Technology Weakness - Transient or the Beginning of an Unwind
Results Have Been Strong for the ‘Disruption’ Giants
We’ve clearly seen a strong period for the IT and e-commerce sector over the past 18 months especially from some index heavyweights. While it’s highly unusual to see companies the size of Facebook, Microsoft, Alphabet and Amazon deliver returns at such high levels, despite this theoretical headwind, they have delivered spectacular corporate results, which has in turn driven share prices meaningfully upwards1.
While strong stock price movements have added to the concern of some investors that ‘disruptive IT’ is not a durable way to generate returns, Facebook delivering rising sales, earnings and cashflow above 20% p.a. in recent quarters gives some indication that strength in certain IT stocks hasn’t been based on a 2000’s style bubble and the ‘hope’ of monetisation. Instead, many stock prices have been moved by the evolution of the Internet, growing penetration of mobile devices and platforms driving monetisation from shifting consumption and user preferences.
Success Has Led to More Crowded Exposure
However, in tandem with concerns that the global economy is plateauing, the organic growth profile of many of these disruptive stocks has made them crowded.
The surprise element unpriced into many high-growth companies 18 months ago (when markets were focused on the cyclical-value rally driven by Donald Trump’s election success) has also faded to leave higher valuations and expectations. With this backdrop and with Q2 ‘misses’ for Facebook and Netflix (two high profile IT bellwethers), some re-positioning by investors out of stocks that have become broadly owned is understandable. This is what we’ve seen in the second half of July as IT, and growth more broadly, underperformed.
This Doesn’t Feel Like a Broad-based ‘Tech’ Bubble
As we think about how sentiment may impact stock prices near term, one key question today concerns whether our holdings in IT are trading at extreme valuations given the growth potential? While valuations have clearly risen, we believe the answer is no. Despite this, some near-term patience may be required after the spectacular gains of recent quarters, and we have been working hard to adjust position sizes for stock-specific risks, including those centred on valuations.
The central question to stock-specific ownership is whether our holdings are on the right side of long-term changes in spending, consumption and user trends and whether the companies can capture this advantage in profit terms over the medium to long term. The investment thesis at initiation for each stock we own, centres on the durability of the business economics and the quality of the product driving growth in monetisation and profitability terms. This provides a strong platform for compounded returns, but only if we are right in our insights and we pay a reasonable valuation.
Is This the Beginning of the Long Awaited ‘Value’ Rally?
Neither of the above will necessarily defend individual stock prices in the near term if investors choose to reposition aggressively. How the recent sell-off evolves is dependent on multiple dimensions, but important considerations are 1) the alternative use of capital, given the long-term growth potential of the global economy remains muted and growth therefore remains a scarce commodity 2) corporate guidance through the remainder of the earnings season by companies in and outside of the technology sector. If we see further misses in IT and strength elsewhere, this may force further short-term repositioning.
The durability of earnings growth over the next 12-24 months is key however and we still find more ideas in IT and other disruptive industries than elsewhere, including deep cyclicals.
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While commentary is growing with respect to whether a Value era might develop from this recent sell-off, this commentary often sits within a broader perspective of rising investor caution, especially following the IT sector experiencing a mixed earnings season. This is hard to envision however, given Value usually has more ‘power’ in periods of greater risk tolerance. If caution grows because investors perceive that risks are rising, buying cheaper cyclicals remains counter-intuitive, to us at least. The thesis may be that ‘Value’ could outperform because ‘Growth’ is expensive and ‘Growth’ will therefore fall further, but we are happy to contend this point given our bottom-up perspective on the stocks we own.
The FAANGs Are Not Homogenous
To conclude, we are not defensive or applying extreme caution at this point, but we are not blind to the top-down risks (trade war, politics and the growing inequality imbalance) or bottom-up risks (valuations, regulation, cost inflation and management execution) that are evolving deep into an equity cycle. The key to long-term success inside and outside of IT remains stock picking and owning those companies that are genuine long-term top performers and avoiding those companies on the wrong side of change.
The market often doesn’t care about differentiation at certain points in time, specifically as momentum builds to high levels, as we have seen at times this year. Equally, headline driven market corrections tend to clear out a degree of investor capital that is anchored on short-term data, especially in this era where heightened quantitative trading around volatility has grown.
Ultimately, the nature of the 'Disruption giants' is embedded in singular and idiosyncratic characteristics and investors should treat them as such. While the market may disagree and continue to pressure ‘the FAANGs’ (Facebook, Amazon, Apple, Netflix, Google), we’ll stay focused on the medium and long-term fundamentals of each stock.
Above all, we tend to find that headline driven sell-offs are helpful with respect to upgrading our portfolios and we’ll obviously look to do this where appropriate, albeit with selectivity and gentle contrarianism at the heart of our stock specific actions.
While we expect a period of slower growth in coming quarters for the company (Facebook has some heightened expense related to addressing privacy concerns, some FX earnings headwinds, and is pursuing its “Story” engagement strategy, which currently has lower levels of monetisation), we remain optimistic on its longer-term outlook. The company continues to disrupt print media advertising revenues via its platform and advertisers’ feedback describing their experience on Facebook is universally positive. That’s important, because it means the recent slowdown isn’t due to advertisers no longer finding value in spending more money on Facebook.
Currently, the firm generates the bulk of its advertising revenue through news feed posts, but management expects that its Stories format will surpass news feed posts by next year. More importantly from a growth perspective, Stories are growing much faster than news feed posts. We think Stories (and potentially video as well) will be a bigger growth driver for Facebook than the news feed has been. The Story ads provide a better experience for both the user, and especially the advertiser, than a news feed ad. All of the data and targeting that Facebook has used to drive the effectiveness of news feed ads will be at its disposal on Story Ads and we think it is largely a matter of building the products and driving advertiser adoption. While adding uncertainty near term, we have confidence this will happen, though it will take time to execute. It is also worth noting that Stories live in all of Facebook’s properties, including Messenger and WhatsApp, both of which have more than one billion users. We think Stories provides Facebook a tremendous amount of raw material to work with and greatly increases its ceiling in terms of future revenue generation.
While the market has reacted to the uncertainty of change and downward pressure on profits, we would point out that “slower growth” for Facebook is still very strong growth. The real reset for the stock is because management guided EBIT margins over the next two years to mid-thirty percent levels from current mid-forty percent levels. We believe they are being conservative.
While we can’t comment on trading activity intra-quarter, we believe the current valuation is justified by our growth outlook going forward.
1The views and opinions are as of 31st July 2018.
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