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Big tech stocks and their risks

You have to understand what their underlying sustainable growth rate is: Iain Power, Truffle Asset Management.
Alphabet (Google's parent company) and Apple are among the top five tech stocks, along with Microsoft, Amazon and Facebook. Image: Gabby Jones, Bloomberg

Apple’s share price is up close to 120% over the past 12 months. Amazon has gained almost 75%, and Microsoft has risen over 50%.

Even if the world wasn’t in the midst of a severe global recession, those would be extraordinary numbers for the three biggest listed companies in the US.

In an Asset TV panel discussion this week, three local boutique managers, all with hedge fund capabilities, attempted to make sense of this extreme market phenomenon.

‘It’s fair to say that there are a lot of really good quality growth companies globally, but it’s important for investors to keep in mind that when you are buying into an Apple or Microsoft or one of the big tech businesses, you have to understand what their underlying sustainable growth rate is,’ said Iain Power, CIO at Truffle Asset Management. ‘Because, ultimately, that’s what your return looks like over time.’

In his view, price-to-earnings multiples cannot expand indefinitely.

“Don’t forget about valuation,” said Power. “Valuation is important.”

However, how does one determine what an appropriate valuation for these companies is? Given the extent of monetary interventions by central banks around the world, do asset managers need to think differently?

‘Material change’

‘You have to be able to value a business,’ said Jacques Conradie, MD at Peregrine Capital. ‘But there has been a structural change in interest rates. This is the first time in human history that the entire developed world is yielding zero. This is a material change and there is just no way that it cannot impact the fair value of equities.’

If cash and bonds are guaranteed to deliver zero, or even negative, real returns, equity valuations have to shift higher because the discount rate has changed. Even with markets at record highs, that means that there is still potential upside.

‘We think that over the next three to six months the increased usage of some of these tech platforms does unwind at the margin,’ said Conradie. ‘But we also think that if you do proper DCFs [discounted cash flows] they still look very cheap if you select the right ones, like Facebook.’

Rob Oellermann, director and portfolio manager at Tantalum Capital, doesn’t find fault with this argument. But he does see other risks that investors shouldn’t ignore.

Structural concerns

‘I completely agree that we are in a structurally lower interest rate environment and multiples could go higher,’ said Oellermann. ‘But there are other structural issues at play in these growth shares that concern me. It’s become a very crowded space.

“Just five shares in the S&P 500 currently make up 25% of the index. That’s as concentrated an index one has seen there in 30 years.”

This is apparent on the JSE as well.

‘Locally, just two stocks in Naspers and Prosus make up 22% in our All Share Index,’ said Oellermann. ‘That’s quite a lot of crowded behaviour. We like those shares – Naspers is our biggest equity exposure – and so we want to hold them. But we do think it makes sense to have a bit of protection there.’

Tantalum is currently employing a short fence strategy on its Naspers holding, which provides 15% downside protection, but which also limits the upside at the same level.

“I do think that narrow market is generally a warning sign and is not an easily sustainable picture,” said Oellermann.

“And I think regulators are also casting a beady eye in the direction of these big tech names. It’s a risk that needs to be priced somehow. I don’t think it’s the interest rate valuation I’m worried about.

“It’s more the fundamentals of the businesses and how one interprets those risks that worry me.”

The regulatory concerns are a significant issue for Power as well.

“I think that all of these big tech businesses have reached escape velocity,” said Power.

“With the size of their ecosystems and the number of users they have, it’s very unlikely that a competitor is going to upset their current position in terms of dominance, or their current business models in terms of monetising their space.

“But there is precedent that when businesses get really big and their benefit from a social and economic perspective is not spread to the wider community, you can potentially start to get risks building from the regulators. We’re not saying that Amazon will get broken up tomorrow, but to the extent that you get more and more market share gains and there is evidence of unsavoury businesses practices, then you get more regulation. And more regulation means more cost.”

External threats

This is ultimately a threat to their growth rates that is hard to quantify.

“These are great businesses,’ said Power. ‘We don’t see that competitors are going to knock them down. But I would not be surprised, particularly if you see a change of leadership in the US, to see the spotlight begin to fall on these businesses, and that could bring a bit of reality back to those valuations.”

It is also worth considering that these businesses are already becoming targets politically as global tensions rise, particularly between China and the US. Asset managers can’t ignore that impacts that government actions might have in this space.

“We have become used to an environment where geopolitical issues have not been that relevant,” said Conradie. “But the world is going to be different over the next 20 years.

“You need to build portfolios that can weather various shocks that you can’t model. That means diversification.

“We own US tech, but we also know Chinese tech and European tech, because you don’t know how this plays out. You have to diversify by company, currency, and business type to deal with this environment that you can’t predict,” Conradie added.

Patrick Cairns is South Africa Editor at Citywire, which provides insight and information for professional investors globally.

This article was first published on Citywire South Africa here, and republished with permission.

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Its the flow of dumb money.

A phrase comes to mind; What is the alternative.

Big Tech is dominating cause what else or where else does one invest? QE has I think made most of the CFA redundant – I’ve got respect for CFAs – as that qualification works when there is a proper price to money, Zero interest rates, there’s no proper price to money therefore how does one value a stock against what is supposedly Risk Free.

Set-up a monthly debit order and buy Tech, don’t go against the herd.

The alternative is proper fundamental analysis.

You look at how long it took to reach 1 Trillion market cap for Apple for example and under 3 years they will be at 2 Trillion… but it does not mean that they are actually have PE ratios that would make sense.

The view of following the herd is how you become cattle to be slaughtered — bitcoin bubble anyone?

The stock prices of these companies can not keep growing indefinitely because their customers are ultimately the ones that fun their businesses… and the income of their customers (read wage growth) is not keeping up with their earnings.

What Bitcoin bubble? Bitcoin doing just fine, just like tech will do fine. Prices have skyrocketed and a good correction would probably be healthy, but trying to time it is an exercise in futility. Buy and hold, btc and/or tech.

It is correct that discount rates could move higher but it must be a risk-adjusted rate. That risk would differ a lot among the candidates.

Apple has incredible operating cashflows due to its ability to extract very high margins for aspirational products & services. It also has a track record of not making stupid acquisition mistakes. I think its largest ever was $3b. It has an incredible and sustained return on capital due to what amounts to the best supply chain management. It raises corporate debt at sovereign levels – recently a zero % Euro issue.

One would need to score all the candidates on such a checklist. Facebook should have a very different risk adjusted discount rate.

My worst trade ever was selling half my Apples before covid when I thought the overall market was insane. Markets went higher and Apple jumped. Could be worse : could have sold more than half…

Even if you take your argument about efficiency and look at the last 5 years of Earnings per Share … it only increased at 33% from $9 to $12.

While the price has increased from $121.06 (02-11-2015) to $458.43 (yesterday’s closing price) which is 378% gain over same period… which is insane and seems like people are betting on price and not on performance.

Data was gathered from https://tools.morningstar.co.uk

Ironically, Apple shares were (split adjusted) $12 per share when I bought them in 2009 – now they earn $12 per share!

Yes, Apple has been re-rated, they used to trade at far lower PE. I suppose in a world of .1% yields on income assets maybe it makes sense to buy a 1% dividend yield that grows and essentially has sovereign risk in its balance sheet. I am not about to buy back that half I sold though! Still patiently waiting for the markets to get a slap. S&P at 2700 makes more sense for me

There are some ratios that are more expensive than March 2000:
Market Cap : GDP by far at record levels
Schiller Index by far at record levels
S&P Equal Weight : S&P at too low a discount

I don’t get it. At some stage the wider impact measured in mortgage and consumer debt defaults has to overcome quantitative easing. Or asset inflation bubble will burst when some weird counterparty risk that nobody saw (like 2007) hits.

@Johan_Buys

I guess when the interest rates increase again in a couple of years — “the tide would have gone out”.

Or as you have stated; something else will happen that will cause a correction on the market.

With PE ratios above 500 and USA and China fighting what can go wrong

to get a different perspective on risk, look at the price of buying protection – it will put PE and risk in perspective

So compare the option cost relative to ruling, of buying June 2021 put option with strike at ruling price among:
S&P
Apple
Berkshire
Facebook
Netflix
Tesla

Part of the market does see risk…

to quote Sensei: “Tech valuations are high when interest rates are low because people are buying companies they do not understand with money that they do not have”

I love that

And there is no “magic 8 ball” that will give you the answer . There are 100s of valuation methods and nobody knows what the market “already priced in or not”

Truworths today , case and point.

Investing in shares has become gambling , the underlying assets are all backed by future cash flows and the future is always uncertain.

The fact that we are at record highs during a pandemic is further proof that it’s all smoke and mirrors.

The implication of being huge (sorry Donald) players in the international online electronic field like Amazon, Alphabet, Apple, Microsoft and Facebook is also their vulnerability to the single chink in their armour which is their programs and software development.

In the same way that the real virus brought down mainstream retail economies in every major city in the world in less than a month, a virtual virus or disruptive program attack could destroy or seriously damage their value in even less time.

Chinese online markets are of equal size and have as vast a range of offerings from games, messaging, trading platforms and of course shopping.

China has 1.4 billion citizens feeding these companies like Alibaba, Tencent and some huge (thanks again Donald) national banks, construction and insurance companies.

What defenses do the FAAMG’s have should President Xi Jinping, President for Life decide to take them on in the virtual space beyond China’s borders?

Conflict between the USA and China cannot for obvious logistical and political reason erupt into a physical boots on the ground scenario and if there is any risk to the markets of the essentially US team of the FAAMG’s other than individual country taxes, this would be it.

Perhaps some fund managers who are heavily invested in the Nasdaq would like to comment on how they would protect their clients in this very possible event?

End of comments.

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