Borrowed growth

Perhaps that sentiment is a little sensational, but investors agree. During a virus pandemic that shakes economic security, consumer demand and global supply chains, cash-rich data experts are the types of company we want to own. The S&P technology index has climbed 15 per cent in 2020, driving a surprising recovery in the wider S&P 500, of which the tech sector makes up a third of the market by value. In the year to date, 20 of the 93 companies in the S&P 500 technology index (not including Amazon, which is listed as a consumer goods company) have reported share price growth of more than 20 per cent.

And tech demand remains high. Much of the world is still working from home. Compulsory masks are encouraging people to keep shopping online. Film delays have postponed the allure of the cinema. If there was ever any doubt that tech would have a defining role in the world’s future, coronavirus has quashed it.

The outlook for technology companies has surely never been so appealing. But there is a counter argument to that sunny assumption, one that has begun to rear its head during earnings reporting season as the big tech companies discuss the outlook. Netflix (US:NFLX), Microsoft (US:MSFT) and Twitter (US:TWTR) are among a growing number of companies whose share prices have stumbled after management tempered expectations for the third quarter and beyond. For all of them, the problem is the same: if three months of global lockdown is the pinnacle of demand for tech services, what comes next?

Timing matters

In the past few months, many tech companies’ shares have been pushed to all-time highs as investors envisage continued demand for their products and services. While the sheer weight of large companies in the sector means they have been the driving force of the recovery in the S&P 500 – Microsoft’s 26 per cent share price rise in the year to date has added $400bn of value to the index – smaller companies have been in equally high demand. Nvidia (US:NVDA), PayPal (US:PYPL) and Advanced Micro Devices (US:AMD) have led the sector’s growth this year, their share prices all up more than 50 per cent.

It’s true that soaring demand for many of these companies’ products and services in the past few months goes some way to justifying demand for the shares. And Covid-19 has undoubtedly highlighted and in some cases exacerbated the world’s reliance on technology. But it remains to be seen if the demand of the past few months would never have happened without the pandemic, or whether it would have merely materialised anyway over a longer period of time. In other words, has Covid-19 generated new opportunities or simply squeezed tech growth into a much smaller time frame?

That’s an important question in the context of company expectations. At the time of writing, the companies in the S&P 500 technology index have an average price/earnings (PE) ratio of 30 times. This time last year, the average PE ratio came in at 27.6. That means investors now have higher expectations of the companies in the tech sector than they did a year ago, before the coronavirus sparked mass disruption.

Where has growth been borrowed?

To justify the higher expectations, companies must be capable of delivering long-term growth. Before the pandemic took hold, the world was already turning increasingly to cloud computing, remote working and virtual entertainment and tech company valuations and long term growth forecasts reflected that. Coronavirus has accelerated this transition, but doesn’t seem to have provided new opportunities beyond those that were already in motion.

Indeed, earnings expectations are the lowest they have been for a long time. On average, tech stocks are expected to report annual earnings growth of 28 per cent in the current financial year and just 22 per cent EPS growth in the following year. That compares with average EPS growth forecasts of 44 per cent this time last year when the sector – trading on an average of 27 times forecast earnings – was already being described as overheated.

Comment from company management is starting to confirm these concerns. In April, Microsoft’s chief executive, Satya Nadella, said: “We’ve seen two years' worth of digital transformation in just two months.” More recently, Netflix’s chief executive, Reid Hastings, has admitted the, "strong first half performance likely pulled forward some demand from the second half of the year". In the third quarter of 2020, the streaming giant expects to welcome just 2.5m new viewers to its platform, down from 6.8m in the third quarter of 2019. 

A spanner in the works

Meanwhile, big tech companies are facing regulatory scrutiny. This week, Amazon’s founder, Jeff Bezos, Facebook’s Mark Zuckerberg, Apple’s boss Tim Cook and Alphabet’s recently appointed chief executive Sundar Pichai faced questioning as part of the House of Representatives' year-long inquiry into competition in the technology industry.

The consensus among regulators, academics and an increasing number of consumers is that the giant tech companies have grown so large they act to stifle competition across multiple industries. These companies have submitted thousands of internal documents as part of the probe, which Congress’ antitrust sub-committee has perused for many months. The four leaders – appearing together in front of the House for the first time – are likely to face wide-ranging questions relating to anti-competitive business practice.

Mr Zuckerberg – a dab hand at House hearings having spent much of 2018 answering questions about Facebook’s (US:FB) role in the Cambridge Analytica data mining scandal – is facing complaints about his company’s strategy to eliminate potential rivals through acquisition. Facebook bought both Instagram and WhatsApp before they grew large enough to be considered threats.

Mr Bezos – appearing in front of congress for the first time – will be forced to explain why Amazon hasn’t abused its power over the third-party merchants that sell goods on its site. Mr Cook – an expert at deflecting scrutiny – has similar complaints levied against his company’s App and iTunes stores, which give preference to Apple’s (US:AAPL) own products and charge high commission to third parties.

Mr Pichai is likely to face the most intense line of questioning. Google alone has had to submit more than 100,000 documents to various state departments researching anticompetitive practices and has been accused of prioritising its own advertisements in its search tool. The company is also facing a separate antitrust probe from the US Department of Justice – the same body that forced tighter regulation of Microsoft in the 1990s.

But the antitrust debate is being muddied by other issues. While the purpose of this week’s questioning was supposed to be anti-competitive practice, all four executives faced different lines of questioning. Facebook has been accused of failing to monitor hate speech on its platform. Republican representatives questioned Amazon’s anti-Trump rhetoric. Google is facing criticism for the way it handles data. Apple’s tax payments are under scrutiny.

More significantly, the antitrust probe is about informing future bills (rather than prosecuting based on past action) and with a US election coming up, the big tech companies can be pretty certain that no big decisions about new policy are going to be made any time soon. It’s also worth noting that regulation doesn’t necessarily lead to poor performance. The DoJ’s interference at Microsoft may have tempered growth prospects for a few years, but failed to hinder long-term growth.

That said, investors should certainly take note of the breadth of regulators on the warpath. Proposals are for a complete overhaul of current antitrust laws, which make it difficult for law enforcers to target companies simply for being too big. The support of the DoJ and Federal Trade Commission certainly gives more weight to the House of Representatives' questioning. In terms of the long-term investment case – which companies that carry PE ratios of more than 40 times certainly need to deliver on – new laws could have an impact on how much money they can earn in the future.

Big tech faces extensive regulation

Beyond the FANMAGs

High valuations and regulatory concerns make up most of the criticism levied at the investment case of the US tech giants. An optimist’s rebuttal? These companies’ quality warrants high valuations.

It’s true that the stocks that have driven most of the S&P 500’s growth this year are phenomenally high-quality companies. Facebook, Amazon, Netflix, Microsoft, Apple and Google (collectively, the FANMAGs) have achieved annualised three-year revenue growth of 22 per cent, average profit margins of 35 per cent and a return on capital employed well over 20 per cent. These companies – most notably Amazon, Microsoft and Alphabet – have exposure to major trends that are likely to shape the way we live in the coming years.

But not all tech stocks come with this quality or long-term growth potential. According to data collected by private investment bank Verdad, 500 of the roughly 3,000 US stocks with a market capitalisation of more than $100m are both more expensive than the FANMAG stocks and have lower-quality financials. Verdad says that these so-called ‘Bubble 500’ companies trade at approximately 14 times forecast sales, but make no profits.

True, the 500 companies only contribute 7 per cent of the value of the S&P 500 – the six FANMAGs alone make up more of the index – but that doesn’t mean their prescence on the stock market isn’t significant. Verdad points out that investors in the S&P 500 are often paying over the odds for lower-quality companies. Despite the fact that some of these companies are operating in very exciting areas of the market (Tesla, for example), it is hard to justify such lofty valuations – most of the FANMAGs have never traded at more than 10 times revenue. 

More importantly, it is worth considering the fact that the lofty valuations of these companies are being propped up by the strength of just a handful of tech giants. Therefore, what is the outlook for the bulk of the companies on the market (by number, rather than value) if the biggest companies begin to disappoint? Bursting the bubble of big tech could spark a spiral of decline that impacts the investment case of all the companies that have risen during a golden digital era.