there are about 261 of those, and you bought every single one of those companies, you’ll be up 65% so far this year”.

Similar to 2000, in 2020 we are being told not to worry about valuations either due to the effect of lower interest rates, or that companies have a long growth runway.  Dive highlights “the valuations of AfterPay (61x revenue) and even more mature and widely used companies such as Zoom (136 x forward earnings) assume both that current growth rates are maintained for numerous years, consumer tastes don’t change and that new competitors won’t emerge.  The lessons of the previous tech boom showed these assumptions to be heroic”.

Bell believes that “low interest rates can justify somewhat higher valuations than the past, but not 100 – 150% in my view.  Valuation still matters and very few tech stocks will justify current expectations over the long term”.

Microsoft’s peak share price in 1999 was US $59.97 which implied a price earnings multiple of 76.  The following year the share price fell more than 60% and it took until 2016 for the share price to trade above the 1999 levels.  Little wonder the ghosts are restless.

 

 

This article appeared in the Australian Financial Review during November 2020.