Technology Stocks – Is there a limit to how big they can become?
11 July 2011
Like bees to honey, investors are often very captivated by technology stocks. Many large”cap tech stocks are household names, and there is much in large”cap techland for all investors (from retail to institutional). This is true whether you are a GARPy investor (AAPL – FY 2011 P/E of 14x for 71% EPS growth), a value investor (MSFT– 15% of Market Cap in Cash, 2.5% dividend yield, 2012 P/E of 9.6x) a momentum investor (AMZN ” up 100% in a year and 20% in two weeks), or if you just like catching falling knives (RIMM – down 60% in five months).
At DCM, we are particularly drawn (on the long side) to companies where our revenue or earnings estimates are markedly ahead of the street. We have this situation today in a few large cap tech names. At Apple, we see EPS in September 2012 of nearly $34.50, with the street down at $29.00. We’re 18% ahead of the street, and see 32% EPS growth for a stock that is on a P/E of 10.3x our number. At Google, costs are very difficult to model because the management (purposefully) does not smooth earnings, and periodically goes on spending binges which are difficult to predict. However, in hindsight, this spending has almost always been wise, and preceded (in fact, facilitated) revenue growth. Our 2012 revenue expectation is $700 million ahead of the street, and we see overall revenue growth of 21% next year. That gets us to $41 in EPS (also ahead of the street) and a stock that, on our number, trades at 12.9.x. Even lowly Microsoft looks interesting. As it generates over 10% of its market cap every year in free cash flow (yes, $2.5 billion per month), and net cash balances should exceed $43 billion by the end of this year. That leaves them on an ex”cash P/E of 8.6x 2011, and they will actually grow earnings by 25% this year.*
Now, depending on your investing style, you can take issue with one or two of the securities mentioned above, but you can’t disregard all three. The question you must be asking for your favourite big”cap tech stock is: “So why is this so cheap?” We’ve asked ourselves the same question. There are many potential answers, but the focus of this piece is on just one of them. Is there a limit to how large a tech company (or in fact any company) can become?
In technology, specifically, the competition is dynamic, and barriers to entry aren’t nearly as large as the regulators would have you think.** Moreover, and this might be a step too far, but is there a limit to how much market cap that tech companies can capture? Is there a limit to their share of the economy? Is there a limit on the present value of all the cash flows that the top five or ten technology stocks can generate until their demise, or is it infinite? It was Benjamin Graham who wrote “it must be remembered that the automatic or normal economic forces militate against the indefinite continuance of a given trend. Competition, regulation, the law of diminishing returns, etc., are powerful foes to unlimited expansion.” Of all industries, this maxim must be most true in the technology sector.
In the period leading to the bursting of the tech bubble in March of 2001, there was an argument that supply and demand for individual shares was impacting company valuations. This ran contrary to accepted finance theory, where the value of the firm was the value of the firm, no matter how many shares were outstanding, or in the float. Supporting the new argument was evidence that the many newly public companies would only release a few shares into the float on their IPO (potentially keeping supply low), and there was evidence of an inverse relationship between shares in the float and valuation metrics. There was also evidence that the many new IPOs sucked away potential capital from other, more established tech stocks. Thus it could be – and this is a stretch – that there is a certain amount of capital out there in the world that is earmarked for certain types of risks. In other words, it could be that there is a finite, or even defined, amount of capital that wants to own tech stocks (everything else being equal).
The NASDAQ Composite peaked at 5,048 in March of 2001, and had plummeted by 78% to just 1,114 by October of 2002 (only 19 months later). In July of 2000, just after the bubble had burst, the largest technology company in the world (by market cap) was Intel. By July of 2011, six other companies had moved ahead of Intel. In July of 2000, Sun Microsystems was ranked number 7. By December of 2009, it wasn’t even in the top 50. Apple wasn’t on the Top 10 list in July of 2000. Eleven years later it is number one. The technology sector would appear to be fairly dynamic, and technology “leaders” don’t seem to stay leaders for long. Eight out of ten leaders in 2000 either moved lower, or out, by 2011.
In July of 2000, the market cap of those top ten tech stocks was approximately $2.5 trillion (and the NASDAQ had already fallen 25%). Less than a year from the NASDAQ peak the value of the Top 10 tech stocks was already below $1.5 trillion. In April of 2001 (at month end) the total market cap of those Top 10 tech stocks was $1.4 trillion. Since then, the NASDAQ Composite index has been up 32%, and the NASDAQ 100 has been up 27%. This is where it starts to get interesting. We created an index of the ten largest global tech stocks, added their market caps, and then reconstructed/resorted this portfolio each month (125 optimisations from July 2000). We then compared the returns of this “Top 10” index to those of the NASDAQ Composite and the NASDAQ 100.
We grant that our index probably captured a survivorship bias that supported its return profile, and that there likely was some momentum bias creeping into the index since we were effectively sorting on winners over time. However, and very interestingly, this Top 10 index didn’t outperform the NASDAQ. It underperformed.
It significantly underperformed. From April of 2001 through July of 2011, the overall NASDAQ composite index rose over three times as much as our Top 10 index over the same period. How could this be?
It could be that our result is tainted by a size risk, although the survivorship and momentum biases mentioned above should have offset much of this. Or it could be that this is just a mathematical construct such that a analysis of anything would show similar results. Perhaps a resorted a portfolio of the fattest hedge fund managers would reveal less weight gain for them than the overall population of fat cats. But maybe hedge fund managers can only get so fat? Similarly, maybe there is a natural limit to the market cap that the largest technology companies can capture?
As previously mentioned, even before the lows of October of 2002, the value of the Top 10 tech names had fallen by a trillion dollars, to less than $1.5 trillion. This only took a year from the peak. Since then, the total market cap of the largest tech stocks can’t seem to sustainably press through $1.5 trillion, and it has pretty much stayed in a $1”1.5 trillion range.**** This certainly is food for thought.
And these thoughts might lead you to the present, where there appears to be at least some evidence of a tech bubble redux. It is impossible to ignore the brewing excitement over companies with “cloud” or “social” models. It might make sense that Salesforce.com trades at a 2012 P/E of 116x (pro”forma mind you, it’s 12,702x on GAAP numbers) while Apple trades at 10x. Or it might not. *****
The capital captured by these high flying stories has already has been staggering. Has this, perhaps, kept a natural lid on the valuations for companies like Microsoft, Google, or Apple? Could it be that this supply and demand effect is impacting things? If there is only so much money out there to be allocated to tech, how much of it is being captured by the “cloud” names, and how much will be captured by the “social” names. In other words, as LinkedIn has already demonstrated, and Zynga, Groupon, Twitter, Facebook and countless others hope to emulate – there is a big appetite for thematic tech stories again. Believe it or not Facebook will probably be in that Top 10 index the day they IPO. Maybe this can help us understand some of the current dynamic in the technology investing space.
Or perhaps there just aren’t more economics out there for the big guys to capture? Even if Apple is on 10x next year’s earnings, how much more room does it have to grow from its $330 billion market cap?
I wonder what the Top 10 list will look like in 2022? What names will disappear from the 2011 list? What names will be on it that we don’t even know yet?
