Another tech bubble?

Tech stocks are booming and the rally shares several features with the dotcom bust of 2000

Given all the hype and hysteria around the technology sector, an obvious concern is whether we are in a bubble in tech stocks. When one looks at its relative performance, and the amount of media focus, this is a legitimate question. The last great tech bubble was the one which ended in the US in March 2000, focused on internet and telecom companies. The bursting of that bubble had severe consequences for markets globally, and thus is worth studying.

Once it burst, the Nasdaq index declined 67 per cent within nine months. It finally bottomed out, down about 80 per cent, nearly two years after the bubble had burst. Of the nine largest technology companies by market cap at that time, seven never reached those absolute values again. Only two, Microsoft and IBM, were able to once again attain their peak market capitalisation, but they took 17 and 12 years, respectively, since the bust. Even for the broader markets, the S&P 500 almost halved within two years of the bubble bursting. All markets globally sold off. The tech bubble impacted everyone and everything.

This was severe wealth destruction, and nobody wants to go through this again. Many research houses have produced reports comparing the technology outperformance of today with the bubble of the late 1990s/2000. What are the similarities and differences and how worried should we be?

At first glance, the similarities are glaring. The technology sector in the US has now outperformed for eight years consecutively, and accounts for almost 37 per cent of the market cap of the top 1,500 stocks (source: Bernstein). The only other time that technology was this important and had this large a share of the market was in March 2000. No sector has been able to dominate the markets to this extent for an extended period. Regression to the mean kicks in.

The performance has been driven by the mega-cap tech stocks, which are up almost 170 per cent in the last 12 months, similar to what had happened in the last tech run-up. In March 2000, at the height of the bubble, 36 per cent of all the technology companies were unprofitable, today this ratio is 33 per cent, the highest it has been since the peak of the bubble. The market’s willingness to ascribe value to unprofitable businesses is cyclical.

Even anecdotally, the buzz around technology is similar to what it was in March 2000. There are large retail flows, the Robinhood stories are well known, and everyone seems to know people who are simply sitting at home and punting the space globally. Trading costs have plummeted and fractional ownership has opened up stocks for everyone. We have a huge surge in blank cheque companies or special purpose acquisition companies (SPACs). They are sprouting everywhere, in every sector and the economic returns for the sponsors seem to be egregious. New initial public offerings (IPOs) are accelerating and they are listing at large premiums. Silly stock price action like what was seen in Apple and Tesla after their stock split also causes concern. The amount of media attention given to the sector, the belief in new business models, willingness to back losses and treatment of start-up CEOs as rock stars all bear strong resemblance to the year 2000.

Clearly, one has to be careful not to get too deeply sucked in. However, before we hit panic stations and sell all our tech exposure, it is worth considering the differences between today and March 2000.

First of all, despite the surge in tech stocks and all the charts showing that the bulk of US outperformance in the last decade has been driven by just 10 tech companies, the numbers were even more skewed in the 2000 bubble. In the run-up to the peak of March 2000, the Nasdaq had compounded at nearly 60 per cent per annum for the prior five years, with the index nearly doubling in the last five months. In the last five years, the Nasdaq has compounded at about 25 per cent, massive performance, but nothing like the five years prior to March 2000.

Another big difference is in new issuance and IPOs. In the two years prior to March 2000, an amazing 231 tech companies went public, and the average tech IPO was up 90 per cent within six months of listing (source: Bernstein). Today, it is different. In the last 30 months, only 36 tech IPOs have happened in the US, and most have delivered no upside within the first six months of listing. Admittedly, the IPO mania seems to be just starting now with companies using both direct listings and the SPAC route. It is, however, nowhere near the fever pitch of 2000. This is a space worth watching.

illustration: Binay Sinha

The other big difference is in valuation. While tech stocks are expensive and trading at a large relative premium to the market, things were much more stretched in March 2000. Back then, the tech sector was trading at a forward price-to-earnings multiple of 53 times compared to 33 times today. On a price-to-free cash flow basis, tech was at a multiple of 118 in 2000, compared to 31 today (source: Bernstein). The tech sector was trading at a 100 per cent premium to the broad market in 2000, compared to a 40 per cent valuation premium today.

These valuation differences do not even take into account the fact that the sectoral mix within technology is far better today than in 2000. Back then, software and internet companies were only 15-20 per cent of the technology sector. There were much larger weights in tech hardware, telecom equipment and semiconductor. Today software and internet businesses are at least 40-45 per cent of the technology sector. These businesses are fundamentally higher margin, generate more free cash, better return on capital, more sticky revenues and deserve a valuation premium.

If we adjust for the change in business mix, the valuation gap between today and March 2000 is even larger than the numbers above. Another adjustment is for real interest rates. Rates are 300 basis point lower today and show no signs of going up for the next two-three years. Such low rates help long duration growth stocks like software and internet companies. Again, valuations look less stretched today when compared to the level of rates.

With Covid-19, many of the tech businesses have sharply improved growth outlook, with an acceleration of three to five years in penetration for most online activities. In many cases their fundamentals have never looked better.

So is this another tech bubble about to burst?

While we are at elevated levels on some metrics and the retail frenzy is worrying, it does not feel or smell like March 2000 yet. We probably have some more juice left in the space, but need to be alert. A frenzy should be sold into. In terms of relative performance, it is unlikely that the unrelenting outperformance of all tech stocks will continue. The main bogey on the horizon is regulation. Its time has come. On both sides of the Atlantic, regulators are gearing up. Antitrust rules will change to focus more on market concentration as opposed to just consumer harm. The free ride that the major tech companies have had vis-a-vis regulatory oversight is about to come to an end. So continue holding your winners. The best businesses should do fine, but keep an eye for the exit door in case you hold some of the weaker and more speculative names.  

The writer is with Amansa Capital