There is a growing debate of whether or not there is a new tech bubble. Generally that indicates there is a new tech bubble forming.
Of course, sometimes these things take years to play out. The brilliant investor Julian Robertson of Tiger Management famously called the tech bubble of the 1990s — in 1998. There were still two years to go. Robertson actually shut down his fund because he said he couldn’t understand the markets.
The market today is a bit different. There are pockets of extreme froth at the same time there is some value. There are areas we’ve written about, such as optical technology, which have growth but not super-high prices. The broader market is not approaching the frenzy of 1999. But yet, in some areas, such as cloud computing, data analytics, social media, and biotech, things have gotten very speculative. Connected people behind the scenes — including CFOs of big tech companies and the people doing M&A — tell me that the valuations in some of these hot new enterprise technology companies, especially recent IPOs, have gotten too high.
Many of the hot newer tech companies, expecially the recent IPOs, are overvalued — in some cases, extremely overvalued. I have some specific examples below. Lets call it the “mini cloud bubble.”
There are objective ways to determine bubbly-ness. That is why Warren Buffett is rich and you are not. Buffett always buys when things are cheap. There are objective ways to determine cheapness: Relative price/earnings; price/book; price to sales. Similarly, there are objective ways to determine that things are expensive.
Price/book does not really work in tech, because most of the highest quality tech stocks are growth stocks and their book values are tied to large amounts of intangibles. That’s why in tech I prefer using the PEG (price/earnings/growth) ratio, which gives you a company’s valuation realtive to its growth rate. PEG is great and there is a large body of research that shows that it works.
But one problem with PEG is if the company still isn’t very profitable, PEG is not a good indicator. A lot of the recent IPOs are at this stage — they are growing into profitability, but they are reinvesting most of their profits. Price/sales is a good indicator for situations like this. It’s also a good indicator when things are “red lining” and getting too expensive. Back in the 1999/2000 tech bubble, it was golden era of glamor momentum stocks and you saw many tech stocks bid up over 10X sales. It almost always ended badly. I cooked up a rule back then: You should never, ever, ever pay more than 10X sales for a company.
There are dozens of tech companies now worth more than 10X sales. In some cases, they are worth 20X sales. Let me just give you some examples of the most egregiously overvalued things — most of them in cloud services, enterprise tech, and social:
Market Cap: $8B
Y/Y growth: 50%
Forward P/E: 524
Market Cap: $8B
Y/Y growth: 66%
Forward P/E: 256
Tableau Software (DATA)
Market Cap: $4.5B
Y/Y growth: 95%
Forward P/E: 1,506
Market Cap: 26.4B
Y/Y growth: 120%
Forward P/E: 223
These were the most egregious examples I found. There are others. For some other “popular” stocks that like to be debated, such as Netflix (NFLX) and Amazon (AMZN), the evidence is less conclusive. Amazon is impossible to figure out because it is constantly investing nearly all of its profit back into new businesses , making it hard to value. The profit margin is very low, usually less than 2%, which means that it has an astronomical P/E of 580, but that hasn’t bothered anybody for years: Investors have bid shares of Amazon up expecting it to be the cloud provider of the world.
Netflix (NFLX) looks a bit bubbly, though it’s price/sales ratio is a modest 2X. With a PEG ratio for NFLX, the stock is definitely not cheap, and at these levels it holds a lot of risk.
The other social media companies, such as Facebook and LinkedIn, are getting a bit rich, but they don’t seem as bad as Twitter, and personally I think they are better businesses. But the valuations are starting to approach lofty ares, with Facebook having a price/sales ratio of 19 and LinkedIn 15, respective (Note: The author has started exploratory short positions in some social media shares, including FB.)
As I mentioned, what’s funny about this market is at the same time you have these young new hot shots, the geezer tech stocks are not richly valued at all. For example, in “legacy tech,” companies such as Cisco Systems (CSCO), Microsoft (MSFT), and Hewlett-Packard (HPQ) trade with low P/E ratios in line with the valuations of rust-belt industrial companies — which may be what they are now.
Cisco trades at a forward P/E of 10.6 and a PEG of 1.35. It’s price/sales ratio is 2.3. So clearly it’s not expensive, but that’s because Cisco hasn’t shown any evidence of high growth in many years. It’s been chucked into the bargain-basement of legacy tech stocks. On a PEG basis, it’s still not cheap, though.
HPQ may be the best of this bunch with a forward P/E of only 8. The problem is that it has no growth — but if the turnaround can progress just a bit, there is upside for the shares.
This is how technology bubbles generally develop — in with the new, out with the old. The hot young companies grow up, go public, and rake in the cash. A fever develops. Their shares get bid up. Then, eventually, reality sets in when growth slows and new competitors enter the market.
What makes this market especially dangerous, I think, is the pace of volatility and change. Think about how fast technology markets changed in the 1990s, which players such as Cisco and Microsoft grew up, and then think about how fast they change now. The disruption period has been compressed, adding volatility. When you combine the volatility of the tech markets themselves with extremely high valuations, what you get is a lot of risk.
This market is completely ignoring risk: The risk that some of these hot new companies might hit growing pains, that a big customer might fall through, that there could be strategic errors.
Stay away from these types of stocks. There are better opportunities.
Can you short them? It’s tough until this bull market starts to show more cracks, but you can try, in small amounts, as I have started to do. (Disclosure: The author has started exploratory short positions in some social media shares, including FB. He expects to get more short over the coming months.)