A couple of you have reached out with FOMO over tech stocks.
Tech stocks have gone on an unbelievable rally since the March 2020 lows, and many of you are wondering if it is too late to be buying tech.
We touched in this briefly in the mid-week article on whether the stock market is in a bubble.
But really – I thought this topic deserved a full article.
Howard Marks – Value v Growth
Howard Marks came out with an incredible article recently on Value v Growth stocks.
I thought it was one of his best memos ever, and I highly recommend you to read it in full.
It’s basically the story of an old man schooled in the ways of value investing, talking to his son, a young, growth-oriented tech obsessed fund manager.
Value Investors (Howards Marks)
Howard Marks built his name over the past 50 years as a junk bond investor.
With bonds, the upside is limited. No matter how well the company does, you only get back your principal, plus the interest.
So an investor like that is more focused on protecting his downside. Money is made NOT by picking great bonds, it is by AVOIDING bad bonds that will default.
If you can avoid picking the bonds that default, and all your bonds pay on maturity, you will make a lot of money.
Such investors tend to be far more cautious by nature, and focus very strongly on fundamentals like cash flow, book value and EBITDA.
Growth Investors (Howard Marks’ Son)
Now growth investors are very different.
In stocks, the upside is potentially unlimited.
If you pick a great company like Amazon in the 1990s, a $1 can turn into $1200 over 30 years (true story).
So an investor like that is more focused on his upside. The money is made by spotting the winners, holding, and adding to them over multi-year periods. While limiting the losses on the duds.
Such investors tend to be more optimistic by nature. Focusing more on the future and intangibles, rather than the past financials.
Value v Growth
Now with that context in mind, here are the key takeaways Howard Marks had when talking to his son:
- Value investing is about picking great companies at decent prices. It is not just P/E or P/B. Many tech companies rely on intangibles such as technology, that do not show up on traditional metrics.
- In today’s world, many sources of potential value cannot be easily quantified. High P/E stocks may be pricing in such value.
- Accordingly, a company with a high valuation doesn’t necessarily mean it’s overpriced, and a company with a low valuation doesn’t necessarily mean it’s underpriced
- Information is so readily available today, that it is hard to outperform simply by having more information. You need to have superior judgment about qualitative factors and future events.
- Just because a company has high growth doesn’t mean it’s unpredictable, and just because a company has slow / steady growth doesn’t mean it’s predictable
- High growth companies can continue growing for a long time, if they have a good business model with strong moat. It is insanely difficult to properly value such companies. For such companies, it may make sense to HODL (ie. hold on for a long time and not rush to take profits).
There’s a lot more nuance if you read the full article, so again – highly recommended.
Understanding the paradigm you are in
One lesson that I’ve learned along the way, is to understand the paradigm that you are investing in.
The 3 big ones are:
- Monetary Policy / Economics
- Politics (what people want)
- Technology
In the 1970s, the name of the game was inflation, so you wanted to buy anything that could protect yourself against inflation. Gold, stocks, real estate, commodities.
From the 1980s till now, the name of the game was falling interest rates, so you wanted to buy all risk assets that would benefit. Treasuries, bonds, stocks.
From 2010 till now, the name of the game was zero interest rates. Technology came into play as well, because the Smart Phone revolution kickstarted a paradigm shift – and a whole new era of businesses build around the Smart Phone App was born. Stocks, and Tech stocks in particular did very well.
Of course, the million dollar question – what is the paradigm for the 2020s decade?
In my personal view:
Monetary Policy / Economics
I think interest rates stay at zero for a long time. It will be years before we see the Feds raising rates again, by which time inflation may be a real issue.
Politics (what people want)
The past 10 years have created record inequality between asset owners, and labour workers.
What the Feds did in 2020 will only make this worse.
And I think we’re getting close to the breaking point of what people can accept – Brexit, Trump, widespread protests etc, these are just symptoms of the underlying problem.
Going into the 2020s decade, I think politics will be a key paradigm.
Governments will try to find a way to rebalance the inequality, and shift more wealth towards the labour workers.
Historically speaking, this will mark an end to the record corporate margins. It is not good for the big corporates.
You can look at the chart below – corporate profits as a % of GDP are at multi-decade highs, relative to employee compensation.
Technology
The impact from technology is only just beginning.
The internet has revolutionized information access, and that will truly change the world.
The 2010s was all about Apps.
Going forward, I think that will expand more into every other facet of our lives. Cloud infrastructure, backend automation, big data analytics etc. The big money is to be made in pairing old world industries with technology.
Is it too late to buy tech stocks?
Let’s come back to the original question.
Thinking of tech stocks as a category on its own is just no longer accurate. Tech is in all aspects of our life now.
Netflix is no longer a tech company, it is a global media company. Google/Facebook are not tech companies, they are global media agencies. Amazon is not a tech company, it is a global shopping center.
You get the point.
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Short term
This is the sentiment chart for the S&P500, and it’s looking very overbought.
Short term, I would expect some kind of consolidation or pullback, so I would be slightly more cautious on buying in the short term.
Do valuations still matter?
Howard Marks mentioned the difficulty of valuing high growth companies.
And I completely agree.
With companies that can maintain >30% annual growth rates many years into the future, any valuation you use now will make little sense. Traditional metrics such as P/E, EBIDTA, cash flow won’t make sense.
The emphasis should be on trying to understand their business model, the industry they operate in, their competitive advantage, ability to execute and monetise etc.
But I don’t believe for one second that valuations don’t matter.
Every time in history when people believed that valuations don’t matter, bad things always followed.
So I completely get that it is super super tough to value a tech stock.
But don’t kid yourself that valuations don’t matter.
If a company’s future earnings do not support the valuations, it will crash eventually.
Metrics wise, I’ve shifted more towards a Price/Sales + Market Cap style analysis, coupled with a strong qualitative analysis of the company and industry. It’s not perfect, and I’m continually refining the process.
Mid to long term
But mid to long term, I’m still very bullish on tech.
I’ve mentioned how technology is going to change the world, and I absolutely stand by that. I think the real impact from technology is only just starting.
The history of mankind is about improving our lives through technology. It’s taken us from cavemen with fire to travelling to the moon.
What has accelerated, is the pace of change.
I think it would be foolish not to allocate capital towards tech.
BUT – FAANG may underperform relative to small cap tech
Low interest rates are a fantastic tailwind for tech stocks. Low interest rates mean a lower discount is applied to future earnings.
However, increasing populism politics, and the shift in technological advancement to new areas, may count against Big Tech.
If I were a betting man, I would say that in this decade, FAANG will start to underperform, relative to small cap tech.
FAANG will face increasing regulatory scrutiny going forward, and calls for their breakup. At the very least, this will hit margins.
The new wave of advancement is also shifting away from the App economy, so unless FAANG can diversify, their growth may start to slow.
Interestingly enough, that’s been the story so far, with small cap tech very strongly outperforming the FAANG, to the point where valuations are looking stretched.
But again, valuations have a big part to play, so despite all the headwinds, risk-reward may still be good because Big Tech has been consolidating for a period now.
If I were to invest, how would I do it?
I’ll be very transparent – the big themes I am very bullish on are (1) Tech and (2) Asia.
I think the first half of this century will be defined by technology reshaping the world, and the rise of Asia.
But again, technology is just so broad, there are so many ways to play it.
For me, I’m exposed to the big software names like FAANG, I’m exposed to the hardware manufacturers like Micron and AMD, and I’m exposed to the smaller caps like Cloudflare.
Because despite all that pontificating, I think the best approach to risk management is always diversification.
Find the big story you believe it (tech), split it up into its constituents (Big Tech, Hardware, Small Cap), and allocate to all 3. And depending on how bullish you are on one sector, allocate more capital there.
You can check out my personal portfolio and stock watch on Patron if you’re keen.
Closing Thoughts
Stories like putting all your money into 1 stock and retiring after 10 years are sexy as hell, but also stupid from a risk management perspective.
As the saying goes – There are bold pilots, and there are old pilots. But there are no old, bold pilots.
Investing is also the same.
Let’s say I give you a 50% chance that you make enough money to retire tomorrow. But there is also a 50% chance you go bankrupt.
And the alternative option – a 95% chance you make enough money to retire in 10 years. Only a 5% chance you go bankrupt.
Which option do you go for? The one you pick probably says a lot about your investing personality.
The way I see it – When you’re investing for a lifetime, proper risk management makes a lot of sense.
Diversify, stay invested, and let compounding do the rest.
No need to take unnecessary risks.
As always, this article is written on 23 Jan 2021 and will not be updated going forward. Latest thoughts (and my stock watch and personal portfolio) are available on Patron.
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