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A Big Tech bubble in the making?

 

17 August 2020

Investment

 

 

In this Investment Spotlight, ANZ Private Banking & Advice Equities Portfolio Manager, Samantha Chien, provides her opinion on the risks and opportunities surrounding these Big Tech firms.

Amid the COVID-19 induced global equity market downturn, some technology companies - Microsoft, Amazon, Apple, Google (Alphabet) and Facebook - have bucked the trend. They have become more valuable - share prices have increased and more people now use their products. Some even argue the current crisis has exacerbated the integration of technology into our lives.

History repeating?

Historically, economies have dealt with industries and companies considered too big to fail. From the pre-global financial crisis (GFC) dominance of the financial sector to the fall of the world’s largest carmaker General Motors in 2009, history has repeatedly shown that large companies are not immune from falls.

While the spectre of the GFC may have faded after 10 years, today we face a new group of information technology entrepreneurs who seem bent on disrupting the world. In a 2012 letter to potential investors ahead of their initial public offering, Mark Zuckerberg, CEO of Facebook, summed up the Silicon Valley ethos by stating Facebook’s then motto, “move fast and break things”.

From its humble beginnings in a college dorm room, Facebook has morphed into a global giant with millions of users on its social media platform.

Facebook, along with other American technology companies - Amazon, Apple, Google (Alphabet) and Microsoft - are now collectively known as “Big Tech”.

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Massive growth through acquisition

Big Tech have consistently expanded their reach and clout through acquisition and consolidation of businesses. Between 2001 and 2019 Facebook acquired and consolidated 90 companies. Google bought and folded 270 companies under its umbrella (chart below).

Source: The New York Times (Tim Wu), ANZ Private Bank, June 2019

Expanding reach beyond technology

While most of the Big Tech companies started with a strong IT focus, they have now expanded beyond their initial business model.

  • Amazon has moved beyond being a retail sales platform to providing cloud computing services to the US government and other large institutional clients. It also now manufactures its own products for sale through the Amazon platform.
  • Apple has joined the electronic payments sector through Apple Pay. Its recent partnership with Goldman Sachs saw the launch of the Apple credit card, which lent more than US$10 billion to customers within two months of its August 2019 launch.
  • Google now generates a large part of its revenue from advertising, unlike its original business as a search engine.
  • Facebook has transformed itself from a retail social media channel to a major advertising platform for small and big business alike.
  • Microsoft’s cloud-computing business now delivers substantial revenue to what was once a company known for its desktop computing software.

Big Tech’s massive valuation

These expansions and acquisitions, have played a significant part in Big Tech almost doubling their weight in the MSCI World Index. With individual market capitalisations of between US$600 billion and $1.6 trillion (chart below), these five companies now dominate the top spots in global equity indices.

 

 

msci
Top 5 names in MSCI World Index Index Weight (%) Market Cap (US$ billion) Last 12 months P/E Last 12 months EPS ($) EPS Growth (%) Div Yield (%) 2019 Return (%) YTD Return (%) YTD Return relative to MSCI World (%)
Microsoft Corp 3.44 1,577 37x 5.67 0.37 0.97 55.3 32.1 34.6
Apple Inc 3.92 1,545 30x 12.75 -2.57 0.83 86.2 32.2 34.7
Amazon.com 2.92 1,377 147x 20.93 60.48 0.00 23.0 66.9 69.4
Facebook 1.32 970 29x 8.23 -0.28 0.00 56.6 16.8 19.3
Alphabet Inc 1.06 647 31x 48.64 7.45 0.00 28.2 13.5 16.1
MSCI World     23x 102.03 -5.7 2.14 25.2 -2.5  

 

Data: Bloomberg, FactSet, 30 June 2020

Is Big Tech in bubble territory?

Asset bubbles in the stock market occur when share prices decouple from fundamentals - usually based on investor over exuberance and incorrect market assumptions.

Extended periods of inflated prices can lead to a misallocation of capital resources as investors chase higher and higher prices. But when asset prices revert to levels based on fundamentals - the bubble bursts. With a combined value of over US$5 trillion, Big Tech make up almost a fifth of the value of the US S&P 500.

Pundits argue technology penetration remains small in the US and globally, a point outlined in the Economist in February this year, which highlighted only 10 per cent of online retail sales were from the West. In that regard, it can be argued that there may be more room for Big Tech to grow and as such, their valuations could well be justified.

What’s driving Big Tech’s valuation?

The extensive reach of these Big Tech businesses means they are able to leverage growth synergies of their multi-unit businesses.

Furthermore, for the Big Tech companies whose revenue is derived primarily from advertising, their cost of capital may be significantly lower than traditional asset-dependent companies. As these Big Tech companies can target advertising from the collection of data, based upon consumption habits freely volunteered by the public, it allows them to enjoy outsized profits relative to their cost.

Given the millions of users who use products owned by Big Tech, there are indications these companies should stand to benefit from greater economies of scale as they continue to expand in size.

Another factor that boosts Big Tech’s growth is their high cash flow/asset light model, which, when combined with the intangible nature of internet services and cross-border jurisdictions, provides a mechanism to minimise tax by shifting profits between countries.

Big Tech’s valuations suggest a belief that their profit may continue to rise sharply into the next decade in a benign regulatory environment.

Big Tech now appears to the market to be a reasonable place for investors to park their cash.

If all is well, what could go wrong?

Before the bubble burst during the GFC, the finance sector enjoyed considerable support from investors, providing similarities to Big Tech now. At that time, the financial sector was seen as a critical and profitable sector of the economy. And it grew in complexity and reach, until its growth was no longer sustainable.

In the case of Big Tech, the extent to which they have embedded themselves into society is best seen during the current COVID-19 crisis.

The use of platforms (such as search engines, social media and video conferencing) and the auxiliary services built into the platforms (such as payment services) could cause significant disruptions if withdrawn suddenly and unexpectedly.

The integration of Big Tech into multiple layers of the economy and our lives juxtaposes with the opacity of these platforms’ algorithms.

The black-box nature of these platforms, when applied at enormous scale could extend remarkable influence over the economy. Facebook’s failure to adequately safeguard personal information, and appropriately disclose how personal information could be obtained by others - as highlighted by the Cambridge Analytica data leak back in 2018 - is an example of how important data protection is for Big Tech.

Furthermore, Big Tech firms have been known to use different tax systems to substantially reduce their tax bills. A recent settlement between the Australian Taxation Office and Google for an additional ~$500 million in taxes, highlights the increasing attention Big Tech is attracting from regulators, and the political pressure being mounted to close potential tax minimisation strategies.

Too big to fail?

Tim Wu, American professor and author of the book “The Curse of Bigness”, argues the high valuation of these companies exemplifies the consolidation of wealth amongst the top firms at the expense of others.

The issue of complexity and concentration in a few companies, which are highly embedded in society, highlights another dimension of risk for global economies - the potential of Big Tech becoming the new wave of mega-corporations that are too big to fail.

The moral hazard of firms, considered too big to fail, is the implied government insurance policy that may embolden a corporation to take increased risks, which then poses further risk to the intricate economic balance of our society.

In this scenario, governments may have to step in to bail out a failing corporation because of the systemic nature of their operations.

The role of regulation

To avoid this kind of worst case scenario, regulation can be an effective tool to maintain financial stability in the economy.

Anti-trust and monopoly issues have already gained attention from regulators and politicians abroad, trying to prevent Big Tech from unfairly capitalising on their monopolistic advantages.

European anti-trust law has already applied this standard to Google and fined them for favouring Google’s own content in web searches.

US senator Elizabeth Warren even advocated a break up of Big Tech businesses. While such measures may seem extreme, it also has the potential to shake up a stagnant sector and inspire new competitive entrants.

Furthermore, as highlighted by the current COVID-19 crisis, political leaders have addressed the public on health safety measures via Facebook and WhatsApp. The evolving role of Big Tech could see them becoming viewed as a public utility, and consequently being regulated like one, similar to electricity providers and water companies.

While this scenario is not certain or may still be some time away, Big Tech has no doubt penetrated a larger part of the economy and our lives than we had once imagined.

In summary

As global economies restructure following the COVID-19 crisis, there are many opportunities ahead for technology companies - however risks exist which investors should be cognisant of.

As Big Tech continue to dominate, we can expect these companies to be increasingly scrutinised by regulators as they become essential services in our everyday lives.

To discuss what this insight could mean for you, talk to your ANZ Private Banker directly, or contact us below

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