Is Big Tech a Bubble?

A long-standing doctrine in successful investing was to buy stocks that were trading cheaply based on an objective measuring method (price vs. book value/earnings/sales), giving you a margin of safety, and then sit back and wait for the market to realise they were undervalued

Once stocks reached ‘fair value’, they would be sold, realising a gain that historically outperformed markets.

This style of investing has a long history and produced many successful managers, the most famous of which is Warren Buffett. But since the previous bull market peak in 2007, value has drastically underperformed. A portfolio’s performance over the last decade can be determined by two primary factors: the level of exposure to the technology sector, and the exposure to US equities vs. the rest of the world. Since most of the world’s largest technology companies are in the US, exposure to the second factor also gave investors indirect exposure to the first.

There is plenty of research showing Value’s long term outperformance vs. Growth, and the two investing styles often run counter-cyclically to each other. Previous peaks in growth investing, such as the Nifty Fifty period in the 1960s where fifty popular large-cap growth stocks were seen as solid long-term buys that could be held ‘forever’ regardless of the share price (many of which have since gone bankrupt), and the Nasdaq 1999 bubble, also coincided with bottoms in value investing. The common narrative at peaks in growth investing is that ‘this time it’s different’, that there’s a fundamental change in markets that justifies higher valuations, and that this will continue indefinitely.

The question investors have to face now is whether we’re in such a period. Long-suffering value investors have been predicting many bottoms in growth vs. value over the last few years, they’ve been wrong every time. If growth already looked stretched last year, this year’s COVID pandemic added fuel to the fire, where high valuations looked justified as we were forced to stay at home, binging on Netflix, ordering food delivery, and even more goods from Amazon. A number of companies this year exhibited exponential upside movements that are often seen at the end of bubbles, such as Tesla’s rise after their stock split. Tesla is now the most valuable car manufacturer in the world, despite only contributing 1% to total car production globally!

While no investment strategy consistently outperforms, in the past it’s been easier for investors to stick to value investing. Periods of underperformance averaged around 4 years, compared to outperformance periods of more than a decade.

In 1999 value’s historical outperformance was seriously questioned, as growth outperformed for a whole decade other than a small blip in 1992-1993. Prominent value investors like Buffett were widely ridiculed as investing dinosaurs: Berkshire Hathaway lost -20% in 1999, while the S&P500 gained 21%, and the Nasdaq put other investments to shame, rising +102%.

These figures marked the last growth bubble peak. From then to the next market peak at the end of 2007, Berkshire gained +152%, the S&P500 was flat for 7 years, while the Nasdaq lost -43%.

Post-2007, the performance reversed again. Value stocks achieved a meagre 6% annualised gain in these 13 years, the S&P500 at 9% annualised, and the Nasdaq again trounced its competition for a 16% annualised return, for a total gain of +550%. Non-US-equities fared worst of all, with many indices still near 2007 levels, for no returns.

The current growth outperformance vs. value has been both the longest and biggest in history. Most telling, half of the whole 13 years of outperformance happened this year alone. All this has led many investors to question whether value investing still works, or whether we are entering a new permanent era of growth and technology outperformance, led by a fundamental change in the way we live our lives.

These figures marked the last growth bubble peak. From then to the next market peak at the end of 2007, Berkshire gained +152%, the S&P500 was flat for 7 years, while the Nasdaq lost -43%.

In trying to answer this question, there is a case to be made that the long-term value outperformance may be gone for good, as technology starts to permeate other industries. After all, Amazon is an alternative to bricks-and-mortar shops with better inventory, lower prices, and a super-efficient logistics system. Google is essentially an advertising company.

A long-term chart of value vs. growth shows that the current growth outperformance has led the ratio back to the 1975 level, erasing four decades of value outperformance. Going forward it is possible that value vs. growth becomes more cyclical, where they alternate outperformance for a number of years each time. If this is indeed what the future holds, value investors, of which I count myself as, need to adjust and no longer stubbornly hold onto the ‘value investing is the best long term strategy’ mantra, but rather be flexible enough to shift portfolio allocations between the two styles.

One of the key macro-economic variables that have supported technology since 2008 has been the sluggish economic growth coupled with very low inflation and zero interest rates. In this kind of environment, the present value of discounted future cash flows of a company that is able to grow earnings above inflation (a very easy hurdle to overcome, given that 30-year inflation expectations are just 1% p.a.) become extremely valuable, easily justifying the current P/Es of around 35x that many tech companies trade at, though it may be a stretch to make this fit Tesla’s 990x P/E. Higher inflation in the short-term looks unlikely given the economy’s output gap caused by the COVID lockdowns, however, a change in inflation expectations would significantly shrink the P/E multiple of these future cash flows.

Long bull markets rarely die from exhaustion. It is far more common for the bull to end with a bang, a parabolic move up that defies expectations. This is exactly what happened in 1999 as young people quit their jobs to become day traders. While valuations are overall not as crazy as 1999, where most tech companies had no profits and hardly any revenue, only ‘eyeballs’, we see some similarities to 1999:

1999	2020
Young people quit stable jobs to make more money day-trading stocks	Robinhood provides zero cost trading, causing significant abnormalities (car-rental company Hertz issues new shares while in bankruptcy, and its stock rises from 80c to $6 in three trading days, before falling back to $1).
Tech IPOs are the new mania, frequently doubling or more on day one	Tech IPOs start again, with a number of stocks doubling on day one
Valuation are stretched and traditional metrics dismissed, such as Palm owner 3Com being worth significantly less than its holding in Palm after spinning it off in an IPO	Valuation are stretched and traditional metrics dismissed, such as Tesla and Apple gaining +50% after announcing a stock split.
Many prominent value investors throw in the towel on the strategy, either retiring, or completely reversing track and buying tech stocks, as George Soros famously did in the middle of 1999.	Growth outperforms value this year by a staggering +30% in a single year, doubling the outperformance of the previous 13 years. There is tremendous pressure on value-oriented managers by their investors to shift to growth.

There is a lesson in all this for both value and growth investors. Value investors need to become more flexible, instead of pointing to history and concluding that the future will be the same as the past. Growth investors need to beware of the risks of having their investments concentrated in tech. Amazon has become one of the biggest companies in the world in two decades, but two years after the last bubble its share price still fell -95%.

By LEONARDO DRAGO

Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.