di Matteo Ranzato e Uttara Thakore
March 26th2014. King Digital Entertainment, maker of the notorious Candy Crush game, went public on the NYSE. Technology has been the main actor in the IPO market recently: LinkedIn, Facebook, Twitter are just some examples of tech companies who decided to open their doors to the public market. Given the importance of each of those firms in everybody’s life, much attention has been given to this sector lately. The value of mergers and acquisitions in this area outnumbers that of other sectors. Facebook just bought WhatsApp and Oculus Virtual Reality. Google bought DeepMind Technology (Artificial Intelligence). The tech sector is extremely hot right now, so it seems prudent to take a step back and try to look at the bigger picture. Is there any value left for investors in this market? Are the prices of those companies high or fair or even cheap?
In 2013, World Bank statistics stated that 35.5 in a 100 people use the Internet. The graph has been moving steadily upward since 2004. The technology sector is clearly destined to expand. So that means more users, more consumers, more marketing targets, more money, and many more intangibles. The speculative nature of investing is further encouraged by this giant question mark that represents this sector. Growth is coming they say. But let’s look at the present before we look at the future.
2013 has been a great year for equities. The bull market has now celebrated its 5th anniversary and the NASDAQ has finally surpassed 4.000 points, something that hasn’t happened since the Tech bubble back in 2000. With investors trying to benefit from this, a general level of euphoria has been reached, euphoria being an index based on the euphoria/pain sentiment, which has reached pre-Lehman levels. All this confidence caused massive inflows in sectors that are hard to value, and whose valuations rely heavily on perception, and on future growth hopes. When the optimistic uncertainty of tech and IPOs combine, investors are willing to justify all prices in the name of “hope”. 74% of the IPOs released in the past 6 months lost money, a level that has been registered only once before: in February 2000. The year 2013 itself has been the second best performing market for IPOs, it was only in 1999 that it performed better. And everyone knows what happened next. Of course, this time it’s different. And that was sarcasm.
It’s the classic contraposition between value companies and growth companies. Investors are seeking high returns, and in this risk-conducive environment, they are confident enough to abandon the companies that are labeled “value”. The quest for growth and returns leads to two main sectors right now. Tech and Biotech, both of them risky: earnings are still to come and valuations appear stretched.
Let it not escape us for a second that the inimitable Warren Buffet avoided this “portfolio-slaying sector” during the dot-com bubble, when most of his contemporaries were doing the opposite. He is known for investing in only one tech-related company. International Business Machines or IBM are oriented more towards the service sector, and meet their financial goals thru long-term planning. It’s a classic Buffet stock, with a stellar history of meeting targets and a clear goal for the future. And it has a dividend. This is in stark contrast to Twitter and other companies in their neighborhood, who schizophrenically upgrade and downgrade on a daily basis. It’s almost like they’re “making it up as they go along”, riding high on their popularity even as the red ink on their ledger is still fresh. Who is to say they won’t go the way of defeated giant MySpace. They don’t know, so they hope and insist you do as well.
862 (LinkedIn), 92 (Facebook), 578 (Amazon), 197 (Netflix), 65 (TripAdvisor) are the Price/Earnings of some hot tech names, but this is nothing compared to Twitter’s Not Applicable P/E multiple. Bloomberg estimates that Twitter’s P/E of next year will be 2,121.3636. Talk about high expectations.
Buffett stated that the Internet, while useful, is volatile. Friend and fellow billionaire Bill Gates said, “Tech firms must always be on their toes because of the intense competition in the sector. Tech offerings are ever changing and the marketplace can change drastically from year to year.”
This is why the two are agreed on one thing: tech stocks should trade at lower multiples. The future of tech is (wonderfully) unpredictable. But unpredictable is the operative term here. You can’t invest with “unpredictable” floating over your head, even if “wonderfully” is its bracketed prefix.
“People are very impressed by hi tech, probably too impressed” says Nobel laureate R. Shiller, “I like to look at long-term earnings. You can’t do that with WhatsApp”. Shiller created his own version of the above mentioned P/E ratio: the Shiller PE. The main difference is that his own metric considers the earnings of the past 10 years (not just of last year), inflation adjusted. If we apply the Schiller PE Ratio to the market in general we find out something very interesting. It has been higher only three times before in history: Black Tuesday (1929), Tech Bubble (2000) and in the years before Lehman (2007-2008).
So we have the bulls and bears, each of them with valid arguments. Occasionally you have the pigs, who are easily swayed and don’t do their due diligence before investing. Before Twitter (TWTR) even released an IPO, the stock prices of a completely unrelated company (TWTRQ) skyrocketed. TWTRQ had to change their name to save investors from themselves. The technology sector attracts more pigs than usual, apparently.
Clearly, classic valuation methods are not suitable to potentially high growth companies. But they can help to understand how high the bar is set for these companies. Those that correctly point out the earnings isn’t the correct variable to evaluate companies can take a look at Price/Sales. On average after 5 years from its IPO a new company has a P/S of 5.87, and its sales figures grow by 212%. In order for Twitter to justify a $47 price 5 years from its IPO (which today is traded at $47), its sales figure must go up by 700%.
That is unrealistic to the point of ridiculous. Companies whose pieces have been bought based on hope and on speculative buying, will be the first to unravel when things go pear-shaped.
Even free cash flows (how much cash can be extracted from a company), tell us the same story. Amazon has an expected FCF in 2015 of just under $ 3 B, and it’s valued at more than 50 times that figure; Facebook (using the same reasoning) is trading at 26 times its 2015 expected FCF, LinkedIn at more than 40, Netflix at more than 50. The expectations are incredibly high, and not easily sustainable: we need to see a huge increase in earnings and revenues in the coming years in order to justify those valuations.
Updating (April 12, 2012), the NASDAQ has had its worst week since 2011. Yesterday it closed at 3999.73, losing the “4000” milestone. The sectors under pressure are Biotech (NBI) and Internet Technology (QNET). Facebook, Twitter, Amazon are significantly off from their all-time high. The Biotech sector on Friday officially entered a Bear Market and the Internet sector is inches away from it.
“Profit taking”, “Healthy rotation in stocks”, “De-risking”: those are the three main explanations for what’s happening. It’s basically: “do NOT panic, growth will come”. And as everybody repeats that, the US’s GPD growth for the first part of the year gets revised to the downside: from +1.8% to +1.6%. But the expectations for 2014 as a whole stay still at +2.7%. The next quarters will be better, I’m sure. Growth will come they say. Maybe it will. But what do they have to show for it?