The turbulence seen on the stock markets over the past few months have perhaps been somewhat inevitable, given current global events. But do the steep drops in tech stocks simply represent a par-for-the-course correction, or a more fundamental shift?
In his monthly article for VideoWeek, analyst Ian Whittaker explores how the wheat is being separated from the chaff, and suggests which sorts of businesses are best positioned to survive, and even thrive.
The stock markets are going through one of their typical panic phases, and it is hard to find a sector that has been more heavily impacted than the tech space. As of writing, the tech-heavy Nasdaq is down over 15 percent compared with a year ago vs the wider S&P 500 index (covering all sectors), which is down under 6 percent.
While the second/third tier tech names have been the hardest hit, even the giants such as Alphabet (Google) and Amazon have been caught up in the storm. It is not just the US players that have been impacted; the Chinese giants of Baidu, Alibaba and Tencent (or BAT as they are often called by investors) have also been pummelled, with fears over wider growth prospects mixed in with concern over what the Chinese Government will do next.
This volatility is nothing new, and it could be deemed a necessary correction given the exuberance in the markets 12 months ago, when high valuations in the tech names were more than justified because the future just looked so good. SPACs (remember them?), NFTs and cryptocurrency were all further examples of assets that investors rushed into, convinced there was only one direction of trend, even if the road along the way might be bumpy.
The key question now is whether this is one of these blips (although a major one) or if it represents something more fundamental happening. There has been a marked increase recently of people suggesting we are back to the days of 2000 and the collapse of the dot.com bubble. Meanwhile a growing chorus are claiming that the supply of cheap money – fuelled by Central Banks pumping it into the system as a reaction to the pandemic – led to companies and sectors being created that, in normal times, would not have passed scrutiny. It feels almost inevitable that there will be some high-profile casualties from the stock market rout.
One argument suggesting there is something more fundamental happening is the marked change in expectations on interest rates. Technology names are particularly vulnerable to increases in interest rates, as their valuations are derived from long-term profits. A rise in interest rates and/or assumptions significantly cuts the present value of those future cash flows.
The days of ultra-low interest rates certainly look over for now, which will have major implications for the funding of the tech space. My personal view is that it is unlikely interest rates will go up to the levels of 4-5 percent (I would be surprised if they got past 3 percent) but even such relatively modest rises will change the investment environment.
Putting aside interest rates, a more important question is whether a business (or sector) is fundamentally sound or not, and it is this that will determine which firms will survive (and thrive) and which will fail. It is true that some good firms can fall victim to unfortunate circumstances and run out of cash just when they were about to show the promise of their product. However, the current market rout is likely to expose names where the fundamentals are not as strong as were once perceived.
Those who heard me speak at the recent (and excellent) New Video Frontiers conference would have heard me mention Netflix as a company that faces fundamental problems. Reed Hastings and his team have done a brilliant job in creating a global streaming platform and reshaping both the pay TV and direct-to-consumer markets when it comes to content. However, there is no doubt in my mind that they are facing very significant headwinds that will be difficult to overcome – especially as competitors have far greater cash flows to finance the struggle. It is unlikely this will change.
The ad/mar-tech space is another area where there are growing concerns in the markets on the long-term potential for growth. The privacy changes driven by Apple, the elimination of cookies and the growing rise of multiple walled gardens – as advertisers see data as a strategic resource to be mined and monetised – is raising in investors’ minds fears that the space is about to be squeezed out of existence. If the sector is to recover favour in investors’ eyes, it needs to come up with a new story that changes sentiment fundamentally. Right now, the markets view ad/mar-tech as (generally) areas that face a strong risk of being disintermediated over time.
The underlying message is that the world has fundamentally changed and we are likely at the start, not the end, of several major global strategic shifts – not least the likely reversal of at least some of the globalisation trends of the last two to three decades. That will impact tech and, while I certainly do not think we are back to the days of 2000 and the dot.com bubble, many areas will see much sorting of the wheat from the chaff. As should be obvious, the key is to be on the right side of the equation.
As usual, this is not investment advice.
