If we compare our coverage to the dot-com bubble (in which the NASDAQ declined 66% from 2000-2002), U.S. Tech is in a better place today.
Unlike in the dot-com era, semiconductor and hardware companies have fundamental earnings power to support valuations.
Many companies under our coverage are supported by healthy free cash flow generation. Among other names that lack GAAP (generally accepted accounting principles) profitability (mostly software), we still see firms making wise investments in sales and marketing to capture sticky customers in rapidly growing end markets in the once-in-a-generation shift toward cloud computing and software-as-a-service. Moaty software companies under our coverage have proven to us that they benefit from customer switching costs and are likely to continue to upsell and cross-sell into sticky enterprises over time.
If our Tech coverage does in fact crash, we suspect it would be macro-driven, not because of highly risky bets on unproven technologies that fail to gain adoption.
Nonetheless, we saw unusual price appreciation in 2020. We identified 11 companies under our coverage where the stock price rose 100%-plus while reaching at least a $20 billion market cap in 2020, meaning that the company added at least $10 billion of market value in a single year.
These types of large moves are rare—we typically only see one or two companies receive such a massive infusion of investor dollars in a single year, and 1999 was the last time we saw more than five companies appreciate to this extent.
In recent years, the market made some wise investments to pile into one or two of these stocks each year (especially FAANG). Investors were wise to pile into Apple and Nvidia, for example. However, many investors did not fare well after 1999, which was the last time that the market rushed into more than a handful of Tech stocks. At best, investors were far too early and it took 10-20 years for long-term fundamentals to catch up with these enormous valuations.
Companies under our coverage where the stock price rose 100%-plus.
- Coupa Software
- CrowdStrike
- DocuSign
- Nvidia
- Okta
- Palantir
- RingCentral
- Shopify
- Twilio
- Zoom
- Zscaler
We would anticipate poor outcomes for many investors buying these stocks at today's prices, most notably Zoom and Shopify.
In order to come close to such valuations today, these firms not only require tremendous future growth and earnings power but also wide economic moats, whereas we are more skeptical about the ability of these firms to fend off competition.
We struggle most with current valuations for Zoom, Shopify, and Palantir, which trade at roughly 2 times our fair value estimates. We struggle to build a reasonable bull-case scenario that can justify market prices. Rather, we would need to see more than 20 years of robust earnings growth out to 2040 to justify such valuations, all while presuming market dominance without fear of competition from others.
Several names trade about 30% higher than our fair value estimates, including Nvidia, Zscaler, Coupa, and DocuSign. We foresee strong revenue growth and earnings for these names, but these stocks would have to fire on all cylinders for a decade or longer in order for future fundamentals to justify today's stock prices.
Instead, some undervalued names across our coverage are Intel, Splunk, Blackbaud, VMare or even fairly valued bellwethers such as Microsoft and Salesforce.
Several other stocks within our list are high quality and appear overvalued, but we can build a reasonable bull-case scenario to justify current prices and we'd likely be buyers on pullbacks. This list includes Twilio, RingCentral, Okta, and CrowdStrike, with the latter two boosted recently by a rosier outlook for cybersecurity spending because of a recent hack breaching a widespread number of enterprises and government entities.
Key takeaways
- We would characterise our U.S. Technology coverage, which skews toward larger-cap companies with sustainable competitive advantages, or economic moats, as overvalued. The median stock within our coverage trades at a price/fair value ratio of 1.18 as of December 30, 2020, which is one of the highest ratios we've seen since 2007. In order to find investment ideas with an attractive margin of safety, we'd like to see a pullback in stock prices across many of our names.
- We see a handful of firms with astronomical valuations that go far beyond our fundamental expectations. We also see sky high price/sales multiples in the top decile and quartile of software stocks. When thinking about a "bubble," we can construct a basket of highly overvalued Tech names where valuations are exuberant and might "burst" in the future.
- We believe these stocks have doubled due to favourable trends in remote working software tools, increasing investment in cloud-based cybersecurity, advancements in artificial intelligence and data center buildouts, and the once-in-a-generation shift to SaaS. We lifted our fair value estimates in 2020 as a portion of this value creation was justified with stronger-than-anticipated growth and earnings, but market prices still soared past our revised valuations.
