Why Tech Valuations are Cheaper Than They Seem
Back in March, predicting the NASDAQ soaring to record levels and pushing 11,000 by midsummer would likely have been dismissed as wishful thinking. Yet here we are. The speed and magnitude of the rise has investors asking if this makes sense. Actually, it kind of does.
Bear in mind, we’re cognizant of the lingering risks on the horizon, whether it’s uncertainty into 2020 earnings, longevity of the stimulus package, or the November election. There are more macro unknowns now than in recent years.
The concern is amplified because the gain is attributed to a small group of stocks. While this is certainly something to pay attention to, the context is what’s important.
If you take away anything from this story it’s two things:
- It’s now possible for companies to grow faster and through longer periods than ever before.
- Not every company is going along for the ride. Companies that fail to adapt, usually at the expense of margin, could lead to 2/3 of the S&P being left behind or even delisted.
Let’s get into each.
Our Next Evolution
You’ve heard of the industrial, telecom, and digital tech evolution. The next chapter is a productivity based one. This won’t eclipse the digital paradigm established over the last two decades, but will be built on top of it.
Productivity improvement comes in two forms: (A) speed or efficiency, (B) improvement in the quality of each unit of time.
This revolution should enable companies to grow faster and for longer periods than ever before.
The current global players can be left behind by new players at lightning speed by ripping out the old inefficiencies and deploying a plug-and-play mindset into every product or service offered.
Typing speed, for example, remained on a linear trajectory through the 1960s. As soon as digital interfaces came about, the improvement in speed was parabolic. Today’s tech can advance almost every service in similar ways.
Simply take a look at Zoom which tripled its customer base and doubled the annual revenue outlook within three months. It’s now possible to build a lasting business with paying subscription-based customers riding on infrastructure that didn’t exist in the dot-com era.
The reality is there is little to no jurisdictional, geographic, or infrastructure hurdles to inhibit a company from reaching end users or customers.
What makes this different from prior inflated markets? Well, to name a few things, businesses are now cloud based (versus heavy infrastructure), built on recurring revenue (versus eyeballs), and able to deliver utility (versus promises).
For investors, market cap-to-replacement cost might be more appropriate today versus the historical heuristic of market cap-to-GDP.
How much does it cost to rebuild the business from scratch, and more importantly, how could you replace the network of customers and users, today?
It’s not just the number of connections to the network, but also the strength of the connections between each other. Ask yourself how these networks will evolve over the next 5–10 years and if these companies will be more or less important.
There’s probably no better poster child for this than Tesla, which saw a meteoric rise over the last few months. (Clockwise Capital does not own Tesla shares)
The question investors should not be asking is if Tesla can overtake the US auto market. That’s the old way of thinking. The correct questions are as follows:
- Can Tesla build cars at superior speed and cost versus global manufacturers?
- Can Tesla’s lead in battery technology proliferate to industries far beyond autos?
- Can Tesla’s advances in self-driving translate into global transportation and shipping?
What these questions have in common is that they are not zero-sum for the user. Legacy automakers losing share to Tesla is a secondary story. The primary story is that market opportunities are global, more readily accessible than ever before, and at speeds that were heretofore unthinkable.
With this in mind, valuations nevertheless do still matter as we have trimmed positions in Apple, Facebook, and Nvidia in recent weeks. The point is that the growth trajectories of these companies will ultimately be steeper and longer because the addressable markets are so much larger.
To better assess valuations within this “nosebleed” group, we are in the process of developing a value “score” based on factors that actually matter, including growth, global market penetration, and long-term margin potential.
2/3 S&P Face Existential Risk
At the turn of the 20th century, steel companies and railroads were the dominant components of the Dow Index. And this made sense, especially given the growth of rail networks across the country. Fast forward to 1910 and 1920, however, each of those decade marks represented about 70% turnover in the Dow components from the companies that built the rails to the companies that actually utilized them.
The analogy is just as apropos today.
Consider any industry, whether it’s manufacturing, retail, media, IT, transportation, financial services, or current big tech — new entrants have the ability to turn these industries upside down by prioritizing end-user utility over margin.
Established businesses are stuck in a no win proposition, either give up profit centers or fight at the lower margin, earnings be damned.
Congratulate Disney for making the bold attempt at streaming, but they have yet to modify their studio model and network businesses. Don’t be surprised if Disney trends toward a 75% reduction in its operating margin profile similar to that of Netflix.
By definition, the establishment fights with one foot anchored into the old paradigm.
As Jeff Bezos famously said, “Your margin is my opportunity”.
Capitalism, no matter how you define it, is the race to the bottom on margin. Profits are boosted through greater productivity in asset turnover.
Amazon gets this, but unfortunately many in the S&P don’t.
Sure, the S&P recovered a lot of its losses, but Covid pulled forward technology in a way no one expected. As a result, value traps are now a dime a dozen. It’s not enough for a security to be cyclically cheap, but rather emphasis should be placed on how sustainable the business will be through the rapidly changing paradigm.
Reactive measures versus proactive ones are a losing proposition.
The silver lining to what society is going through is that the improvement in products and services have accelerated. Our daily lives are bound to get better once we’re on the other side of this. In fact, there is not a time in human history where improvements in cooperation didn’t lead to better outcomes.
Investors would be well served to evaluate companies in this manner. Scale free growth is the new normal.
Clockwise Capital is an asset management firm with a private equity approach to the public markets. We focus on the meaning of time and the role it plays in people’s lives. We believe the essence of a great investment resides in the ability of a company to either save their customers time, or improve its quality. We understand how technology evolves to drive these two factors, which we believe define human progress. As a result, we search for securities with cyclically depressed valuations whose companies save time, thus using secularly advantaged industries to build a concentrated portfolio. With each series of investments our goal is to optimize edge, maximize return, while also minimizing correlation. This allows our portfolio to maintain a liquid, low duration fixed income balance, ready to capitalize on market volatility, while still generating market beating performance.
