Obviously, regulatory risk has grabbed the spotlight in tech of late.
I’ve written so much about this over the past two months I’m having a hard time going back and digging up all of the posts, but here are a couple of notables, with the last one documenting the bloodbath that unfolded in the sector on March 27:
- ‘Maybe There Isn’t A Big Tail Risk’ In Tech (?)
- Amazon, Tesla, Facebook And Investing In ‘The Future’
- The Day The Robots Died
This debate is obviously crucial for the market going forward. Everyone is acutely aware of how important it is for tech high-fliers to avoid an Icarus moment until we finally see the fabled “rotation” back into value or, more simply, until another sector proves it’s capable of taking the baton in this aging bull market.
And I mean look, usually by the weekend I’m running low on patience and my sense of humor has been slowly beaten into submission by the manic news cycle, so allow me to just to say in a very dispassionate way that investing is not as simple as saying “this is what people seem to like now in terms of gadgets and websites, so I’ll just buy those stocks and nothing could possibly go wrong.” Remember, there was a time when people couldn’t pry themselves away from their BlackBerries. So you know, anyone offering to invest your money for you based on a “strategy” that involves uncritically buying FAAMG is either a charlatan, a moron, or more likely, both.
Over the past month, we’ve seen what can go wrong with these companies. The bottom line is this: shit happens, homie. And it’s not always fair.
It’s not at all desirable, for instance, for the President of the United States to be bullying Amazon around on Twitter. But look, if it wasn’t Trump it was going to be someone else because as I explained last month, anyone who thinks Jeff Bezos is going to be able to keep doing what he’s doing without hitting a bunch of roadblocks along the way is delusional:
It was (and is) ridiculous to assume that we’re going to simply transition seamlessly to a world where Jeff Bezos serves your healthcare needs, provides you with retail banking services, gets you a mortgage, sells you drugs covered by the health insurance he also sold you, and delivers those drugs to your home that he owns the mortgage on via a drone that was activated by his female alter ego “who” now giggles at you for no reason.
Regular readers know I think Trump’s attempts to intervene in Amazon’s business represent an egregious abuse of power and betray a rather alarming penchant for childishness and jealousy on the part of a sitting President. But that’s not the point here. The point is, eventually Bezos is going to start running into pretty high hurdles on his quest for world domination. He’ll probably clear them, but they’ll pop up.
Same thing with Facebook. The chickens have come home to roost. You can’t expect lawmakers to sit idly by as the democratic process in America is hijacked via a platform that, seemingly by virtue of the founder’s naïvety, was used by foreign intelligence services to rig a goddamn Presidential election. And I know what you’re thinking with that: “well, how could an investor have seen that coming?” My answer would be: “have you ever been on Facebook?” I mean, anyone could have seen that coming. Just like anyone with a shred of common sense knows that Elon Musk’s ongoing effort to take over outer space and usher in the era of autonomous cars isn’t going to play out without some folks getting accidentally killed along the way.
None of the above is to say that these companies won’t ultimately dominate the future – it’s just to say that if you think that’s going to be smooth sailing all day, everyday, you’ve got another thing coming as an investor.
Ok, so that brings me to a new note out from Goldman that finds the bank summarizing recent developments on the tech frontier and talking about about what the reconstitution of the tech sector is likely to mean.
At issue here is the notion that when economic growth can be defined as “modest” (as opposed to “tremendous”, I guess), growth tends to outperform and as you’re well aware, nothing is more closely associated with “growth” than tech.
“The sector is currently forecast to have among the fastest annual growth in sales and earnings during the next two years [as] consensus forecasts sales growth of 15% and 7% for 2018 and 2019 vs. 6% and 5% for the balance of the S&P 500 ex. Energy,” Goldman writes, in a note dated Friday, before adding that “consensus bottom-up EPS growth is also strong: 17% and 9% for Tech vs. 17% and 8% for S&P 500.”
But, as the bank goes on to warn, “two important forces are disrupting how investors view the Information Technology sector: Regulation and re-classification.”
Here are some excerpts from the bank’s discussion of regulation:
The risk of future regulation threatens the long-term growth prospects of some Tech companies. The Zuckerberg hearing revealed to many government officials the scale of personal data that FB users had agreed to allow the firm to gather, raising regulatory risks. On the same day in Washington, D.C. Goldman Sachs equity research analysts hosted discussions with policy experts regarding Technology regulations. Comprehensive data privacy legislation in the US is viewed as unlikely this year. However, investors should expect regulation through other channels, such as State Attorneys General or self-regulation.
Goldman Sachs’ lead analyst for the Software industry and select internet companies, this week published a report gauging the potential impact of Europe’s General Data Protection Regulation (GDPR) which takes effect on May 25. The report shows the advertising revenue sensitivity to changes in pricing and impression trends. FB could potentially see revenue fall by up to 7%, although the impact could be negated if it obtains user consent for processing personal data. GOOGL’s net ad sales could witness a -2% to 0% impact from GDPR given our view that Search is largely protected as it relies less on user data to generate advertisements. For context, GS forecasts FB will grow sales by 35% in 2018 (to $55 billion) with a 38% net margin while GOOGL will grow sales by 21% (to $134 billion) with a net margin of 23%.
Meanwhile, the re-classification event has very real implications for investors (I mean, I hope that’s obvious, but just in case…). As Goldman reminds you, “in September, the major index providers MSCI and Standard & Poor’s will re-categorize components of the global equity markets [and] using the S&P 500 index as an example, five current constituents (GOOGL, FB, EA, ATVI, TTWO) comprising nearly 20% of the existing Information Technology sector will be re-classified into Communication Services.”
What’s left in tech (Goldman calls it “legacy tech”) isn’t going to look as great for investors seeking exposure to growth, but it will likely have more attractive valuations. To wit:
The future “legacy Tech” sector has expected 2018 and 2019 sales growth of 9% and 5% and margins of 22% and 23%. However, the “legacy” Tech sector trades at a lower valuation (EV/sales of 3.9x and P/E of 17.5x) compared with existing Tech (4.0x, 18.4x), and the remaining stocks in the S&P 500 (1.8x, 16.4x). The firms at the top of the Info Tech sector will also change. The largest stocks in the “legacy” Tech sector will be AAPL (19% of sector), MSFT (16%), and INTC (5%), each of which has lower earnings growth but lower valuations, a higher shareholder yield, and less regulatory risk than the departing firms.
So who cares? Well, you do. Because to the extent this entire thing is propped up on tech (and look, it’s clearly an overstatement to say “it all depends on tech” or that “without tech it all falls apart”, but you know just as well as I do that if tech takes a dive, it doesn’t bode particularly well for the broad market and it also has spillover potential to Hong Kong, South Korea, etc.), then as someone who likes to pretend you’re informed, you need to make yourself aware of everything said above.