Bumps along the road towards a technological revolution

As broad investor sentiment has become increasingly positive on technology, Pierre-Henri Flamand outlines the potential risks of crowded market positioning and the possible evolution of regulatory pressure at some point in the future. While US tech companies are delivering stronger earnings than we saw ahead of the 2000 tech crisis, and the market is a long way from that kind of a bubble, he argues that we may begin to see investors rotating some capital out of these companies and into more compelling opportunities.

27 OCTOBER 2017

At a recent conference of financial CIOs from around Europe, I mentioned that I wasn’t entirely convinced by valuations in the tech sector. There was an audible intake of breath. Given expectations surrounding companies in this area, it’s hard to be anything but bullish on tech at the moment, and I’m a long way from suggesting that the current surge in tech stocks is a repeat of the 2000 bubble. It is clear to us that this time around, there are not only real revenues, but real earnings being made by firms in this space. The best disruptive technologies – from cloud computing, to autonomous vehicles, to cryptocurrencies – are designed to exploit clear weaknesses in existing business models and provide consumers with better, faster, cheaper products and services.

Masayoshi Son, head of Japanese conglomerate Softbank, has raised USD100bn for his ‘Vision Fund’ with the aim of investing in technology1. Son speaks to investors about the coming of a new ‘singularity’, arguing that we’re on the cusp of a new paradigm, where artificial intelligence will propel dramatic and far-reaching changes to daily life. It’s no surprise to us that, with this sort of talk going on, the Nasdaq is testing new highs.

It’s not that I disagree with Softbank’s bold vision of the future. We are living in remarkable times, where the pace and scale of change is unprecedented – not only to how we consume, but to how we perceive the world and each other. I’d just suggest that investors who are expecting extraordinary near-term returns from technology stocks could possibly find themselves waiting rather a long time, and potentially missing out on opportunities elsewhere. So rather than questioning the ‘if’ of Son’s vision of the coming singularity, I’d question the ‘when’.

Not a bubble, but there’s fizz: the danger of crowded places

It’s hard to generate particularly positive performance in a place of strong consensus, and that intake of breath when I raised the prospect of tech being overvalued among my CIO peers is indicative of a more generalised position across markets – it has become almost scandalous to step outside of the mainstream position when it comes to tech stocks. This overwhelming optimism around tech makes for a crowded marketplace in my view. It was salutary to note that when tech, and particularly the FAANG stocks (Facebook, Amazon, Apple, Netflix, Google) sold off at the beginning of June, and then again at the end of September, long-short hedge funds suffered some of their worst trading days of this year2.

It’s not only hedge funds that have been piling into the sector. Tech stocks have traditionally been seen as high-growth, high-volatility investments. Investors historically accepted that they’d back a failure for every success: a MySpace for every Facebook, a Pets.com for every Amazon. However, the positive performance of US tech stocks in recent months has been so smoothly inexorable that a number of names in the sector are now screening as ‘low-volatility’, meaning that they are being bought by exchange traded funds and ‘smart beta’ rules-based investors.

It may be that we are indeed at the dawn of a new era, but in pockets of technology there seems to remain some distance between the cashflows and the valuations they seek to justify. Priyan Kodeeswaran, portfolio manager of our Innovation Equity strategy, refers to so-called ‘unicorns’ – start-up firms valued at over USD1bn – which have seen themselves bid up to sometimes markedly inflated levels. In his view, it could only take a few ‘down rounds’ – new financing raised at lower valuations than previous fundraising – for the tone of the whole market to change. Again, this is not to deny that performance has been supported by decent fundamentals in many cases, but in our view, investors must recognise that market movements are also about positioning, and crowded spaces can be dangerous.

Data harvesting and the regulatory tail risk

Another tail risk worth keeping an eye on when it comes to tech firms is the path of regulation. To generalise, the latest wave of optimism surrounding the sector has come from the profits that these internet platforms generate from the way they harvest, refine and monetise data, which has so far been unimpeded by regulation. This relies on the fact that most users of these technologies remain fairly relaxed about the pact involved – that they get a service like Facebook, YouTube or Dropbox for free or very cheaply, and in exchange they hand over a nebulous but high-value asset: data.

Again, this is an area where Priyan Kodeeswaran is leading our team’s forward-looking research. His strategy focuses on investing in areas of rapid change and disruption, and Priyan sees regulatory intervention as an outlying risk, but one which investors should bear in mind. ‘Regulators have historically focused on the issues that they recognise from old-world business: they aim to prevent anticompetitive behaviour, and things which disadvantage consumers. But many regulators have struggled to map these focuses onto the new templates of technology companies – for example, British regulators came close to negatively impacting the business models of telecoms operators several years ago. Today, regulators in the US and UK appear largely unconcerned about the harvesting of data, but their counterparts in Europe (and particularly Germany) are more focused on this aspect of the business model.’ It is conceivable that, at some point in the not-too-distant future, government regulators may decide to go after the data oligopolies, and if this happens, current valuations could be challenged.

Tech names could be the source of funding for opportunities elsewhere

Our team is currently constructive on Asia, where we’re witnessing a major cyclical upswing, and we’re guardedly optimistic on Europe (despite the difficult political backdrop). Both of these regions present opportunities which appear to us more compelling, and with greater near-term upside potential than most of the US tech universe. Over the coming months, it may be that the Nasdaq takes something of a breather. While earnings have indeed gone up among tech companies, their multiples have risen significantly more in segments of technology market. In this context, it would not surprise us hugely to see investors funding positions in these territories by the targeted selling down of holdings in tech stocks.

Priyan often quotes Amara’s law to me. This maxim, coined by the futurologist Roy Amara, states that societies tend to overestimate the impact of new technologies in the short term, while underestimating their long-term effects. It’s a useful rule for investors in the tech space, particularly at a time like the present, when grand claims are being made about everything from augmented reality, to wearable tech, to driverless cars. As such, Priyan has built an investment strategy around long-short positions in the tech space, seeking to maximise returns by backing the disruptors and shorting the disrupted, as well as exploiting overhyped stocks where he believes that the market has priced in an overly-optimistic future. In a sector that we believe will see greater differentiation between those companies that benefit from disruption and those that don’t, we think a long-short investment approach may make sense: backing those whose business models are sustainable, whose cash flows are tangible, and whom we think may benefit from the days of reckoning that are to come, reaping rewards while others falter.

1. Cited in public financial news outlets, including Bloomberg here.
2. Source: Morgan Stanley, September 2017 (sell-offs recorded on 9 June and 25 September 2017).

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