Technology stock valuations are reminiscent of bubble territory, according to BMO Global Asset Management's fund manager Thomas Wilson, who does not own any technology stocks in his funds.
Valuations have reached new highs through investors’ willingness to pay over the odds for growth as well as an overconfidence that companies have no competition and a premium on disruption.
“I have no exposure to tech across all the funds that I run,” the manager of the F&C UK Mid Cap fund said. “I think what has happened is in a world where growth is very hard to come by in terms of economic growth, investors have been prepared to pay up ever higher valuations to gain access to companies with growth.”
This has not just affected the technology stocks however, with a premium placed on any company with stable, visible cashflows with steady growth prospects.
“Like Reckitt Benckiser at the large-cap end. It has fairly visible, not spectacular but dependable growth and the multiples that investors are prepared to pay to access that growth has gone ever higher,” he noted.
Share price performance of stock over 10yrs
Source: FE Analytics
Indeed, Reckitt Benckiser’s share price has risen 148.01 per cent over the last decade and peaked at 188.99 per cent earlier this year before a small correction in July.
This has been accentuated by central bank policies, which have seen trillions of dollars of new money enter the system through quantitative easing (or money printing) which has needed to find a home and has largely done so in the stock market, bidding valuations up higher.
Turning specifically to technology, Wilson said that companies such as Amazon and Facebook in the US have done very well from this phenomenon, as a premium has been placed on fast-growing companies.
“The problem with tech is it is a very fast moving industry and marketplace and at the point where you are paying 30 times earnings – and for some stocks it is a lot higher than that – that implies significant growth in the free cashflow of that business,” the manager said.
“But more importantly to me, most of the value in that business is years and years out – really way beyond a reasonable forecast horizon.”
The difficulty for investors in the technology sector therefore is that they are investing in a company which operates in a constantly changing and evolving market, while paying valuations on forecasts that are many years in the future.
Wilson added: “If you are paying a really high valuation for a business trying to work out how that market evolves, who the winners and losers are that is very difficult.”
An example of this in the UK mid-cap sector is online takeaway order website Just Eat, which has seen its share price rise 159.72 per cent since its launch in 2014.
Share price performance of stock since IPO
Source: FE Analytics
“The online takeaway market has lots of moving parts to it – you have the platforms who just facilitate orders like Just Eat but you also have the likes of Deliveroo who actually participate in the delivery of orders and it is all part of effectively one market,” the manager noted.
“A lot of these businesses in the early stages don’t make much money. They may grow very fast but any business can grow without making money because you can market it a lot, give products away etc.
“When you are paying a very high valuation, trying to work out how much profit it is going to make in 10 years’ time and where that is going to reside is very difficult.”
However, while new companies such as Just Eat can be caught out by innovation and a changing marketplace, history shows that even the most established players can fall by the wayside if they are not careful.
Indeed, Wilson highlighted mobile phone maker Nokia and camera producer Kodak as two recent examples of companies that have struggled to keep up with their respective changing markets.
“These were actually very established businesses at the time that were making profits and cashflow that were seen as impenetrable business models where competition would never come in,” the manager said.
“It did and ultimately there was no protection on the downside because of the valuations that you had to pay to access that.
“The assumption that competition won’t come in or that the market won’t change is a very dangerous one. If you’re paying a valuation where you have to rely on a significant amount of cashflow decades out in an ever changing market like tech – to me that is very dangerous.”
One of the main themes in the market over the last decade has been disruption, from Netflix reimagining the television sector to online retailer Amazon changing the way people view the high street.
But choosing which companies will ultimately win and which will lose is exceptionally difficult. After all, if these companies can disrupt their respective industries why can’t they themselves be disrupted?
This swathe of interest in technology disruptors has been particularly prevalent in the US, where the S&P 500 Information Technology sector has returned 205.18 per cent, 63.49 percentage points ahead of the wider S&P 500 index.
Performance of indices over 5yrs
Source: FE Analytics
“I don’t invest in the US but I think that some of the market behaviour that you are seeing is very reminiscent of bubble territory in the sense that a few stocks are leading the market and they tend to be tech-led,” the manager said.
“Look at the likes of Tesla recently, where the production was materially below their guidance yet the shares over the course of the next few days actually ended up higher than prior to the announcement.
“I get this sense that actually businesses need not make money – investors are happy to look through substantial periods where businesses are losing money, not generating positive cashflow and to me that is reminiscent of a bubble.”
However, timing when the market will burst is very difficult to do and rarely is there one defined event that can be given as the catalyst for such movements.
What is clear is that the air comes out of the bubble much faster than it went in, giving investors very little warning or time to move out.
“It could happen tomorrow, in a month’s time or in a year’s time you just don’t know but the potential losses in investing in some of those stocks is clearly very high so why would you want to take that risk?” Wilson said.
“When does it actually happen? Who knows. Bubbles tend to go on much longer than you think but I see no reason to invest in those companies.
“It is dangerous behaviour to know that valuations are extreme and there is excessive risk taking yet all the time these stocks are going up be happy to be on board and try to get out when it ends, because ultimately the doors are a lot narrower on the way out then they are on the way in.
“Forecasting when that happens is ultimately futile and is near-on impossible. This view that you can time the market is just not true so we take the view that we would just rather not get involved in that behaviour.”
As such Wilson said he is more interested in companies that are not being disrupted than those doing the disrupting.