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What are we paying for? - Why investors are fond of the US tech stocks

Date : 01/08/2017
Author:  Marmore MENA Intelligence

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‘FAANG’ stocks, as they are fondly referred, have been the epicentre of the US stock market in the recent past. Technology stocks account for 25.6% of S&P 500, making it the largest sector constituent. Tech stocks fuelled the rally in the US markets in 2017. Apple, Google, Netflix, Facebook and Microsoft with a weightage of 11.1% in S&P 500 index contributed a 34.5% share in the rally of the index in 2017 (YTD).

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Trading at a premium would be an understatement to refer to FAANG stocks as they trade at stratospheric valuations (price to earnings ratio). Analysing all possibilities, we could for sure say one thing, what is driving the valuation is the frenzied investor behaviour of paying too much today for earnings that are likely to accrue in the distant future. So, what are we paying for? – Investor irrationality.

History tells us that investors have similar investment patterns in the past when it comes to US tech stocks. This kind of overexcited investing in tech stocks was the root cause of the catastrophic collapse of the stock markets after the dotcom bubble in 1999. Technology itself seemed to be an impressive business plan for the investors those days. Hence, these tech companies also spent more money on marketing their company to investors. However, markets turned to reality sooner, leading to the crash right at the start of the millennium. Poor financial management, lack of profit generating activities and no vision for the future business pushed investors to realize that tech companies can no longer be their exquisite investments. Many tech firms delisted, closed their offices and some even went bankrupt. In 1999, there were more than 200 companies that filed for an IPO in NASDAQ and vanished after the markets crashed in 2001.

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Analysts who have either given a strong buy/buy recommendation for Amazon estimate that 92% of the price paid is for earnings that would be reaped after 2020(The Economist). In a decade, it is estimated that Amazon would trade at a PE of 10x. Amazon’s customer base is expected to reach 788 mn by 2025 generating a revenue of USD 3 trillion (almost the size of India’s GDP). Amazon’s valuations can be only justified by the exponential growth in its revenue, never with the earnings the company has made in the past nor with that anticipated for the future. Technology is an arena where ten years is too large a time horizon. 10 years before, products that were pioneers in use are no more existent today. With iPhone having being introduced, Apple was forced to kill its one master innovation, the iPod. Nobody thought of cloud hosting and the widespread use of internet two decades before. Technological breakthroughs generally disrupt the existing business models and can change the landscape of a sector/ companies that were till then operating quite successfully. This threatens the basis of estimating earnings for the future, especially in the longer term.

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Net income has never moved in line with the revenues of the company, rather stayed divergent for almost 25 years. The chart above conveys the business model of Amazon, their focus has been to drive down prices and gain market share, which they have quite successfully done in the past three decades. Investors still believe that Amazon is in its nascent stages, and it could turn around to make profits and generate returns for the shareholders. This can happen only if the utopian dream of creating a monopolistic retail and web services market comes true. What would happen if Amazon increases the price of its services when it feels there are no more competitors? This strategy of cannibalising market share by reducing price has never worked out in the long term. The prospect of future earnings cannot happen just by holding market share. For now, Silicon Valley majors seem to have lost ground of their unique proposition – ‘Innovation’, which was at the heart of their organizations when they were incubated.

Similar stories seem to appear on many walls of Silicon Valley. Google and Facebook depend on their advertising revenue to a larger extent. When there is another technological innovation threatening their business, these tech giants have engaged in acquisitions at unimaginable valuations. The large tech companies are unable to innovate new income generating activities in-house, and with a huge cash reserve they have all decided to look for inorganic growth. The classic example would be the acquisition of Whatsapp by Facebook after facing tough competition from Google. The private messenger service ‘Whatsapp’ was valued at USD 19 Bn and acquired by Facebook in 2014. Apple has acquired more than 20 companies in the last two years. It is a qualm if these firms could run for years like these, without innovating in house and focus on profit making activities. Technology has too many competitors to acquire and to enter into price wars.

Snapchat’s IPO listing defeats it all, where the loss making company offered no voting rights to investors and the prospectus stated that it has no intention of paying cash dividends for the foreseeable future. The prospectus states that the company expects operating losses to continue in the future and may never achieve or maintain profitability in the coming years. The company is yet valued at $18.5bn. This displays the passivity of investors towards tech investing, owing which US tech companies afford to lack corporate governance, claim to make losses, deny rights to shareholders, and yet attract investments.

Majors in the Silicon Valley, Apple, Microsoft and Google have been more attractive in terms of their valuations compared to companies such as Amazon, Netflix and Facebook. Product and service line diversification of Microsoft and Apple have generated consistent profits for these companies, unlike in case of the others. Not all tech stocks run similar risks and are not equally overvalued. However, a majority of them, especially those struggling to generate profits are stocks that thrive on the promise of glorious tomorrow.

All said and done, Amazon is just a classic case of fundamentally weak but an overvalued stock. The situation may not be indicating another bubble in the stock markets as in 1999, though nothing much has changed about the way investors have picked companies. In the long run, disconnect between the revenues and the ability to generate profits is a risk that many tech companies have embedded in their business models. Investors have unfortunately failed to take notice of the same.

Bottom line for investors – ‘Look for bottom line numbers before investing’.


 This article is published in "Marmore Blog"


Tags:  Investors, Market, Stock, Technology, US

Ratings:
 Current rating: 0 (3 ratings)

Home bias among GCC Funds - Preference for Domestic Stocks in Regional Funds

Date : 19/07/2017
Author:  Marmore MENA Intelligence





Home is where the heart is….
 
Strong bias in favour of domestic market stocks/securities among international equity funds in developed markets is well documented through various academic studies. For instance, U.S investors in international markets allocate nearly 70% per cent of their fund to domestic securities despite the fact that U.S equity market comprises only 60% per cent in the benchmark index (MSCI World). Though such behaviour is inefficient from a diversification standpoint; the phenomenon, dubbed as “home bias” is widely witnessed globally.
Institutional constraints such as barriers to invest across boundaries, limitations on repatriation of investment income, varying corporate governance standards, higher transaction costs and currency risk have been put forth as possible reasons. Interestingly, closer to home regional mutual funds in GCC markets suffer from home bias as well, despite the region being largely homogenous and frictional costs to invest across the region are largely non-existent.
 
The primary goal of a fund manager is to maximize returns while minimizing risk. However, the presence of varying country-level exposures among fund portfolios in achieving a common goal – to outperform the benchmark index (S&P GCC Composite Index for conventional equity funds and S&P GCC Composite Sharia Index for Islamic equity funds) – is puzzling, as this bias is a result of conscious and intentional move made by the fund manager. Indeed by overweighting domestic exposure the fund managers are adding on to the risk that they could have diversified away.
 
Possible explanation for such behaviour could be attributed to the perceived informational advantage of fund managers over their country stocks. Fund managers are more familiar with domestic stocks and thus have a higher degree of confidence in their ability to generate outperformance through active management. For instance, local fund managers could talk with employees, managers, and suppliers of the firm, they could obtain key information from local media, social events, and the close personal ties with senior management, all of which could provide them with better information than their regional peers and provide a distinct advantage. In part, home bias could also be an extension of “confirmation bias” as fund managers may simply feel more comfortable about their domestic investments when they keep hearing about them in local media. Country specific systemic risk factors such as political risk or poor corporate governance practices could also influence the fund manager allocations resulting in home bias.
 
An analysis of the GCC funds
In our analysis we observe that the level of home bias among GCC mutual funds (equity) is heterogeneous in nature. Funds in markets such as Saudi Arabia and Kuwait exhibit significant home bias (greater than 10% overweight to home market) while United Arab Emirates (UAE) funds have been observed to exhibit moderate home bias (greater than 5% but less than 10% overweight of home market). Funds based out of Qatar and Oman exhibit relatively minimal home bias. Based on our observation, Bahrain funds did not exhibit any home bias. In fact, GCC funds domiciled in Bahrain had underweighted their domestic country.


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Liquidity, Trade Costs & Home bias
In general, home bias, especially by Saudi Arabia and UAE fund managers could be justified due to their larger size and presence of multiple sectors. Greater size and diversified nature of their markets enable them to be relatively liquid in comparison with other markets in the region. Higher liquidity would also reduce direct transaction costs and market impact costs. On the other hand, fund managers based in Kuwait and Oman with home bias should reassess their portfolio allocation due to illiquid nature of their markets on account of relatively smaller market size and concentrated sector exposures.
 
Impact on Performance
All the funds considered in our study that exhibit home bias has underperformed their respective benchmark in the past 1year. Though GCC markets are largely inefficient and have greater scope for alpha generation through active management, the results suggest that excessive home bias could take a toll on the fund performance. Interestingly, the Qatar-based fund with least home bias had also underperformed the benchmark.

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Conclusion
As per our analysis, funds exhibiting home bias have underperformed the benchmark index. In light of this finding, fund managers of GCC funds should avoid the temptation of overweighting their country of domicile as they run the risk of being over-run by foreign funds that need not have home bias. Additionally, fund investors especially the institutional investors could have home bias as an additional parameter of analysis while selecting regional fund managers.

 This article is published in "Marmore Blog" 

Tags:  Capital, Funds, GCC, Market, Stock

Ratings:
 Current rating: 5 (3 ratings)

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