Investors have done well buying and owning high growth, high beta stocks in Australia.  Indeed, some of the best performing stocks over the course of the last 18 months have been companies with little or no profit to speak of, merely the promise of a new business model or new technology.

Two of the top three performing stocks in Australia over the last year, at the time of writing, are Nearmap (+175 per cent) and Afterpay (+173 per cent).  Neither company generates any free cash flow, yet trade at 16 and 37 times revenue respectively. Wisetech Global and Altium are two more high flyers over the last year, and while they do generate free cash flow, it would take 72 and 54 years respectively for an investor to be paid back through free cash flow.

It’s common for investor to become enamoured with the promises associated with new technology or new business models.  But this however is not the first time new technologies have promised, if not have actually, changed the course of human history.  Nor is it the first time that new technologies have triggered a flurry of hope on the stock market.  Throughout modern history we have seen railroads, the telephone, horseless carriages, commercial air travel and the television revolutionise the world. While long term winners emerged, they didn’t make their investors collectively wealthy.  Indeed, Ben Graham, the intellectual dean of Wall Street once quipped; ‘You can get in way more trouble with a good idea than a bad idea’.

Back in late 1999 – just before the Tech Wreck of early 2000 – Warren Buffett gave a prescient speech at the Allen & Co annual conference at Sun Valley.

Showing a list of US airlines that emerged following Orville’s flight at Kitty Hawke, Buffett noted:

“Now the other great invention of the first half of the century was the airplane. In this period from 1919 to 1939, there were about two hundred companies. Imagine if you could have seen the future of the airline industry back there at Kitty Hawk. You would have seen a world undreamed of. But assume you had the insight, and you saw all of these people wishing to fly and to visit their relatives or run away from their relatives or whatever you do in an airplane, and you decided this was the place to be.

“As of a couple of years ago, there had been zero money made from the aggregate of all stock investments in the airline industry in history.”

So, investors should be increasingly wary even though long-term winners will emerge.  Indeed, extreme caution should be applied by Australian investors in our emerging tech names as the tide of sentiment to towards big tech shifts internationally.

Floating unicorns

The first observation to make is that a veritable tidal wave of ‘unicorns’ – tech start-ups worth more than a billion dollars – are preparing to go public this year. Companies including ride sharing competitors Lyft and Uber are expected to list as is Postmates, Pinterest, AirBnB, Peleton, Zoom and Slack. Indeed, Goldman Sachs recently estimated that a total US$80bn of funds being raised could be double the annual average since 1990.  Meanwhile Renaissance Capital believes 226 companies could go public this year, with a combined value of US$697bn. Assuming a public float of 15 per cent that’s a record US$104bn in IPO raisings.  Investors should always be concerned about increases in supply especially in a world of stretched valuations where the slightest hint of trouble induces fear.

And investors should be scared.  Despite the apparent maturity of these businesses and their multibillion market valuations, in 2018, 83 per cent of IPOs were by unprofitable companies, which the highest on record since 1980.

In fact most tech companies going public today are unprofitable and some spectacularly so. Lyft lost US$254 million in the third quarter of 2018, while Uber hasn’t made a profit in the nine years since being founded and in the fourth quarter of 2018 it lost US$865 million.

The second point to make is that much of the global boom in tech stocks today can be attributed to two things.  The first is simply ultra-low interest rates. Interest rates act a bit like gravity on the value of assets with low interest rates (low gravity) raising the present value of future cash flows.  And when a company is making no profits today, all its value is tied up in that promise of future cash flows which of course can be ‘infinite’. Sometimes however, indeed more often than we’d care to admit, those future cash flows fail to emerge, wiping out equity holders as expectations are met with reality.

The second reason, for the current booming prices of many loss-making technology names, is the same reason they often boom; it is easier to promote new technologies because, as Buffett once observed, “there’s no quantitative guideline”.  When a company is losing money today, but promises to make lots in the future, the sky is truly the limit.

But while company losses boom, along with share prices, a shifting undercurrent of sentiment towards the activities of big tech is gaining a momentum all its own.

On the nose?

Little more than a year ago, Facebook was being ensnared in a US investigation into Russian-backed election meddling and the use of ‘physcographic’ profiling of 50 million unwitting users to subvert the outcomes of the UK’s Brexit vote and the 2016 US Presidential election.  At the same time, growing distrust among advertisers emerged with Proctor & Gamble announcing a 50 per cent reduction in digital marketing spend and the European Commission fined Google €2.4 billion over antitrust, while Israel’s justice minister warned that its government was then considering taking “legal action” against Twitter for ignoring repeated requests to remove online content that was inciting terrorism.

Since then more of big tech’s business practices have emerged and a groundswell of popular resentment may be gaining enough momentum to cause regulators and governments to act.

One of the most disturbing revelations has been the collection of data without consent.

Germany discovered that Google’s street view cars were not only taking pictures of housefronts, they were illegally downloading data from any and all unencrypted Wi-Fi networks.  The data collected included pictures, texts, chats and emails (containing private and financial data). Google also admitted that following its purchase of Nest, it embedded microphones into the home climate control system enabling it to listen to conversations and send, store and share the with third parties.

According to EPIC, Samsung’s ‘smart TVs’ listen to conversations on the couch near the TV set and pass those conversations to data analytics companies for processing and resale.

The US Federal Trade Commission’s case against Genesis Toys, revealed the ‘My Carla’ interactive doll sends data from children’s spoken interactions for processing and resale for data analytics and advertising. Germany had already banned the ‘My Carla’ doll, after it requested personal information from children such as addresses and parent’s names.

The Wall Street Journal recently exposed multiple health apps, including a ‘track your period’, sending personal data to Facebook.

Surreptitious data collection may be the tip of the iceberg with monopoly behaviour, a lack of self-regulation, large-scale social influencing experiments and growing doubt about the efficacy of online advertising (Proctor & Gamble discovered users spent less than 1.7 seconds looking at their digital advertising) all conspiring to create a groundswell of opposition that may soon be reflected in coordinated regulation.

Germany’s recent antitrust action against Facebook may yet prove to be a dam buster. Facebook has been banned from automatically harvesting user data from third-party sites, preventing it from tracking “like” and “share” button clicks or interactions through its ad- conversion tracking code on millions of sites. The ruling also prohibits Facebook from combining accrued data from its own real estate including Facebook, Instagram, and WhatsApp. In response, Wired magazine ran the headline; “German Regulators Just Outlawed Facebook’s Whole Ad Business”.

For investors in Australian technology stocks there is only one thing that matters.  The variance of returns evaporates when the US market falls.  Investors in companies such as Afterpay, Pushpay and others are making profits from the shares even though the business isn’t making profits from its activities.  Consequently, a yawning chasm exists below market prices and reality.

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Roger Montgomery is the chairman and chief investment officer of Montgomery Investment Management.