US Equities: Tech gorillas prevail
The big five tech companies look likely to offer some good returns at least for the next decade or two. But deciding when to buy them might not be so easy
At a glance
• Warren Buffett’s investment in Apple is a change of heart after previously insisting he would avoid technology companies.
• Despite the historical precedents, few can envisage the dominance of the big five (Amazon, Apple, Facebook, Google and Microsoft) being challenged in the foreseeable future.
• Amazon’s business model, with its heavy emphasis on achieving dominant market share, is open to question.
• Microsoft is strongly entrenched but it is probably the most vulnerable of the big five.
The news in May that Warren Buffett had invested $1bn (€900m) in Apple after its share price had fallen by a third since summer 2015, was another demonstration of the staying power of the dominant big five companies of the internet age. Buffett had always been adamant he did not know how to value tech companies. His focus on investing in companies with predictable cash flows did not sit comfortably with a sector where there was always the danger that even the market leaders could be undermined by new technology.
Buffett may still be wary of the others in the big five with Amazon, Facebook, Google and Microsoft still outside his comfort zone. The history of tech companies is littered with names that used to be dominant that have fallen by the wayside or are just shadows of their former strength.
“Ten years ago, the big tech companies would have been IBM, Microsoft and Cisco. IBM has been successful in moving its business away from hardware towards IT services, but it won’t make it back into the top group,” says Paul Markham, a portfolio manager at Newton Investment Management.
He adds that Cisco has been subject to one of the other big themes in tech hardware – Chinese competition. “Many Chinese Government entities and corporates were unwilling to use local suppliers for infrastructure technology because they didn’t think the product was good enough. But now we are seeing Ericsson and Cisco being dislodged by Chinese competitors which are doing what the Japanese did to the Americans in the 1960s – they are partnering with them, becoming clients, learning from their intellectual capital and then making very similar products at much lower prices.”
“Anything that looks promising… can be acquired by one of the big gorillas who all have big enough balance sheets to buy them”
Despite the historical precedents, few can envisage the dominance of the big five being challenged in the foreseeable future. “In a lot of the markets it does seem to us that it is the winner who takes most. To have the best product, to innovate that product consistently and then to be able to build on a network effect of having many users, has meant that the winner is becoming dominant, whether it is Google in search, Amazon in e-commerce, Facebook in social media, etcetera,” says Connor Browne, a portfolio manager at Thornburg Investment Management.
But it is questionable whether dominant market positions make for good investments. As Matthew Benkendorf, CIO of Vontobel Asset Management, points out, one key issue for investors with the tech giants has been their reliance on stock options to motivate staff at the expense of investors. “Stock options have become a cultural feature of working for tech companies. As investors, we do need to incorporate them into our valuations.” Amazon does not have that problem but the jury is still out on its business model.
“Amazon is willing to grow unprofitably for as long as it takes, until it gains sufficient market share that it can price out other players and becomes a price setter. You are playing very high multiples for a very low margin business. You get a very low return for that high multiple. I would rather wait until we see some cash flows and we know what sort of returns we are getting on invested capital,” says Markham.
In contrast, Benkendorf is a fan. “We believe Amazon is still cheap. The market is slowly coming to accept that foregoing near-term investment for future pay-offs is the absolute right strategy. It is competing against others who are much more focused on near-term margins. It is destroying margin in traditional retail.”
Which of the gorillas is most vulnerable to a fall? They all have strongly entrenched positions but each faces its own unique challenges. Markham sees Microsoft as the most vulnerable from the perspective that it has a specific set of technologies. Benkendorf agrees. “It is competing on the cloud with Google and others,” he says. “In its traditional businesses, it will be facing threats. Looking out five, 10, 15 years, I get a little worried.” But, as Markham adds, Microsoft is so deeply embedded that it is unlikely to be dislodged.
What also protects the dominance of the big five, as Markham points out, is their ability to acquire new technologies such as Skype. “That becomes self-perpetuating – anything that looks promising, even with what looks like very high multiples in terms of price to sales which in a high-growth phase is how you value these things, can be acquired by one of the big gorillas who all have big enough balance sheets to buy them”.
The odds are that all of the five gorillas of the internet age are likely to be around for the next decade or two at least. They are also encroaching on each other’s space while also facing continual challenges from new contenders. They may be great companies but deciding when is best to buy them to make great investments may not always be easy.