Chancellor: Technological growth comes at an irrational price
LONDON, Sept. 9 (Reuters Breakingviews) – The desire to find the next Alphabet (GOOGL.O), Amazon.com (AMZN.O) or Facebook (FB.O) is so overwhelming that investors are looking for growth at all costs. Just about any software company offering cloud-based services now orders a nosebleed assessment. The discount rates by which these companies are valued make no sense. However, by buying loss-making companies at exorbitant prices, investors expose themselves to extraordinary losses.
Tech bubbles tend to form when investors project the returns of a previous generation of market leaders onto new companies. Thus, the mania for English canals at the end of the 18th century was inspired by the great profitability of the Bridgewater Canal, completed in 1761. Likewise, the mania for British railways of the 1840s was stimulated by earlier successes, such as the Liverpool and Manchester Railway, which opened in 1830. During the dot-com bubble, every day trader searched for the next Microsoft (MSFT.O).
The current tech bubble is no different. For nearly two decades, the stock prices of Amazon, parent company Google, Alphabet and Apple (AAPL.O) have risen more than 20% per year. Since their IPOs, Tesla (TSLA.O), Netflix (NFLX.O) and Facebook have seen their stock prices rise at annualized rates of around 60%, 40% and 30% respectively. Over the past year and a half, technology stocks have provided the bulk of market returns. They now represent one-third of the MSCI All Country World Index, a higher level than at the peak of Internet madness in 2000.
A generation ago, investors like Peter Lynch, the famous Fidelity fund manager, popularized the investment discipline of buying “growth at a reasonable price”. They even gave it an acronym: GARP. Today’s investors buy growth at all costs. Animal spirits aren’t so much directed at established tech giants. Alphabet, Facebook and Microsoft are trading at a premium of around 50% to the US stock market; their valuations do not seem unreasonable given their dominant positions in the market and their attractive earnings. At the height of the dot-com bubble, Microsoft shares sold at double their current earnings multiple.
Instead, investors have their heads in the cloud, otherwise known as the Software as a Service (SAAS) industry. The BVP Nasdaq Emerging Cloud Index has increased by around 300% since its inception in October 2018. Companies in this index, which range from Adobe (ADBE.O) to Zoom Video Communications (ZM.O), trade on stratospheric valuations. Since profit is nonexistent for many, it is valued on multiples of income. For example, software vendor Adobe has a market capitalization north of $ 300 billion on some $ 15 billion in sales. Adobe’s valuation is relatively conservative: the cloud complex as a whole is trading 28 times forward sales.
A new valuation metric, known as the “Rule of 40,” proclaims that any business with combined sales growth and cash flow above 40 is a good deal. Based on this metric, it would make sense to buy a stock that is expected to double in earnings in a year even though losses were half of sales. Cloud businesses are popular because they promise high margins and a reliable stream of recurring subscription revenue. They are launched into their “total addressable market” – another dubious measure.
At current valuations, they will have a hard time delivering. Earlier this year, Australian investment firm TDM Growth Partners estimated that the median cloud company in the BVP index would need to increase its profits by 30% per year for 10 years in order to generate an acceptable risk-adjusted return. To date, only two major software companies – Microsoft and Salesforce (CRM.N) – have achieved this feat.
A study by strategist Michael Mauboussin of 57,000 state-owned companies since 1950 found that only 1 in 300 listed companies increased sales by 30% per year over a 10-year period. Ben Inker, head of asset allocation at GMO (and my former boss), points out that since 1981, companies that trade more than 10 times their sales have generated only half the return of the S&P index. 500. Investors who buy SAAS stocks at almost three times this valuation will be lucky to get their money back.
The extravagant valuations applied to growing businesses aren’t limited to the cloud. TDM calculates that another darling investor, Peloton Interactive (PTON.O), which sells exercise bikes with online subscriptions, is expected to increase its current subscriber base from 2.3 million to 25 million over the course of the year. next decade to justify its current valuation of $ 29 billion. Marathon Asset Management estimates that if Airbnb (ABNB.O) took 50% of the vacation rental market (double its current share), it would still only be worth half of its current market value of $ 99 billion.
Tesla (TSLA.O) is the ultimate reality distortion machine. In 2015, CEO Elon Musk proclaimed that the electric vehicle maker would increase sales by 50% per year for a decade. At the time, Tesla’s sales were worth $ 6 billion. As Mauboussin observes, no business starting with sales of this size has ever grown at such a rate.
Tesla’s assessment implies that it will dominate the electric car market. But as Vitaliy Katsenelson, CEO of Investment Management Associates points out, the time element is being ignored. “Reaching an annual production of a few million cars will take time – a lot of time. Lots of land needs to be moved, permits issued, equipment installed, people hired, ”Katsenelson wrote a year ago, noting that none of this was included in Tesla’s inventory.
Today’s extreme valuations are not just the result of high expectations about exciting new technologies. Ultra low interest rates have corrupted the discount rates necessary for the valuation of companies. Investors appear to apply a smaller haircut to uncertain returns in the distant future than to more immediate gains – a practice known as “hyperbolic discounting”.
“In Star Trek,” Katsenelson noted, “there are handy wormholes, which cut corners through space, bringing you into this galaxy a billion light years away in a matter of hours. Interest rates have disrupted the temporal properties of the market and created a wormhole in time and in Tesla’s actions. It will take years, if not a decade, for Tesla to produce enough cars to justify its valuation. Today’s stock market valuation assumes that it has already happened – that capital has been raised and spent and that it has cost nothing. ”
Since Katsenelson made the comments, Tesla’s share price has more than doubled. But these wormholes will one day close. Speculator warning.
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Editing by Rob Cox and Karen Kwok
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