BAT-FANGs, TAMs and MAUs - are their valuations fair?

Advances in the internet, artificial intelligence (AI) and automation are disrupting established business models, and creating new growth markets for innovative companies. The technology sector has performed well, helped by superior growth potential and investors shifting money into the beneficiaries of structural change.

The US S&P 500 Technology Index delivered a total return of 39 per cent over the first 11 months of 2017, versus 20 per cent for the wider S&P 500. Technology has outperformed over a longer time frame also, returning 65 per cent over the past three years versus 36 per cent for the wider index. Although there’s talk of a bubble in the sector, we believe valuations are justified.

The five largest American companies are technology stocks —the FAAMGs (Facebook, Apple, Amazon, Microsoft and Google/Alphabet), a twist on ‘FANGs’ (Facebook, Amazon, Netflix and Google/Alphabet). The FAAMGs all returned between 31 per cent and 57 per cent over the first 11 months of 2017.

Global investors are increasingly familiar with a new acronym, BAT - Baidu, Alibaba and Tencent, China’s dominant internet players. China has developed strong internet champions, shielded by the effective blocking of Western internet services. Baidu has emerged as the Chinese equivalent of Google. Alibaba is a fierce competitor of Amazon, and Tencent rivals Facebook. These companies benefit from a focus on the world’s most populous nation and a benign operating environment. They have achieved their market dominance through ‘leapfrogging’. China’s middle class has grown rapidly and there has been much less development of bricks and mortar infrastructure, meaning less competition from incumbents for Alibaba in retail, and from Tencent in media and games. 

As a result, Alibaba represents more than 10 per cent of China’s total retail sales and 75 per cent of online sales, seeing annual growth of more than 50 per cent. Meanwhile, Amazon represented 38 per cent of US online sales in 2016 and only 4 per cent of total retail sales. Tencent’s Weixin social media app has far greater penetration (+90 per cent) and three times the average daily user time of Facebook, and offers more utility to its consumers, including news, games and payment applications. This means Tencent is much less reliant on advertising for its revenues, unlike Facebook and Google. The Chinese internet players are also well-established in growth areas such as cloud computing and payments, and have been acquiring a presence outside China. They are also investing heavily in AI, a key battleground for all the major global internet companies. The performance of these companies has been even stronger than their US peers in 2017. Tencent and Alibaba both achieved a total return of 100 per cent, while ‘laggard’ Baidu has returned 43 per cent. These companies now dominate their stock market, representing 34 per cent of the MSCI China Index between them, and 10.7 per cent of the wider MSCI Emerging Markets Index. This is a concerning level of index concentration, which is even more acute than in the US, where the five FAAMG stocks represent 13 per cent of the S&P 500.

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In the US and China, passive funds are exacerbating the situation because they blindly replicate the index, buying stocks when they go up and selling them when they go down. 

Sustained performance by a small group of stocks is causing concern that we might be entering another period of mania similar to the dotcom boom of the late 1990s. Notably, there has been an increase in the prevalence of financial measures used to justify valuations that we would not typically use, such as cashflow, sales and profits.

One example is TAM (total addressable market), which gives an idea of scope for revenue growth. Another is MAU (monthly active users), indicating the size of a firm’s user base, positive network effects and the potential to monetise this user base. 

While we are alert to the potential risk of an emerging bubble, these internet leaders are well-established, with attractive business models rather than just ‘hope value’, and they generate prodigious cashflow. Most have no debt and are extremely profitable. 

Second, these companies are not trading on ludicrous valuations. Amazon is an outlier trading on more than 100 times annual earnings, but this is due to its tendency to reinvest profits into new ventures. 

Typically, these companies trade on stretched but justifiable cashflow multiples and have cash surpluses. Therefore, there is some fundamental value in the sector, unlike during the dotcom boom.

For now, we are sanguine.

Sanjiv Tumkur is head of equity research at Rathbones.
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