We are now officially in a bear market, at least when it comes to US stocks, and the rout in the stock markets shows no signs of ending. Within this, the tech sector is out of favour when it comes to investors.
Put simply, rising interest rates (or the expectation of them) mean that the future profits of tech companies are discounted back at a much higher rate, resulting in a lower valuation at today’s values. Technically, that is the same for all other companies but, given the tech sector has a heavier weighting of companies which generate losses now in the hope of profits later, it has hit the sector particularly hard.
This collapse in sentiment is now starting to have real-life consequences when it comes to challenger firms, even those with multi-billion valuations and across a variety of sectors. Even the most prestigious names have been hit. Last month, ‘Buy Now Pay Later’ pioneer Klarna accounted it was cutting 10 percent of its workforce and focusing on short-term cash preservation. Used car reseller Cazoo has announced it was cutting 15 percent of its workforce and save over £200m in costs over the next 18 months.
Is this situation likely to change any time soon? The short answer is probably no. I have my doubts whether interest rates will rise as significantly as some are predicting – my view is that there are serious question marks as to how much the Western economies can take in terms of interest rate rises plus also the fact that places like China and Japan are cutting rates complicates the picture significantly. However, that is not the key issue, which is that the providers of capital, particularly in Venture Capital and Private Equity, have been spooked by the choking off of cheap stimulus money and so are likely to withhold funding.
It also means that many management teams, especially those with Private Equity or VC backers, are likely to be under intense pressure to rein back spending and focus on cash preservation. Unfortunately, there is a large degree of herd mentality behaviour when it comes to how investors view future prospects. The same firms who twelve months ago were waxing lyrical about the long-term prospects are, in many cases, scaling back their plans sharply. That doesn’t reflect a change in the long-term opportunity, more the mood music when it comes to the investing environment.
Also do not expect a recovery on valuations soon. Valuations are likely to remain muted. As I have mentioned several times in the past, the way most stocks are valued by analysts (a Discounted Cash Flow valuation) means that higher interest rates (or expectations of them) means a much lower valuation for tech firms, even with modest rate increases. The reason for this is simple: for many tech firms, which are not expected to make meaningful profits for years to come, the present value of their outer year (positive) cashflows reduce very significantly when interest rates rise.
What should managements do? I always take the view that, if a company is solid and has positive long-term fundamentals, then they should ignore the short-term fluctuations and focus on their long-term goals. In some ways, the current turmoil can be a plus as rivals pull back spending. There is also the opportunity for strategic – and opportunistic consolidation, especially for those firms with healthy balance sheets. The reduced valuations of many companies, even good ones, means that – from the long-term point of view – fortune may favour the bold.
There is, of course, one other point to make, which is more negative. What the stop of cheap money has also shown is that there were probably many companies out there who survived, not because they had good, sustainable long-term business models but because they were in the right place at the right time to benefit from investors who needed to put their capital somewhere.
Now that the tap has been turned off, suddenly questions that should have been asked before about their long-term viability are now being asked. It is hard not to think that many investors will see significant – and probably permanent – losses on their investments.
Ian Whittaker is founder and Managing Director of Liberty Sky Advisors. For further insights and articles, subscribe at www.ianwhittakermedia.com