Business booms and busts follow a pattern. They start with an exciting change in the economy. Managers and investors collectively create a story about it, which begins as an explanation, then morphs into an extrapolation, and then into an exaggeration. Eventually the data contradict the narrative, boom turns to bust, and a bout of austerity follows. A rout in internet firms’ share prices since August has led plenty of people to ask if the tech industry is experiencing this sequence of hope, hubris and hurt for the second time in two decades. The answer is: to a degree, yes. The level of hype is particularly high, and some of the numbers are decidedly soft. That matters because tech firms are now so big and so spendthrift that a slowdown could damage the economy.
Rarely in stockmarket history have so many investors made so much money from so few shares going up for so long. Some 37% of the rise in the value of all firms in the s&p 500 index since 2013 is explained by six of its members: Alphabet, Amazon, Apple, Facebook, Microsoft and Netflix. About 28% of the rise in Chinese equities over the same period is owing to two firms: Alibaba and Tencent. Managers and investors have bought into a tale of effortless disruption by an elite of firms led by the world’s brainiest people.
Now the trend has reversed in startling fashion. The median drop in value of those eight firms has been 21% since the start of September, double the decline in global stockmarkets. Some $900bn has been vaporised—more than the eight firms were worth a decade ago, and double the value of Indonesia’s stockmarket. The pain has spread beyond the giants. The share price of Xiaomi, the largest tech listing of 2018, done in Hong Kong, has fallen by half from its peak (in dollar terms). Africa’s most valuable firm, Naspers, has sunk by 38% from its high, thanks to its large stake in Tencent. Scottish Mortgage, a ftse 100 investment trust that has bet big on tech, has tumbled by 18%.
Tech investors must have known that hyperbole was rife. In September Jeff Bezos, boss of Amazon, boasted that there was no limit to the size of his firm’s market and that he did not focus on day-to-day matters. Bankers have told Uber, a midsized, unprofitable firm, that it might be worth $120bn, double its valuation in May. Ads for tech-focused exchange-traded funds fill America’s financial press—there are 239 specialist options for retail investors. Unfashionable firms are blowing the bank to mimic the cool kids: Walmart has paid $16bn to buy 77% of Flipkart, an Indian e-commerce firm which is expected to lose over $1bn next year.
What, then, do the recent falls say about the big tech firms? A rise in real interest rates in America is not the technology sector’s fault, and explains about a third of the decline in the eight tech firms’ market value (using a discounted-cashflow model). But the rest of the drop reflects three, tech-specific worries: decelerating growth, falling profit forecasts and rising capital intensity.
Start with growth. In the third quarter the median of the eight firms saw their sales rise by 25% compared with a year earlier (using a blend of actual figures and estimates for firms that have yet to report). That is impressive but below the rapid pace set in the prior quarter, of 40%, and the slowest figure for three years. On October 26th Amazon gave a range for its expected sales growth in the fourth quarter for which the midpoint was 15%; a sharp slowdown from the 31% underlying rate in the first quarter. It pointed to one-off factors, including currency moves and an accounting change, but perhaps the law of large numbers is catching up with it. Of the eight firms, all but Microsoft have seen their rate of growth slow.
The second worry is falling forecasts for profits. To justify their loftier valuations at the start of September, the eight firms would collectively need to triple their profits over the next decade, to $550bn. The median odds of any one of the firms achieving this are 14%, based on the performance of all listed firms in America since 1950. More ominously, Wall Street forecasts for medium-term earnings are also falling as analysts take a more realistic view of tech business models. For the median of the eight firms, estimates for 2020 have dropped by 8% from their peak. Predictions for Facebook in particular have sunk by 18% to reflect the cost of sanitising its platform—hiring more moderators and carrying less virulent (and appealing) material. Analysts have cut their forecasts for Netflix by 11% to reflect escalating content costs, and by roughly a quarter at Alibaba and Tencent to reflect competition in China.
The last concern is rising capital intensity. Investors love tech stocks for their high margins and low investment. But this view no longer fits reality. For the eight firms total investment has tripled since 2013, to $180bn a year. Internet firms are now the corporate world’s largest spenders, but exhibit little of the rigour seen at conventional big investors such as Shell or Intel. The probable result is lower returns as firms throw cash at mediocre new businesses and enter the markets of rivals. China’s big companies are battling over e-commerce, entertainment and payments. In America there are more signs of overlap, with Amazon moving into advertising and Apple into video. Measuring tech firms’ return on capital is tricky owing to their intangible assets. But if you treat research and development as an asset with a ten-year life, the median return for the eight firms has dropped from 40% in 2013 to 26% this year.
Only one of the eight firms—Netflix—needs capital markets to finance itself. The others sit on $350bn of net cash and in most cases are controlled by their founders, who can shrug off slower earnings and share-price gyrations. If a crash in valuations is unlikely, however, some belt-tightening is in order. That raises a new risk. The big six American tech firms employ almost a million staff, and account for a fifth of all investment by s&p 500 companies. Amazon’s cut-throat pricing has lowered online inflation by about one percentage point. It is the ultimate tribute to the rise of the tech industry that if it sneezes the economy could catch flu.