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High-flying tech stocks can justify valuations

Rainfall records are being broken in the San Francisco Bay Area: six inches since the start of the year, the most since 1982. Local drivers react by randomly deploying wipers, brakes and lights; it is no surprise that autonomous cars are being developed here.

Other Silicon Valley records look equally hazardous. The technology-dominated Nasdaq Composite index has set further highs this week and stands more than 10 per cent higher than the peak of the dotcom bubble in 2000.

The market’s skew to tech is startling. Even in the heady days of 2000, Walmart and General Electric were among the top five US companies by market capitalisation. Last year, for the first time, they were all tech: Apple, Alphabet, Microsoft, Amazon and Facebook. However, Warren Buffett, a technophobe when it comes to his own investing, has since spoiled the party: Berkshire Hathaway has overtaken Facebook and Amazon.

More broadly, tech dominates the S&P 500, accounting for more than 21 per cent of the benchmark’s value compared with financials’ 15 per cent. A gap that wide is found in bubbles. More alarming still: soaring stocks are outpacing revenue growth. The tech sector is valued at 3.5 times sales, higher than at any point since 2000. 

This might encourage some big initial public offerings, such as Snap, owner of Snapchat, the messaging app. A rumoured $25bn valuation for that company on $1bn of revenues looks like another sign of froth. It could also endanger existing stocks as investors switch to the new names. Goldman Sachs analysts note that since 2010 internet stocks have fallen whenever IPO issuance has risen.

And yet, for all the evidence of reckless abandon, there are convincing counterpoints. Using the more meaningful yardstick of earnings rather than sales, valuations are not outrageous. At 22 times earnings, the tech sector is far removed from the 70 times p/e of 2000. Back then, Microsoft had a $500bn market capitalisation and $8bn of net income. Today it has a similar market cap but its profits are twice as high. 

“There has been a renewed emphasis on profitability and not just growth,” notes John Kolz at Credit Suisse. “Is that because growth was harder to come by? Or was that the right thing to do?”

The sector’s current dominance ranks below that of financials in the run-up to 2008 and far less than the dotcom bubble when tech stocks accounted for more than a third of the equity market’s value.

For IPOs, Snap may well be overvalued — though it has plenty of fans — but it is unlikely to suck investors away from existing stocks. First, institutional investors have dry powder after mergers and buyouts. Second, in a change from the past, some of the biggest asset managers already own big chunks of private unicorns. While some managers will want to buy at the IPO, others will already own the shares.

The technology-dominated Nasdaq Composite index has set further highs this week and stands more than 10 per cent higher than at the peak of the dotcom bubble in 2000 © Bloomberg

As a backstop to valuations, there is an unprecedented amount of private equity money, including the $100bn SoftBank fund, which is yet to be deployed, other sizeable funds from Thoma Bravo and Vista Equity, which have been hyperactive in the past two years, and traditional players such as Silver Lake.

For their part, the top strategic bidders were relatively quiet in 2016. One theory is that companies are being cautious to ingratiate themselves with investors. It is not necessarily what investors want, however. “We would argue the legacy technology companies have been mistakenly buying back their stock or paying dividends when they should have been investing in R&D or transformative acquisitions,” says Brad Slingerlend at Janus Capital Group.

Whatever investors’ views on capital deployment, there should be more to deploy this year if Congress proceeds with a planned reduction in capital gains on repatriated earnings, encouraging companies to bring back hundreds of billions of dollars of cash to the US for possible use in dividends and deals.

This is all without having to believe that the industry is entering an exciting wave of technological innovation. The shift to the cloud and progress in artificial intelligence and embrace of internet of things (sensors in all manner of devices) should, though, give more momentum. And despite the hazard warnings, shares in technology companies should not hit the skids.

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