By David Holohan
On the arrival of the Trump administration to the White House in 2017, there were widespread concerns as to what impact the incoming president’s policies would have on global stock markets.
Investors could have been forgiven for hoping for the best but expecting the worst.
Unexpectedly, US equities surged over the following 12 months, spurred on by a fiscal spending splurge combined with the delivery of significant corporate tax cuts. One of the strongest performing parts of the market over this period was the technology sector.
Spurred on by jubilant management teams and bullish investment strategists, investors have piled into the tech shares, expounding the adage that ‘this time it is different’ to justify the increasingly racy valuation multiples that were attached to the ever-increasing tech stock prices.
The reality is that it is never different and human frailties continually fall victim to not believing in the warnings from the past.
There are several warning signals that we could be approaching the top of the cycle for technology.
In recent weeks, the flow of money into the US technology sector has been significant, running at the highest annualised rate since the early 2000s, reflecting upbeat optimism among retail investors that the momentum that carried the sector higher in 2017 will continue indefinitely.
The valuation multiples of several of the largest companies in the technology sector have recently been at levels, where previous IT CEOs derided fund managers for buying their shares during the dotcom bubble.
Both Netflix and Facebook — despite their recent travails — are among several technology companies that are trading over 10 times revenue, a level that the CEO of Sun Microsystems asked fund managers after the boom: ‘What were you thinking of buying shares at such ratings?’ Netflix and Facebook had also probably reached a point whereby the extent of their expensiveness left no room for additional upside.
Amazon is also a company that is in the crosshairs of US politicians, including President Donald Trump, as rivals cannot compete with an internet behemoth whose investors do not seem to require the company to generate profits. The market capitalisation of technology versus the overall value of the US economy is back to levels last seen during the height of the dotcom bubble and raises a further flag.
While there is a good argument that technology is a more important part of the economy than during the dotcom bubble, for large parts of the last decade, it was possible to invest in large technology companies trading on 10 to 15 times earnings versus the current 15 to 25 times that has become the norm over the past two years.
Significant share buybacks have augmented these ratios while underlying profit growth is expected to be a lot less spectacular in the year and years ahead, stripping out the benefit of lower corporation tax rates.
And management teams typically recommend buyback programmes to the board towards the top of the economic cycle and then, having used their cash resources, do not have the ability to take advantage of subsequent weaker share prices to purchase their stock at the low point of the cycle.
Investors should use the current malaise in the technology sector to examine the business models of companies to understand whether they can generate profits or not. Many companies have received the benefit of the doubt from markets over the past several years, but as larger investors face increasing losses from selloffs, their attention will turn to those companies who have performed exceptionally but have weak fundamental underpinnings.
Many social media companies and cloud computing start-ups fall into this category of having business models that focus on generating user growth but have no tangible profits and no firm way of generating them in the future. Unfortunately for investors, the shares of these companies are now priced at levels that suggest the next big move will be to the downside and as a sector that provided marvel on the way up, may cause a lot of distress on the way down.
David Holohan is chief investment officer at Merrion