Big tech’s reckoning

Roger Montgomery

By

June 14, 2018

It’s natural for any parent to want more for their children than they had themselves. But one of the great challenges of any wealthy family is to imbue their kids with a drive to achieve. This is no easy task and often requires tough love – precisely the opposite of what comes naturally.

If central banks were parents, we would say they have failed in their parental role and succumbed to the desire to see no harm come to their children. They have mollycoddled their economies, preventing their collapse by breastfeeding way beyond an age considered acceptable or appropriate.

In return, the kids have exercised their sense of entitlement and misallocated their resources through private equity and venture-capital funds, fuelling a band of companies that disrupt incumbents but can exist only with their parents’ ongoing generosity.

The result? Many new-age tech companies (born and managed by Millennials who have never experienced a recession) continue to exist despite being unproductive and unprofitable, thanks to the financial teat being available for far too long.

Thanks to well-intentioned central-bank parents, real capitalism, that which has been responsible not only for the prosperity of the Western world but also its security, no longer exists. Central bank intervention and financial repression – the holding down of interest rates below inflation – have represented a tax on savers and a transfer of benefits from lenders to borrowers.

As is typical of wealthy parents, Western central banks feared short-term pain for their offspring, and by withholding challenges they have passed the baton of long-term gain to nations that don’t prioritise human rights, meritocracy and the rule of law.

The fear of deflation (officially, inflation below 2.00 per cent) has led the US Federal Reserve to maintain a below-inflation interest rate many years after the recession of 2009, while simultaneously accumulating more than US$4 trillion on its balance sheet amid a collapse of the US dollar, not wanting to be outcompeted by surging central banks from Japan to Europe engaged in quantitative easing of their own. Both developed-world and emerging-nation children have been breastfed for way too long.

DEBT SOARS

It’s worth noting that famed investor Stan Druckenmiller recently observed the most “pernicious deflationary periods of the past century did not start because inflation was too close to zero. They were preceded by asset bubbles.” Put a metaphorical tick in the box next to the question: Is a key ingredient for a deflationary bust in place?

Unsurprisingly, debt has soared, and the assessment of risk has been corrupted. This corruption can be seen in almost all asset markets, from the record prices being achieved at auctions for vehicle licence plates, to the oversubscription for 100-year Argentinian bonds.

In the corporate debt market, the vast majority of debt accumulated since 2010 has been used for financial engineering, including share buybacks, special dividends and mergers and acquisitions.

Precious little has been directed towards productive use. It’s the same situation as the wealthy teen, with little experience and suckled for way too long, being given the family fortune and asked to go start a company.

Bankruptcies have been minimal, except in retailing, despite arguably one of the most disruptive periods the business world has ever experienced.

Private equity and venture capital funds, flush with a tidal wave of money migrating from cash deposits paying punitive interest rates, have fuelled unprofitable companies that make no money for far longer than would have occurred at any other time in history. Only if the purse remains open can many of these companies continue to disrupt incumbents who themselves are shackled by the desire to make profits.

BEWARE THE NEWEST NEW THING

Warren Buffett was famously quoted as observing that it is only when the tide goes out that we see who was swimming naked. For as long as free money keeps them alive, we cannot know how many corporations are dead men walking.

Only when we start descending the other side of this financial volcano will we see the consequences of misallocated resources and wasteful, ill-judged investments that occurred over the last decade.

Throughout history, investors have routinely backed the newest, new thing, from automobiles and TVs, to photocopiers and commercial air travel. But more often than not, people have been burned as input costs fall, suppliers increase, and declining retail prices benefit consumers at the expense of shareholders.

The current wave of enthusiasm is built on the premise that Millennials have developed, or will develop, technology and business models that disrupt the hegemony of incumbent institutions and oligopolies, whether that be in centralised manufacturing (3D printers), taxi companies (Uber), hotels (Airbnb), the oil oligarchs (electric cars), or even car manufacturing itself (car sharing).

A concurrent investment fad is represented by the hope that technology will enable a cleaner and greener world. But we have to keep in mind that these hopes are possible only because of financial repression.

TESLA TEETERING

One company upon which all of the above trends converge is Tesla. Perhaps more than any other company, Tesla symbolises the hopes and dreams behind the wave of exuberance fuelling the current boom in tech stocks. It is the poster child for what is possible, and what is so wrong, with current monetary policy settings.

Elon Musk at Tesla has ridden the wave of enthusiasm surrounding new technology and business models, along with the hopes surrounding a clean green future, better than anyone else. The company now sits on a market capitalisation of about US$50 billion ($66.8 billion), and US$10 billion of debt, despite having delivered about 100,000 vehicles last year and having frequently delayed a promised ramp up in production. Put another way, Tesla is worth $500,000 per 2017 vehicle produced. By way of comparison, Ford sits on a market cap of about US$45 billion and sold about 6.6 million vehicles in 2017. Ford is worth about $6800 per 2017 vehicle produced.

It cannot last. Either Tesla’s car production needs to rise rapidly, or its share price must fall equally rapidly.

Meanwhile, almost every automotive brand has announced plans to offer either an electric version of their current models or an entirely electric fleet, within a few years. Volkswagen announced at the recent Beijing Motor Show the construction of six dedicated electric vehicle manufacturing plants in China by 2022. Elsewhere, Porsche has launched a four-door, four-seat car that looks completely different than anything else in its line-up. It showcases a raft of new technology, including a super-fast charging 800-volt battery system and eye-tracking driver heads-up display.

There is little question that Tesla changed the world of electric vehicles. Before its Model S, nobody wanted to drive an electric car. But the Model S is nearly seven years old and while it is still attractive, the subsequent Model X achieved only lukewarm sales and the Model 3 has quality issues. Meanwhile, everyone else has caught up. That is the basic thesis for why Montgomery Investment Management recently shorted Tesla in our global long/short funds.

And don’t forget that a conga line of senior execs at Tesla have left and a takeover by another manufacturer is probably ruled out by the company’s debt and market cap.

Of course, while funds are cheap nobody cares about such bad news. It won’t be until the teenagers acknowledge the problem that parents will be forced to deliver some tough love.


TOPICS:   Investment theory,  Roger Montgomery,  Stan Druckenmiller,  Tesla,  Warren Buffett

Share your comments and feedback with the editor

Sponsored content

Playing Now: