Sometimes, having decades of experience in the stock market feels uncomfortable – it can make you too fearful. If you haven’t read The Money Game by Adam Smith (real name George Goodman), I recommend reading Chapter 12, where he explains the phenomenon far better than I ever could. For example, those of us who lived through the dotcom crash have vivid memories of it and as a consequence were far too conservative in the Covid tech bubble. Now it’s all unwinding, much like last time, but faster, and in greater size, as the stocks are bigger.
Here is Bill Gurley, one of the best tech investors in the world, on the subject: "A generation of entrepreneurs and tech investors built their entire perspectives on valuation during the second half of a 13-year amazing bull market run. The unlearning process could be painful, surprising and unsettling to many. I anticipate denial."
Gurley is spot on. The believers will anchor on the 12-month price high, a dangerous strategy. Twitter’s (US:TWTR) board sent a clear message about that approach when they accepted Elon Musk’s bid. That should, but probably won’t, discourage those who follow Cathie Wood of Ark Invest.
I was amused recently as value investors started to sniff around tech – a big-name investor and someone I respect emailed me to ask which tech stocks I would buy on a five-year view. Schroders' value team put out a blog: “Is misfiring Netflix (US:NFLX) now a value stock?”
Nick Kirrage, co-head of the Schroders Global Value team, said: “Areas of the market that have the biggest chance of falling in value are those that are the most expensive... There are some phenomenal tech businesses out there, and the time will come when value investors like me will have the chance to buy them. It’s just a matter of being patient.”
Given the pace of some of the declines, he may not need to be too patient. David Sacks, a highly successful internet technology investor, highlighted some of the falls using data from tech-focused investment fund Altimeter Capital. The de-rating of the internet index versus its long-term average, let alone the fall from the eye-watering peak, is enough to arouse interest.
The SaaS Index – a valuation tool for software-as-a-service businesses – has now dipped below its pre-Covid median enterprise value (EV)/sales ratio, having seen a 50 per cent plus decline from the peak. It’s still not exactly a bargain at 7.1 times forward sales.
EV/sales is one of my favourite valuation parameters and has become the fashion for lossmaking tech stocks.
In the dotcom bust, 'value' buyers would sniff around a stock that had been cut in half only to see it fall in half again. And then again. As US investor David Einhorn once said: “Definition of a stock that’s down 90 per cent? One that fell by 80 per cent, then halved.”
And you don’t need me to tell you that 40 times earnings before interest, tax, depreciation and amortisation (Ebitda) and 16 times revenues are incredibly steep valuations. There are, of course, companies that justify that – one in 100 tech stocks. If you buy stocks at those sorts of prices, the odds are you will lose money. At 8 times revenues for a software stock, the odds were in your favour for the past few years, but that was an unusual time. It’s conceivable that it’s repeatable, but it’s far from a low-risk strategy. The fall from an overpriced top is never a useful guide to where value lies.
There is an additional factor to bear in mind. And that’s stock options. Let’s look at the reaction of companies to the fall in their share prices.
What now, after the fall?
Everyone in tech companies loved stock options when the stocks were going up – employees got free options, the stock price was going to the moon, and they became rich. Management loved them because they got lots of options, and staff were happy because they were being paid often a ridiculous amount for their efforts. Shareholders couldn’t really complain much because the stocks were doing well – who cared about the 5 per cent dilution when you had a 100 per cent capital gain in a year or less?
Fast forward 12 months and the picture doesn’t look quite as attractive to tech employees. That Lamborghini they bought on the back of a week’s gain in the stock price may have to be paid for in real dollars. Those options are likely to be heavily under water and there is almost no chance that they will make the holder money. Employees can then become so unhappy that they look for another job with stock options that are actually worth something – because if you start at a new company, they will offer you options based on today’s stock price.
So you certainly should not be surprised – and you should perhaps show a little understanding – when management reprice employee options. In reality, they have little option (sorry) if they are to retain staff. This is probably already happening. Here is Coinbase (US:COIN), the crypto platform, in its recent first quarter (Q1) results. Its stock-based compensation charge had gone from $105mn in Q1 last year to $352mn; it was $263mn in Q4.
Meanwhile, its revenues are falling and the stock price has collapsed:
So the market cap has shrunk 80-odd per cent, while the stock-based compensation charge has gone up more than three times. One reason might be more staff. This will not be true for all tech stocks. Many of them will be laying people off instead. Investing app Robinhood (US:HOOD) has one of the highest ratios of stock-based compensation to revenue (87 per cent last year in our screen) but has announced plans to lay off about 9 per cent of its employees.
More common, I suspect, will be that companies issue additional options – if the share price is falling fast enough, employees may be spooked and management may feel the need to issue even more options to retain them.
Where options are repriced, the accounting treatment is to value the new options and amortise the difference versus the original over the remaining vesting period. So we may well see a pick-up in stock-based compensation, but as every company seems to add it back to adjusted earnings, and analysts seem to ignore it, I am not sure there will be the share price reaction that would result if companies switched from issuing shares to paying in cash. Although that is also likely to be a trend.
Therefore, this is a pattern that is unlikely to be unique to Coinbase. If we look at options struck at Alphabet (US:GOOGL) and Meta (US:META), to pick two random examples:
The Alphabet stock price when I wrote this piece was $2,256, down 22 per cent from $2,897 at 31 December, but still well in the money at 39 per cent above the average strike price. But I bet the coders feel poorer. So far, no need to change any valuation calculations for the company. But it’s something to watch – will there be creep in the number of options granted?
The Meta stock price when I wrote this piece was $190. It was $336 at 31 December. The average options are worthless and need a 30 per cent hike in the share price to be worth anything. Meta could reprice those units, representing 3.6 per cent of shares in issue. It’s not the biggest issue for Meta right now, of course, but a repricing would be dilutive.
One of Wall Street legend Bob Farrell’s rules was that bull markets are more fun than bear markets. Hopefully, the correction (or dose of reality) in the tech sector will mean a greater differentiation between strong businesses and fads going forward. The fads will fade away and there will be a lot of zeroes – among them will be outright frauds and some simply overhyped situations where there was no intention of theft. For many companies, impoverished shareholders will see further declines in the value of their holdings as stock options are used to retain talent.
For the stronger companies that are left, there will be cutbacks – I was surprised that at its Q1 results there was little mention of cost-cutting at Netflix, for example, as that is one obvious way of addressing its profitability issues; subsequently, it cut Harry and Meghan while 150 employees have been laid off. But the norm is likely to be the repricing of stock options across the sector. This will make shareholders even poorer, but managements have few choices.