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THIS TIME IS DIFFERENT

Is Big Tech a bubble?

A LONG-STANDING doctrine in successful investing was to buy stocks that were trading cheaply based on an objective metric (price versus book value/earnings/sales), giving you a margin of safety, and then sit back and wait for the market to realise they were undervalued. Once stocks reached 'fair value', they would be sold, realising a gain that historically outperformed markets.

This style of investing has a long history and produced many successful managers, the most famous of whom is Warren Buffett. But since the previous bull market peak in 2007, value has drastically underperformed. A portfolio's performance over the last decade can be determined by two primary factors: the level of exposure to the technology sector, and the exposure to US equities versus the rest of the world. Since most of the world's largest technology companies are in the US, exposure to the second factor also gave investors an indirect exposure to the first.

There is plenty of research showing value's long- term outperformance versus growth, and the two investing styles often run counter-cyclically to each other. Previous peaks in growth investing, such as the Nifty Fifty period in the 1960s where fifty popular large-cap growth stocks were seen as solid long-term buys that could be held 'forever' regardless of the share price (many of which have since gone bankrupt), and the Nasdaq 1999 bubble, also coincided with bottoms in value investing. The common narrative at peaks in growth investing is that 'this time it's different', that there's a fundamental change in markets that justifies higher valuations, and that this will continue indefinitely.

The question investors have to face now is whether we're in such a period. Long-suffering value investors have predicted many bottoms in growth versus value over the last few years, and they've been wrong every time. If growth already looked stretched last year, this year's Covid-19 pandemic added fuel to the fire, where high valuations looked justified as we were forced to stay at home, binging on Netflix, ordering food delivery, and even more goods from Amazon.

A number of companies this year exhibited exponential upside movements that are often seen at the end of bubbles, such as Tesla's rise after the stock split. Tesla is now the most valuable car manufacturer in the world, despite only contributing one per cent to total car production globally.

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Value investing

While no investment strategy consistently outperforms, in the past it's been easier for investors to stick to value investing. Periods of underperformance averaged around four years, compared to outperformance periods of more than a decade.

In 1999, value's historical outperformance was seriously questioned, as growth outperformed for a whole decade other than a small blip in 1992-1993. Prominent value investors like Mr Buffett were widely ridiculed as investing dinosaurs: Berkshire Hathaway lost 20 per cent in 1999, while the S&P500 gained 21 per cent, and the Nasdaq put other investments to shame, rising +102 per cent.

These figures marked the last growth bubble peak. From then to the next market peak at the end of 2007, Berkshire gained 152 per cent, the S&P500 was flat for seven years, while the Nasdaq lost 43 per cent.

Post-2007, the performance reversed again. Value stocks achieved a meagre 6 per cent annualised gain in these 13 years, the S&P500 at 9 per cent annualised, and the Nasdaq again trounced its competition for a 16 per cent annualised return, for a total gain of +550 per cent. Non US-equities fared worst of all, with many indices still near 2007 levels, for no returns.

The current growth outperformance versus value has been both the longest and biggest in history. Most telling, half of the whole 13 years of outperformance happened this year alone.

All this has led many investors to question whether value investing still works, or whether we are entering a new permanent era of growth and technology outperformance, led by a fundamental change in the way we live our lives.

In trying to answer this question, there is a case to be made that the long-term value outperformance may be gone for good, as technology starts to permeate other industries. After all, Amazon is an alternative to bricks-and-mortar shops with better inventory, lower prices, and a super-efficient logistics system. Google is essentially an advertising company.

A long-term chart of value versus growth shows that the current growth outperformance has led the ratio back to the 1975 level, erasing four decades of value outperformance. Going forward it is possible that value versus growth becomes more cyclical, where they alternate outperformance for a number of years each time. If this is indeed what the future holds, value investors, among whom I count myself, need to adjust and not stubbornly hold onto the 'value investing is the best long-term strategy' mantra, but rather be flexible enough to shift portfolio allocations between the two styles.

One of the key macro-economic variables that has supported technology since 2008 has been the sluggish economic growth coupled with very low inflation and zero interest rates. In this kind of environment, the present value of discounted future cashflows of a company that is able to grow earnings above inflation (a very easy hurdle to overcome, given that 30-year inflation expectations are just one per cent per annum) becomes extremely valuable, easily justifying the current P/Es of around 35x that many tech companies trade at, though it may be a stretch to make this fit Tesla's 990x P/E.

Higher inflation in the short-term looks unlikely given the economy's output gap caused by the Covid-19 lockdowns. However a change in inflation expectations would significantly shrink the P/E multiple of these future cashflows.

1999 again?

Long bull markets rarely die from exhaustion. It is far more common for the bull to end with a bang, a parabolic move up that defies expectations. This is exactly what happened in 1999 as young people quit their jobs to become day traders.

While valuations are overall not as crazy as 1999, when most tech companies had no profits and hardly any revenue, only 'eyeballs', we see some similarities to 1999. (Refer to graphic)

There is a lesson in all this for both value and growth investors. Value investors need to become more flexible, instead of pointing to history and concluding that the future will be the same as the past.

Growth investors need to beware of the risks of having their investments concentrated in tech. Amazon has become one of the biggest companies in the world in two decades, but two years after the last bubble its share price still fell 95 per cent.

  • The writer is co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund-management services to endowments and family offices, and wealth-advisory services.

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