How would you characterize the technology-related investing landscape over the past few years?
We’ve definitely seen a continued shift towards the highest capitalization stocks in the tech sector. From a competitive standpoint, these large companies have gotten more powerful as they have fortified their market share and expanded into a variety of markets. In conjunction with this trend, we’re seeing a bigger discrepancy between private and public market valuations. Most of the largest and strongest private companies in the tech sector have chosen to wait as long as possible to go public due in part to easy access to capital and soaring private sector valuations.
We now have a bifurcated market where the highest growth rates today among publicly traded companies are generally in either the extremely large-cap or small-cap companies. Most of the technology companies that had an IPO during the last few years entered the markets at a very dangerous phase in their growth. Whether looking at Snapchat, Blue Apron, or GoPro, these types of companies often have already seen a majority of their growth in the past while they were still private. This makes it very treacherous for public company investors in the technology sector.
So, are you not investing in mid-cap technology stocks?
Not entirely, no. But the highest valuations relative to growth that we are seeing today are within the mid-cap part of the market. Large- and mega-cap companies have fairly reasonable valuations given their market position and growth rates. Small-cap companies, on the other hand, have been somewhat orphaned by investors leading to select opportunities for active managers.
One of the things that we believe differentiates our fund from our peers is that we have representation in both the very largest tech companies as well as the very smallest. This barbell approach we believe makes the most sense right now since the mid-cap technology companies are apt to have slowing growth while valuations remain rich, which is obviously often a poor combination for generating positive returns.
Do you feel that passive investing and the increase in money flow to larger cap names have distorted the market?
Perhaps a bit, though we believe the risks have been somewhat exaggerated. Given the strong performance of the market-cap weighted indices, it comes as no surprise that investors have shown a real enthusiasm for passive investment vehicles like index funds and ETFs. The continued interest into these passive products certainly pushes more investments into the mega-cap companies that hold higher weightings in the index, but it’s still hard to make the case that this has bolstered valuations into wildly overpriced territory given how dominant the large players have become and their continued high revenue and profit growth.
Due to economies of scale and network effects, the owners of dominant platforms continue to see strong a disproportinate amount of success. The leading mega-cap tech companies use their competitive position to generally attract the best employees and their financial strength to build deep balance sheets, which along with the rising value of their stocks, enhances their ability to acquire other companies. We have written about this phenomenon in depth in our Power of the Platform whitepaper, which you can view on our website.
Still, it wouldn’t surprise us if at some point the growth rates of these mega-cap companies slow down more than expected, leading to below-average market returns for both those companies and the passive investment products so heavily invested in them. If that happens, and investors again seek out actively managed products, we could see a mirror image reversal of the virtuous circle that drove these stocks higher. The opportunity here may be in the smaller companies that are not represented in the major indices as these investments can have a better risk/reward profile.
In the past, large technology companies with dominant platforms often become complacent, victims in part of their own success, and can’t respond quickly or forcefully enough to changes in the market. Research In Motion (RIMM) and its Blackberry products, for instance, provide a good recent example. Don’t you worry the same thing will happen to today’s technology giants?
It’s a concern, of course. Technology changes all the time. It’s why we believe in the active management process. But to their credit, today’s leading technology companies seem acutely aware of this history and have done their best to try and stem the creative destruction tendencies of technological change. These companies have been very aggressive defending their market position while exploring investments into new areas. Think of how smoothly Netflix has handled the transition from DVDs to streaming video, for instance. Similarly, Google gives their engineers the freedom and time to explore innovative new ideas, and the company recently changed their corporate structure to make sure they could continue to invest in the most promising of these markets. We’ve seen this with Facebook as well over the last 5-7 years, as the company not only expanded its core market but also made large acquisitions in very early stage companies such as Instagram, WhatsApp, Oculus, and many others.
In past cycles, larger companies have been much more inclined to try to compete through internal development. That strategy has a much more checkered history. It’s the buy vs develop in-house debate. Most large tech companies tend to be somewhat insular and much more willing to try to develop products internally whereas going outside can be a faster and more successful option. Even if the initial price appears steep.
By the way, if there is one mega-cap technology company that has us a bit more worried of late about being able to evolve effectively to retain its dominance, it is probably Apple. Their ecosystem remains strong, and their products are still insanely great, but it just appears that over the past several years, the company has been more of market follower than a leader, and that is something that bears close watching.
Aside from this difference in corporate behavior, how is the current technology rally different from what you saw in 2001?
In the late 1990s companies would IPO as quickly as possible, often recognizing higher public valuations than they could get in the private markets. Investors were so keen to get involved in anything technology and Internet related they were willing to pay high premiums for the smallest and most speculative companies. In a lot of cases these companies lacked a creditable path to profitability and had only scant revenues. Now companies are seeing the best valuations while private and are hesitant to go public for many different reasons, including competitive disclosures, and the increased scrutiny of being a public company. The best companies are waiting as long as possible to go public. So, a lot of the IPOs that occur today are often large-cap and mega-cap stocks, whereas back in the late 90s most IPOs were small-cap and micro-cap valuations.
Are you concerned this rally is unsustainable or is there more room to run?
Hospitable macro conditions mean this rally could have more room to run. The large tech players must maintain their rapid growth, which for the near-term still seems likely. What we may see that’s a bit different over the next several years is a broader market where returns are more widely distributed across all market caps as opposed to just the largest of the large players.
These larger mega-cap companies won’t necessarily all of a sudden blow up. It’s just that smaller stocks may outperform significantly in the next stage in this bull market given the outlook of a faster growing economy. If that were to occur, investors would probably be open to taking more risk, which would flow mainly into earlier stage companies. It’s our opinion that this is likely the next phase of the market ahead.
It’s not that investors are overly enthusiastic about stocks, but rather they have limited options in today’s environment. When calculating valuations most investors utilize the risk-free rate, which has been held at historically low levels by central banks, which have not had to worry much about the specter of accelerating inflation. Unless we see monetary policy shifts and dramatically higher rates on sovereign debt, the current equity market valuations remain attractive. When yields on US treasuries are this low and investors can earn a dividend yield from high-quality US stocks of 3-4% it's easy to see why many are interested in the latter.
Where are the most compelling investment opportunities in today’s market?
To me, the best opportunities today are in companies that leverage consumer generated content. The market is also seeing a relentless shift to mobile, which is probably being best captured by the most popular technology leaders, namely Apple (AAPL), Google (GOOG), and FaceBook (FB).
We also think the battle to control the home is extremely important, and probably best exemplified by the innovation we’re seeing with home assistant products like Amazon’s Echo and Google’s Home, and soon, Apple’s HomePod. The rapid development of the voice-activated home assistant market is a great example of the creative destructive process we were talking about earlier – Google’s incredibly profitable text-based search business could be threatened here – and we see a similar phenomenon happening along with numerous other innovations, like augmented reality, machine learning, and the driverless, computerized automobile.
The technology sector is constantly evolving, and lately it seems, it is doing so at a quicker and quicker pace. Experience and focus can be a huge advantage. This has been the case for the last 20 years, and will probably be the case for the next 20 years. But as volatile as it can be, we believe the technology space offers some of the most exciting opportunities and attractive long-term returns versus almost any other sector.
*The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
Fund holdings and sector allocations are subject to change and are not a recommendation to buy or sell any security. Fund holdings can be found here.