Engines That Move Markets (2nd Ed)

by Alasdair Nairn

  The valuation of Internet stocks bears little resemblance to the excesses of the bubble period and remains in a reasonably narrow band. When comparing the movement in market prices for technology stocks in 2000 and the time of writing, the conclusions are significantly different. Although the US Internet index has now exceeded the peak levels of the 2000 bubble, it has done so on the back of rising revenues and profits, rather than promises and blue-sky numbers. The valuations, measured by price-earning ratios or price to book, may or may not prove to be full, but they are no more extended that the US market as a whole. This is very different from the bubble environment when valuations were extreme and could not be justified in any circumstances. Euphoria dissipates quickly but scepticism born of the pain that follows can last a considerable time. If the Internet bubble was a warning to investors not to get carried away, the experience of the financial and mining sectors – both of which subsequently experienced their own bubbles – is evidence that those lessons are rarely heeded for long. In the technology sector, however, public markets have fortunately been less willing to suspend disbelief than before.

  Partly because of the success of Google and Facebook, and partly because the IPO market is less active than before, the main difference today is that companies have remained in private ownership much longer than previously. As a consequence valuations are increasingly determined not by public markets but by a fairly narrow group of investors operating in the pre-IPO market. In early 2016 the combined market capitalisation of 170+ of these so-called ‘unicorns’ (private technology companies with a valuation greater than $1bn) exceeded half a trillion dollars.¹¹⁰ Whether or not that aggregate valuation eventually gets validated is open to question, but it does not automatically mean that the outcome has to be a repeat of the earlier technology bubble.

  10.34 – The link between interest rates and Internet share prices, 2007–2017

  Source: Thomson Reuters Datastream.

  10.35 – Relative performance of Internet stocks

  Source: Thomson Reuters Datastream.

  10.36 – Post-bubble performance (2005–17) – all about earnings growth

  Source: Thomson Reuters Datastream.

  It is true that the private-equity funding of Google and Facebook has encouraged many others to try and replicate those successes. If history is a guide, the mortality rate among the 170+ unicorns will be high and the probability of picking winners low, even if the embedded technology actually succeeds (always a demanding assumption). It is interesting that a number of successful professional fund managers whose normal area of operation is listed equities have recently been trying to buy into the returns that appear to be accruing in private equity. The difficulty they face is that unlisted investments are subject to different valuation factors and ultimately require either a public listing or an acquisition by rivals so that the private equity holders can exit. Will the $0.5trn of value accorded in aggregate to the unicorns all be realised? On past history it looks a tall order. History also suggests that, if it is eventually realised, it will accrue to a relatively small number of investments – with the vast majority of the remainder falling by the wayside.

  That is not the same as concluding, however, that the private firms represent a new technology bubble in waiting. Firstly, the quantum of funds which has flowed into US technology is a fraction of what happened during the tech bubble of 1999–2000. Secondly, the largest part of this funding has been devoted to a relatively small number of private companies, such as Uber. Finally, and perhaps most importantly, the majority of the returns obtained in technology stocks continues to accrue before they go public. While the venture capital community keenly extols the virtues of its style of investing, an equally valid interpretation is that, given the attractive returns already made by private investors, there may be little or no headroom to create attractive IPOs for public equity investors. A more likely route is that private equity firms will try to encourage hitherto listed equity investors to participate ahead of any IPO, both to validate the price and partially cash in. New investors will then see a nominal profit on IPO, but support the share issuance as their other funds participate, thus allowing a later exit for the original investors as the price is potentially supported. The question then is whether by this stage any potential for capital appreciation remains?

  What this points to is an unsurprising conclusion. Just as in the TMT bubble, we have had a period of low interest rates and this has expanded valuations across all types of asset. On this occasion private investors have been slower to seek public listings, preferring to raise valuations with successive funding rounds. That suggests that it will become significantly harder for investors in public markets to make money when they do eventually list. One of the characteristics of a bubble is that it tends to be undiscerning; sometimes the name of a company alone is sufficient, if it is a fashionable segment of the market, to command a premium valuation. The list of companies in the unicorn stable is more diverse than that. Many of the unicorns may never justify their current valuation. On the other hand, some may well earn – and deserve – their higher valuations. This outcome would be entirely consistent with history.

  Part 4: Looking to the future

  Towards a brave new world

  Through a boom-and-bust period, followed by one of sustained development, the Web and its accompanying infrastructure have reached a position of initial maturity. Notwithstanding pockets of under-penetration in more isolated areas, the developed world is now largely connected. Navigation and access to information is relatively straightforward and little technical expertise is required. At the time of writing the first edition of this book, the world was still in the midst of euphoria about the potential of this exciting new technology. The financial markets have since moved on to what is often called Web 2.0, the period that followed the TMT stock market collapse. Many of the companies that emerged during this phase were at least in gestation during the previous period, so it is important not to draw too great a distinction between the two periods.

  The pace of change has been rapid. Although the Internet only began to register in the public consciousness some 25 years ago, the early years of the Web are becoming a distant memory for many. So-called ‘millennials’ struggle to recognise the environment that preceded the Web, when letters and the postal service were still a necessity and the clunky ‘fax’ machine was the most rapid form of transmission. Even email, the first ‘killer app’, has been to some extent superseded by social media. Despite the changes that have taken place and the apparent ubiquity of the Internet made possible by the rapid spread of mobile devices, the likelihood is that in terms of impact we may still be in the early stages of its development.

  To recap some of the themes discussed earlier: the shift to online advertising will continue, but more slowly, and at some stage the gorillas of the space, Google and Facebook, will find growth harder to achieve. Online retailing is now relatively mature and future growth is likely to be evolutionary rather than revolutionary. Similarly, delivery of digital media content is now widespread and no longer a new area. Participants will continue to turn their attention to creating new content. The biggest area of future disruption is likely to be in the financial sector. This is a sector which has grown to be cost-heavy and burdened by systems redundancy. In all likelihood new entrants will pick away at segments of bank services and be able to provide a higher-quality product at a lower cost. Given the competition between security and ease of use, this is a relatively slow-burn development, but it is highly likely to be a dominant investment theme in the coming years.

  Banks – where the money is

  As discussed earlier, the financial sector has taken an ever larger part of the national cake. Arguably this has been the product of bureaucratic structures, inertia and inefficiency rather than the result of innovation and a better customer experience. Digital disruption remains in its infancy in the financial sector and the time is ripe for this to change. Payment companies s
uch as PayPal and Square have emerged and have so far largely operated as front ends for existing payment-processing systems, whether on PCs or (increasingly) for mobile devices. Further penetration into the payments system seems inevitable. Similarly, peer-to-peer lenders such as Funding Circle in the UK or Lending Club in the US are only the pioneers in what promises, by cutting out the middle man, to be a much more extensive raid on the traditional lending business of the banks. No doubt credit quality issues will hurt the new wave of lenders when economic conditions deteriorate, but this will pause rather than halt the underlying trend. It seems inevitable that in short order we will see many traditional banking functions migrate to handheld devices as new, nimble companies exploit the IT legacy issues all incumbent banks face. The emergence of blockchain technology, the system of interconnected ledgers that underpins bitcoin and other forms of digital money, also has the potential to revolutionise the cost structure of the banking industry.

  Money is by far the largest digital product in the economy, so the scope for Internet-driven disruption in the financial services business is considerable. It promises to produce the kind of efficiency gains that long-suffering bank customers have waited in vain to experience for years. The importance of the financial sector to the global economy was emphasised by the global financial crisis, which brought with it both a renewed focus on the regulatory regime and a concern over the ‘too big to fail’ aspect of many participants. Given the operating practices that were revealed in the wake of the crisis, it would be hard to argue that trust in banks is widespread. All these factors make finance highly susceptible to the disruptive forces and efficiency gains that we have already seen at work in other industries. It may well be, in fact, that the global financial crisis will turn out to be a landmark turning point for the structure of the financial sector.

  To take one topical example: recent years have seen the rise of cryptocurrencies. A cryptocurrency is a virtual digital asset used as a means of exchange. It is similar to existing fiat currencies in that it depends upon trust. The difference is that fiat currencies rely on trust in issuing governments whereas cryptocurrencies rely on trust in the backing blockchain accounting system – the exchanges, the ‘wallets’ that hold the currency, and the process of new issuance (‘mining’). Blockchain provides proof of ownership, the wallets provide storage, and mining controls the effective money supply. Cryptocurrencies are largely unregulated and unmonitored. It is indicative of the lack of general trust in the conventional banking system that bitcoin, the primary cryptocurrency, has achieved such prominence. Despite the negative headlines associated with the collapse of exchanges such as Mt. Gox and the use of cryptocurrencies to facilitate drug trafficking, by 2017 the price of bitcoin was soaring as speculators jumped on the bandwagon. One did not need to speculate on the future viability of cryptocurrency and other non-traditional means of exchange to know how this would end. Nor is it difficult to envisage the level of regulatory discomfort with a parallel currency system operating outside government control. However, this should not lead one to dismiss the potential use of the technology involved or assume that cryptocurrencies have no future at all.

  Platforms and networks: the holy grail

  Where there are few intrinsic barriers to entry, the ability of companies to sustain profitability depends upon the traditional parameters of economies of scale or intellectual property. The holy grail of scale is to become a successful ‘platform’ which other suppliers need so badly that you are seen as indispensable. On mobile, Apple has created an ecosystem – iTunes and the App Store – which should allow premium pricing to be sustained. Android has successfully protected Google’s market share during the transition to mobile. By contrast Nokia, which once had the dominant (circa 40%) position in mobile handsets, was relegated to a footnote in history with its eventual purchase and closure by Microsoft.

  There is an important lesson here for investors. When hardware becomes commoditised and software becomes the differentiator, hardware firms find it very difficult to make the transition, partly for cultural reasons and partly because of the embedded handicap of their prior history. In the case of Nokia, the company was dominated by skilled engineers and scientists. In a world where this was key, Nokia prospered. However, when the user interface took over as the critical factor, it played directly into Apple’s hands. Because of its historic hardware culture and its dated system architecture, Nokia was persistently playing catch-up to the point that it ceased to be relevant in an industry it had dominated only a few years previously. It is a repeating theme for investors to remain wary when industry leaders built on hardware expertise come under attack from software entrants. The cultures are very different and the rule-based incumbents struggle to encompass the more anarchic form of software developers, particularly when playing catch-up.

  Content is king

  The increasing bandwidth available to users means that digital distribution of content has become ubiquitous. Streaming businesses such as Spotify (for music) and Netflix (for films) have quickly made clunkier CDs and DVDs redundant. No longer do the constraints imposed by physical delivery apply. Historically distribution was constrained by shelf space. If consumers wanted something different from the broadcast schedule they had to visit their local video store and rent a DVD. The catalogue available to them was constrained by the shelf space of the store in question. The same applied to the purchase of music. Consumer preferences were only revealed within these constraints. Digitisation, compression and distribution have created almost unlimited choice by removing these constraints. What has become immediately apparent is that consumer tastes are much more eclectic and varied than was hitherto supposed. As a consequence back catalogues of content have retained a much higher value than anticipated. This phenomenon was characterised as ‘the long tail’ by the editor of Wired magazine, Chris Anderson. The implications are profound and extend beyond simply music and video. The ‘long tail’ does not suggest that there will no longer be ‘hits’. It rather illustrates that there are deep and valuable niches in consumer preferences which have previously been difficult to identify and access. These niches are now accessible and hence monetisable.

  Critically, despite the technology expertise embedded in the creation of the distribution channels, the regulatory framework ensures that it is content or control of content that is accruing the returns. To the traditional forms of entertainment must be added an industry which has moved on from its early individual console days to take a whole new form. Improvements in processing power, memory and communications have revolutionised an electronic gaming industry where not only are the numbers of users growing exponentially, but such is its popularity that it has become a spectator sport to rival soccer and athletics tournaments. Electronic gaming has become a significant component of the quoted technology sector.

  This is not to say that all content is helpful. To the extent that content drives usage and hence derives data, there is no incentive for any site to pay attention to the veracity of that content. Unburdened by the restrictions placed on the published press, there is a real danger that a network of unsubstantiated rumour is created which could undermine legitimate sources of news. The unfolding scandals relating to the 2016 US presidential election are only just one example of this. Currently, the label ‘fake news’ seems to be applied to any news that does not suit a particular agenda rather than to that which has no empirical or factual underpinning. To that extent it has ironically undermined the term itself. However, fake news does exist and eventually one would expect the driving out of legitimate news by fake news will reverse as the population tires of such sources and gravitates back to sites and copy underpinned by genuine research and analysis. Perhaps the 2013 purchase of the Washington Post by Jeff Bezos rather, than as some perceived it, being a vanity project, was simply another example of his prescience. The newsprint advertising model was destroyed by the Internet, leaving high-quality journalistic content on the verge of bankruptcy. Such cont
ent languishing at low cost can be snapped up and embedded in the new distribution and information model that the Internet created. Given his track record it should not come as a surprise if Bezos yet again proves to be the one who understood best the opportunities being created.

  More efficient asset utilisation

  The advent of the Internet has encouraged better price discovery to the benefit of consumers, and with it the ability to create efficiently functioning marketplaces in the utilisation of large assets. For consumers the two most obvious underutilised assets they own are their homes and their cars. For homes, Airbnb – a network that enables homeowners to offer paying customers a direct way to rent rooms or whole properties – is probably the best-known new entrant, but there are many other competitors emerging in this space. With cars, Uber has the greatest visibility, but there are many other direct competitors and taxi-hailing applications. The one outcome that can be predicted with a degree of confidence is that assets will be better utilised in the future than they have been in the past.