Mini bubbles are occuring all the time in tech, but it is vital not to confuse unicorns with the whole sector, says William de Gale.
The chart below frightens people: after such sustained performance, is the tech sector about to collapse? I am regularly asked “Aren’t we in another tech bubble?”
At any moment, there are always bubbles in tech, and they tend to be centred on businesses that are new and experiencing explosive revenue growth because they are creating a lot of value for customers.
Such companies may temporarily have huge valuations, but they often have little realistic chance of ever achieving healthy profitability, and thus, in the end, they are worth little or nothing.
In my opinion, many of the current herd of unicorns fall into this category: the excess capital that swamped private equity markets from 2011 encouraged managements to focus entirely on growth, without any need to worry about cash flow or profitability.
Any spending that accelerated growth was good, even if it made no economic sense, and all thoughts of profitability were expected to wait until market dominance was achieved. However, market dominance is a lot easier on a whiteboard than in real life.
Such mini-bubbles are taking place the whole time in tech, to a greater or lesser extent, but only once in my investment career has this developed into a situation where almost all tech stocks were subject to bubble valuations. This was in 1998 to 2000, triggered by a complete reconfiguration of the industry as a result of the development of the internet.
This is unlikely to be repeated in the next decade: the tech bubble and its collapse were the formative experience of the current generation of senior equity portfolio managers, which is why Uber, WeWork and other profitless unicorns have failed to attract the huge investments from US long-only funds that are required to support a $50 billion (£42 billion) valuation in public markets.
The current decision-makers for the largest pools of money will not invest in a business with no plausible route to decent profitability, whatever the current growth rate – they have seen first-hand where that path leads. The current unicorn mini-bubble may now be deflating as a result, as a wave of West Coast hope breaks on a wall of East Coast scepticism.
However, it is important not to confuse the unicorns with tech: they are completely unrepresentative of the information technology sector as a whole, which has been experiencing strong, profitable growth for a decade. Earnings have grown with share prices, and valuations of good businesses remain reasonable.
This isn’t a second tech bubble: the reason that the tech sector has been outperforming the market so consistently for so long is that it accounts for almost 100% of the entire market’s earnings growth and we argue that this monopoly of profit growth largely results from the fundamental change in technology that we identify as the direct connection of systems to the real world, which really got going about 10 to 15 years ago.
This phenomenon seems likely to continue for many more years, as the explosion of the myriad applications enabled by direct connection has only started. The IT sector should therefore dominate market growth for years to come, and thus continue to outperform.
Technology is no longer an industry vertical – IT is now an economic horizontal, its application determining success in every other sector, and thus it is sucking all growth out of the rest of the market as businesses are forced to spend their excess returns keeping up with technology, rather than investing in their own growth.
But I must stop and check myself: could I be blinded by this opportunity and might I therefore have missed the steady inflation of valuations to unreasonable levels?
Let’s have a look at valuations for the sort of stocks that we like to hold: the fund’s typical holdings have mid-teens or higher EPS growth, an average GAAP RoE of about 20% and substantial barriers to entry. These are high-quality, extremely profitable growth businesses, creating plenty of value for outside shareholders. And yet the weighted average forward P/E of stocks in the BlueBox Global Technology Fund today is still only 25.
That’s pretty much where it has been for years. These stocks are outperforming the equity market not because valuations are rising, but because their earnings are outgrowing everything else. And this isn’t about to stop.
William de Gale is lead portfolio manager at BlueBox Global Technology Fund.