(Ir)rational Exuberance Redux?

In 1996, Fed Chairman Alan Greenspan famously coined the phrase “irrational exuberance” during his speech at the American Enterprise Institute. Chairman Greenspan attempted to warn of highly elevated market valuations, particularly across much of the technology sector. Investors not only ignored his warning, but also drove the NASDAQ up another 300% before peaking on March 10th, 2000. While irrational exuberance was most pronounced in technology, media and telecommunications industries, even multinational blue-chip companies traded at excessive valuations. Coca-Cola, for example, traded at nearly 60 times trailing earnings at the peak. Perhaps investors viewed Coke’s inflated valuation as a bargain relative to the NASDAQ’s nonsensical trailing PE of 175x.

Much has been written about the folly during the tech bubble – and rightfully so. Many of the dot.com darlings quickly perished. After declining by nearly 80%, it took no less than 15 years for the NASDAQ to return back to its March 2000 highs. It’s clear that markets vastly miscalculated valuations across most stocks, however, the euphoria during the tech bubble could be viewed as prescient. One could argue that markets accurately anticipated the profound implications technology would have on all industries and most businesses. Over the past 20 years, we have witnessed industries from print media to physical content retailers (e.g. physical book, video, and music retailers) relentlessly disrupted by technology companies. And many industries from linear television distribution to automotive manufacturing face increasingly dismal futures. On the other hand, some of the strongest global brands have leveraged technology to deepen their competitive advantages. Nike, for instance, has heavily and persistently invested in mobile initiatives (e.g. Nike, SNKRS, and Nike Training Club apps), distribution centers, Nike+ memberships, and omnichannel capabilities. During its 2020 fiscal year, Nike generated digital commerce revenue of $5.5 billion, an increase of 45% over the prior year. Its SNKRS app alone generated nearly $1 billion of revenue last year, up from around $70 million of revenue in 2016. For perspective, across its over 800 locations and 2 million square feet, Finish Line generates revenue of around $2 billion. Nike’s digital capabilities have resulted in greater control over its distribution, allowing for improved inventory management, merchandising, pricing and overall brand experience.

Over the past 20 years, technology has truly permeated all aspects of business. Its pervasiveness has been on display lately, as technology enabled many parts of the global economy to function in a world that was virtually closed. E-commerce, digital payments, cloud computing, digital advertising and other technology industries have been increasingly viewed as beneficiaries of the unfortunate and challenging implications of COVID-19. Correspondingly, many stocks within these industries have rallied sharply. Technology stocks performed relatively well into the depths of this year’s decline and led the market throughout the recovery, as the market has revalued free cash flow that will likely be pulled forward by a couple of years. However, the strength of technology stocks has resulted in an emerging narrative that technology is in the midst of a bubble. In some ways, today’s equity markets share some resemblance to the tech bubble of the 90s. For example, “growth” has outperformed “value” by 200% over the past decade, with the spread between the Russell 1000 Growth Index and the Russell 1000 Value Index actually wider than the time of the tech bubble. Today, Facebook, Apple, Amazon, Microsoft, and Google (FAAMG, an abbreviation created by Goldman Sachs) account for 23% of the S&P 500, which is also a greater percentage than the five largest companies held back in 1999. However, unlike in 1999, today’s top five companies are actually all technology businesses. So, are technology stocks again in bubble territory? Has irrational exuberance returned?

Starting with the growth vs. value debate, unfortunately, we don’t have much to add. As intrinsic value investors, we do not believe that growth and value are mutually exclusive. In our view, profitable growth is a key driver of value creation. Therefore, we are elated and not dissuaded by the identification of profitable growth, particularly when it’s mispriced. These beliefs are core to the investment philosophy of our Intrinsic Value Strategy. On the other hand, it is unquestionable that the S&P 500 is highly concentrated in the top five technology companies, with Microsoft, Apple, and Amazon each sporting ≈$1.5 trillion market capitalizations. However, it is often less reported that FAAMG is expected to account for nearly 18% of the S&P 500’s earnings in 2020. Moreover, the business models of FAAMG are immensely superior to the cohort from 1999, particularly relative to GE, Walmart, and Exxon Mobil. Interestingly, Microsoft is the only company out of FAAMG to have also occupied the top spot in 1999 (Amazon had a market value of a mere $25 billion in 1999, Apple was left for dead, Google was founded in 1998 and was private at the time, and Facebook hadn’t been conceived). And even Microsoft is arguably a superior business today. Microsoft historically sold its software under perpetual license agreements, however, the company is in the midst of transitioning to a subscription model. While both models are terrific for Microsoft, the subscription model removes the lumpiness from product cycles and results in improved profitability over the lifetime of a subscriber. Said differently, Microsoft’s subscription model is highly recurring and generates predictable revenue at superior economics. With Azure, Microsoft is exceptionally well positioned to gain market share in the public cloud infrastructure industry. Cloud computing was basically nonexistent in 1999. Currently, cloud computing’s addressable market is over $1 trillion, with Amazon, Microsoft, and Alphabet collectively accounting for less than 10% of the market. Today, Microsoft’s market capitalization is nearly 3 times larger than in 1999, notwithstanding its trailing earnings multiple of 80x at the end of 1999. Microsoft now trades at a much lower earnings multiple of ≈30x; and while it isn’t optically cheap, we believe the company’s valuation is justified by the quality and durability of its business model.

Like Microsoft, Amazon, Alphabet, Facebook and Apple are all outstanding businesses. They all are truly dominant within their industries, with wide economic moats and large addressable markets. All five have capital-light business models with fortress-like balance sheets. Importantly, the group can leverage the power of technology to magnify the benefits of scale. For instance, Facebook typically adds the equivalent of Snapchat’s entire user base in a single quarter. Not only does Facebook’s scale attract more users and advertisers, but it also allows for far superior monetization. During the first quarter, Facebook reported average revenue per user (ARPU) of $34.18 in the US & Canada, which was nearly 10 times greater than Snapchat’s North American ARPU. Scale also translates into durable revenue growth. Alphabet’s Google Search business is now over 20 years old. And yet, Google Search reported revenue growth of over 15% in 2019, on a revenue base that is nearly $100 billion with gross margins of approximately 90%.

FAAMG have achieved enormous scale quickly with extraordinary capital efficiency. Collectively, the balance sheets’ of FAAMG have a tangible invested capital base of approximately $155 billion (excluding cash, cash equivalents, marketable securities, and intangible assets). For 60 years, Exxon Mobil has consistently ranked as one of the 10 largest companies – and it has actually ranked as the largest in the past. Exxon’s balance sheet has tangible invested capital of approximately $227 billion. Exxon earned an average annual operating profit of $35 billion over the past 15 years (Exxon’s operating profit was $7 billion in 2019), yielding a respectable 15% normalized return on tangible capital. Alphabet alone earned $34 billion of operating profit in 2019 (+24% year over year) on a tangible capital base of $63 billion – or a pre-tax return on tangible capital of 54%.

While certainly impressive, returns on tangible capital for FAAMG are actually understated, as the group is significantly investing against large addressable markets, thereby depressing near-term profits. Notwithstanding the value creation that often accrues from investment spending, forgone near-term profitability is often conflated with bubble-type valuation. And Amazon is the poster child for this argument. For most of its existence as a public company, Amazon produced very little of GAAP earnings in relation to its market capitalization. Amazon’s recent decision to forego and reinvest the entirety of its second quarter operating profit (or nearly $4 billion) is a good illustration of its capacity for reinvestment. Therefore, Amazon’s true earning power is masked by such investment. We estimate that Amazon could diametrically improve its reported profitability by moderately reducing the pace of its investment. However, AWS, Amazon Prime, Fulfilled by Amazon, Third-Party Sellers, Amazon Echo/Alexa, Kindle, and many other outstanding and valuable business unit/services are the direct result of Amazon’s insatiable capacity to reinvest.

Since FAAMG are deeply entrenched within their industries with advantaged business models, some have argued that these companies aren’t an indication of irrational exuberance, but are instead monopolies that have abused their market power. While technology companies will likely continue to disrupt the incumbents, we believe the group’s behavior has been significantly more pro-competitive than anti-competitive. Countless businesses have been created on the back of these platforms. Prior to Facebook and Alphabet, only the largest companies could afford to advertise on traditional mediums with large audiences. Today, a majority of Facebook’s 8 million advertisers are small to mid-size businesses. Companies of all sizes are able to purchase highly relevant and measurable ads targeted at large audiences. Also, most of the services offered by Alphabet and Facebook are free to consumers, who are not compelled to use their services. And yet, consumers return in droves under their own volition, offering strong evidence that consumers derive significant value from the many services offered by Alphabet and Facebook. In the physical world, Walmart’s finite shelf space was mostly reserved for the largest consumer packaged goods companies. Today, small businesses not only have access to Amazon’s infinite shelf space and its 150 million prime members, but Amazon will also store, pick, pack, and ship products on the behalf of its third-party sellers. Consumers all around the world benefit from Amazon’s wide assortment and rapid delivery, all of which is offered at exceptionally low prices. During the tech bubble, most of the capital raised by startups was used to fund the procurement and deployment of IT infrastructure. With a credit card today, any size business can provision IT infrastructure powered by the full might of Azure and/or AWS. Amazon and Microsoft have also significantly reduced the cost of operating information technology for companies of all sizes.

In conclusion, while excesses certainly exist in today’s public and private markets, FAAMG are unlikely the source of such excess. As investors in FAAMG, we believe the group is reasonably valued at the very least. Unlike the tech bubble, the price performance across much of technology is supported by exceedingly strong fundamentals, and not by blind faith and exorbitant valuations. In many ways, today’s technology companies are arguably the best businesses the world has ever witnessed – and are infinitely superior to most of the technology stocks of the 90s.