The Dow Jones Industrial Average, the broader S&P 500 Index and the tech-heavy Nasdaq Composite Index set record highs all through 2017 and into 2018.
The rise of so-called FAAMG stocks – Facebook, Amazon, Apple, Microsoft and Google (renamed Alphabet) – explains much of the increase in the US stocks indices. Over 2017, Apple rose 48%, Microsoft 40%, Amazon 56%, Facebook 53% and Alphabet (Class A) 33%, increases that helped the S&P 500 Index gain 19% last year.
The success of the tech giants, which are now among the largest listed companies by market capitalisation, is fanning talk that we are in the midst of a tech bubble similar to the dotcom bubble that peaked in 2000, when unproven business models, many losing money, were priced on often ridiculously optimistic projections. Many caution that a tech correction, even a crash, is coming.
While the tech giants are in regulator’s sights, some tech stocks might be overvalued and stock prices are notoriously turbulent in the short term, we think that many of the tech leaders are not overvalued, even after allowing for their recent share price gains and regulatory risks. The global tech leaders have bright long-term futures because each dominates an expanding – and profitable – sphere of the digital world.
Apple’s iOS and Alphabet’s Android are the leaders of the global oligopoly in mobile operating systems. While Apple sells devices, its products can be viewed as ‘subscription’ payments to access Apple’s iOS platform and ecosystem of services. Already more than 500 million people are iOS users and that number has recently been growing at a doubt-digit annual rate. iPhone sales are an annuity-like revenue stream because existing users replace their devices over time with the latest ones, and Apple enjoys a user retention rate of about 95%.
Alphabet through its Google arm has a near-monopoly on global search advertising in many developed countries. Alphabet has used the riches from search to invest in often-radical products and services in the hope it can build leading positions in potentially massive markets.
Three of these businesses stand out. The first is Maps because Alphabet can use the site to connect people to local businesses. Another is YouTube, which is poised to encroach on the US$150 billion spent on TV ads worldwide. The third is Google Cloud. Cloud infrastructure is a US$30 billion market now, but providing internet-based processing has the market potential to be worth US$1 trillion in coming years.
Facebook is like Alphabet in terms of an outstanding core business and promising peripheral ones. Facebook’s core social platform, with its more than two billion users, is a highly advantaged advertising business because Facebook is adept at building engagement and targeting ads. The other businesses, especially Messenger (one billion users) and WhatsApp (1.2 billion users), are yet to be turned into money-making machines but these both have the potential to earn vast sums.
Microsoft dominates key segments of the business-software and data-centre markets. It has high customer retention rates and enjoys sustainable earnings growth as a result. While these markets are seemingly mature, the advent of cloud computing means that the software markets enjoy great potential.
Growth drives value
Investing largely comes down to what someone is prepared to pay for future earnings. But the most quoted valuation measures can often be misleading.
Apple, for instance, trades at a modest discount to the price-earnings multiple of the S&P 500 Index. However, when you adjust for its large cash balance and the high-growth services and wearables business (which deserve a higher multiple on a standalone basis), the implied multiple for the ‘core’ iPhone business is a significant discount to the index. We estimate an implied one-year forward price-earnings multiple for the iPhone business of around 9.1 times compared with 20.0 times for the S&P 500 on 31 December 2017. It’s a similar story when you delve into the valuations of Alphabet and Facebook.
Speculation abounds about whether or not the US share market is overvalued. There are always risks to markets. But one thing we do not think investors should be overly concerned about is the risk that the leading global technology stocks are vastly overvalued.
The tech giants outpace the S&P 500 Index over 2017