A Blog by Jonathan Low


Dec 18, 2018

The Reason Tech Stocks Should Not Move Together

Could it be that both the dramatic increase in the equity markets over the past year - and their equally precipitous decline - is due to a destructive and inaccurate obsession with the similarities of the tech companies that have dominated those markets - rather than effectively assessing their differences? JL

Jeff Sommer reports in the New York Times:

All big companies today are tech companies. In late 2018, using advanced technology isn’t a distinguishing characteristic. “What we call ‘tech companies’ includes a broad range of companies at different stages of maturity. The aging process for tech companies, which usually start out as high-growth companies, is rapid." The differences between tech companies tend to be more important than the similarities. When it comes to assessing what individual companies are worth, treating tech stocks as homogeneous is a  mistake. It is sloppy thinking that leads to wacky share valuations and an inefficient, vulnerable market.
The stock market often acts as though tech stocks were members of a close-knit family that must always travel together.
Tech stocks, as a group, drove the stock market higher in the first part of 2018, and led the entire market lower this autumn, or so it is frequently said. I’ve lumped tech stocks together this way myself in describing market action recently and as far back as the early 2000s.
Talking about tech as if it were a monolith isn’t entirely wrong. Tech stocks often do move in a pack — mainly because investors frequently treat them as a cohesive entity.
But when it comes to assessing what individual companies are really worth, treating tech stocks as a homogeneous group is a major mistake, says Aswath Damodaran, a New York University finance professor. It is a form of sloppy thinking that leads to wacky share valuations and an inefficient and vulnerable market. As he has written in his provocative blog, the differences between tech companies tend to be more important than the similarities.

Facebook, Amazon, Apple, Netflix and Google were joined together under the acronym Faang when they accounted for much of the market’s rise. But they are not remotely the same in organization, focus or business model, nor are older companies like Microsoft, IBM, Intel, HP and Cisco.
“What we call ‘tech companies’ really includes a broad range of companies that are at different stages of maturity,” Professor Damodaran said in an interview. “The aging process for tech companies — which usually start out as high-growth companies — is very rapid.
“Also, some companies are more tech at their core. Some are less tech,” he added. “We should be looking at companies along a kind of a spectrum, along at least two dimensions.”
The problem, then, is twofold.
■ First, Professor Damodaran said, “tech companies live in dog years.” They have accelerated life cycles and behave differently as children and mature adults. A young money-burning company like Tesla and an old cash-generating company like IBM need to be evaluated with different metrics.
■ Second, tech has become ubiquitous. “Nearly all big companies today are tech companies, at least to some degree,” he said. In late 2018, simply using advanced technology isn’t a distinguishing characteristic.
Even the newspaper industry — which used linotype machines and pneumatic tubes when I started as a copy boy in the 20th century — has a lot in common with tech companies. Like Netflix and Spotify, for example, The New York Times and The Washington Post use streaming technology and data analysis to feed information and entertainment to growing armies of digital subscribers.
“On the day that, say, 60 percent of profits and revenues come from digital sources, do we reclassify these companies as tech companies?” Professor Damodaran asked.
Similarly, he compared Tesla, which makes electric cars and is widely viewed as a tech company, with Ford and General Motors. Should Ford and G.M. be categorized as tech companies, too, when the bulk of their revenue eventually derives from electric vehicles?
He is not suggesting that every company will need to be called a tech company. Perhaps none of them should. But, certainly, we should be more careful about describing — and valuing — those that now seem pre-eminently in the tech mold.
Tesla and IBM are at two ends of what Professor Damodaran calls the tech company life cycle.
As an infant company, Tesla poses a valuation challenge. Assessing the value of a stock typically starts with an assessment of earnings and cash flow, but that requires imagination with Tesla because it churns out annual losses, not earnings. Yet investors in the stock market collectively say Tesla is worth about $60 billion, more than G.M. or Ford, which make profits.
Will Tesla become profitable enough to justify its current price? Professor Damodaran believes its shares are grossly overvalued. “But it’s hard to know with a young company,” he conceded, adding that Tesla is “a risky proposition but not an impossible one.”
Old profitable companies like IBM are easier to value. The stock market says it is worth about $110 billion, based on a price-to-earnings ratio of 8.4. That ratio is less than half the level at which the average stock trades, presumably because IBM hasn’t been growing rapidly and, by some metrics, has been shrinking.
There is risk in buying these shares, too, but of a different sort. It’s paramount for an older company to generate cash at a reasonable share price, and trying to “reinvent a company like IBM” — and shift it into a high-growth mode with big acquisitions like IBM’s planned $34 billion purchase of Red Hat — could be a dangerous waste of cash, Professor Damodaran said.
“An old company can’t run as fast as a young company can, and usually it shouldn’t try,” he said.
There are exceptions, though. In Professor Damodaran’s typology, Apple and Microsoft are ancient but have experienced rejuvenation, Microsoft most recently with the strategic turn to cloud computing taken by its chief executive, Satya Nadella. Apple had a second life with the return of Steve Jobs in 1997 and the subsequent births of the iPod and iPhone — though Apple is looking its age now, Professor Damodaran said. Both companies generate enormous amounts of cash, he said, and so can be valued with traditional stock analysis.
Sober analysis is critical to market health. Consider the damage done by bouts of magical thinking about the value of tech stocks.
In March 2000, for example, at the height of the dot-com bubble, the market gave Cisco Systems a value topping $500 billion, briefly making it the world’s most valuable company.
In a misjudgment of stupendous proportions, investors gave Cisco a greater value than 24 big companies combined — including Apple, Ford, J. P. Morgan, Anheuser-Busch, McDonald’s, Staples and Texaco.
What were people thinking? Apparently, that Cisco was worth an astronomical price-to-earnings ratio of 196.2 because it would grow at a breathtaking pace forever and become the beating heart of a transformed economy. That vision was revealed to be hallucinatory when the dot-com bubble burst. Today, Cisco trades at a price-to-earnings ratio of about 19.3.
While valuations are generally more subdued today, imprecise thinking about tech stocks abides, with troubling implications.
Amazon, for example, trades at a price-to-earnings ratio of 109 — more than five times the valuation of the average stock. That has given its shareholders, including its founder, Jeff Bezos, astonishing wealth. It has allowed the company, which is old in tech years, to behave like an upstart, Professor Damodaran said, plowing profits into new businesses and disrupting entire industries.
Investors have chosen to believe that, at some point, Amazon will raise prices sufficiently to reap big profits. Yet with higher prices, it could not constitute as much of a threat to competitors and might not grow rapidly. Like Tesla, Amazon’s business model raises this question: Can the company ever earn enough to justify the share price it still commands? I asked the same question recently about Netflix, and could pose similar queries about other high-flying stocks.
The answers should be different in each case, because tech stocks really aren’t the same. One day, grouping them together is likely to seem quaint and, possibly, dangerous.


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