Why I think Andreesen Horowitz is wrong

Interesting Fortune article on a presentation by Mr. Horowitz (a famous VC investor) in which he argues that, despite what to laymen (like me) might appear excessive valuations and activities in the tech space, there is no need to worry about a bubble.

The full presentation can be found here and is very interesting. Although I am low-tech and certainly not as competent on the matter as him, some charts triggered an immediate reaction and I feel the need to comment on some of his slides.

Let’s start with the first one which is supposed to show that (in inflation adjusted terms) we are a far cry from the mania levels of 1999,

InflationadjustedTechValuations

Now, I won’t go into the topic of CPI measurement problems, but when I saw this chart I immediately was reminded how, a few years back, gold bulls were arguing that gold, although already in a decade-old bull market back then, was no bubble since it has not taken out its old, inflation adjusted high. (Btw. although I am an adherent of the Austrian school, I have never owned gold as an investment.)

Here is the chart I am talking about,

GoldInflationadjusted

The fact that the inflation adjusted high was not taken out has not prevented the gold price to fall by almost 40 percent since its 2011 high (the chart would have to be updated). I hasten to add that this has happened despite the fact that the central banks have continued to print money and the deterioration in the geopolitical and economic backdrop all of which are believed to be fundamental to the gold price…

Now, Mr. Andreessen could argue that the fundamentals of gold pricing are debatable (and I would agree), whereas for corporations it is doubtlessly earnings that matter and on this front there is equally no need to worry. He supplies this chart to back up his claim,

S&PITIndexFwdPE

No question, forward multiples have already been higher; but nobody is predicting a draw-down of 80% like at the beginning of 2000 anyway – however, trust me, being down 40-50 percent is no fun either.

What we need a sense of perspective: thus, I compare the forward multiple of around 20 with the trailing PE ratio, i.e. the one based on what has been earned in the past 12 months. This allows us to detect potential over optimism in analyst forecasts (not unheard of). Thus, I did a bottom-up calculation (based on individual PE and current market caps) and arrived at a trailing PE of 26 for the index. If you think that (low PE) heavyweights, such as Apple and Microsoft unnecessarily distort the index, you will prefer the average trailing PE of 30. That’s not cheap!

(Note: the Bloomberg trailing PE ratio for the index is way lower at 19.3 as it is based on index weights, which I think is (heavily) misleading here. Horowitz himself seems to use either a market weight or average concept for the forward PE in his presentation which is more meaningful for the question at hand (the index forward PE would be around 16, source: Bloomberg).

With implied earnings growth of between 30-50 percent, the question of who is more bullish, Mr. Horowitz or the average Wall Street analyst, is open for debate. In my experience, this particular forward PE should be taken with a grain of salt.

But there is more, for instance this lovely chart,

Techasapercentage of S&P

Of course, flatness is a matter of definition, but an increase from 15 percent in 2002 to a 20 percent share is not that stable in this context, if you ask me. Further, as every market participant knows, the dotcom mania was different from the current exuberance, in that back then, the froth was concentrated in tech only whereas the rest of the market was actually cheap – a fact which has allowed many a long only hedge fund to sport good risk adjusted returns (and low beta) thereby giving the (wrong) impression of not being overly exposed to the market.

This prompted me to ask the following question: what would the share of the S&P IT index have been in 99/00, if the rest of the market had been valued at the same multiple as nowadays?

Let’s see…

First we need to back out the valuation of the rest of the market at the top, i.e. year-end 1999. My Bloomberg tells me that the trailing PE for the S&P 500 IT sector was 65.43, whereas the S&P 500 (which includes the IT sector, mind you) showed a PE of 29.32. Applying Mr. Horowitz’s share of 30 percent and solving the equation, it turns out that the S&P ex IT was valued at a trailing PE of around 13.8 (!) back then, that’s cheaper than the market valuation at year end 2008, for instance, just sayin’…

Next, I try to determine what would have been the relative weight of the IT index, had the rest of the market been valued at close to current levels, ceteris paribus. I will use a trailing PE of 19 (vs. 13.8 historic) for that matter. A little algebra leads to the interesting result: the IT index’s weight would have been 23.8 percent!

Wow!

That’s very close to current level of 20 percent and crushes Mr. Horowitz’s thesis (who I think agrees that dotcom was a mania). It further shows how misleading the inflation adjusted chart really is.

At this point I have to add a very good argument made by the author of the article,

(…) While it is true that today’s tech P/E multiples are closer to the early 1990’s than the late 1990’s, a big part of that is because so few of the unicorns have gone public. So is it really an apples to apples comparison? Moreover, while it is true that public equity investors were the main beneficiaries of stock price run-ups for companies like Amazon AMZN2.22% and Microsoft MSFT-0.69%, they also were the primary losers when a wider swath of VC-backed tech companies collapsed in late 2000 and 2001. When trying to understand the current lack of unicorn IPOs, one common explanation is that these companies, while typically older than 1999 IPO issuers, share traits like unprofitability and immature corporate governance. What if VC firms like Andreessen Horowitz are nearing the same type of inflection point that public equities investors hit in late 2000? Different but the same? The flip-side of hoarding value appreciation by keeping companies private is that you’re also increasing risk (…)

Good point!

Anecdotal evidence and personal experience certainly suggest that the bubble in the private markets is even larger than in the public domain…

Then this chart,

Unicorns

Mr. Horowitz tries to calm worries by showing that the so-called “unicorns” (companies with billion Dollar market caps that are expected to be “disruptive” and without earnings) are only a drop in the ocean of tech companies.

Now, while it is true that the “unicorns” pose, ahem, specific challenges to valuation and thus require a large degree of faith, my scepticism is by no means limited to them. For instance, it can be argued that facebook is also kind of loftily valued (trailing PE north of 80 and forward PE of 50+), especially since actual earnings growth has left something to be desired recently.

Or, take amazon (a company which I love as a client): while already mature (by tech standards) and definitely disruptive to all kinds of industries, the proof that it can turn a profit to support its valuation is still open to (heated) debate. While I have no doubts that Jeff Bezos could increase its bottom line by increasing the amount it charges on shipments by, say, a Dollar or two, it is questionable whether orders would not drop precipitously, if he charged more. And since nobody out there can possible know the answer to this question, it can be said that amazon’s valuation also requires “unicorn” like faith, to some extent. It is not for no reason that the adjusted sector weight is close to dotcom levels as demonstrated above.

Further, the valuations of a lot of these are not independent, as there is a feedback loop between, say, facebook’s valuation and the value of every other network/data driven concept. I would like to know from Mr. Horowitz how often he uses comps like market cap/user in VC financing rounds, to show how those revenue free businesses are worth something after all. I bet it’s a lot.

Let me be clear: Feedback loops are normal in valuation, but they are much more pronounced for companies where valuations cannot be supported by earnings and cash flow alone…

No discussion of the tech sector, would be complete without growth opportunities. I found this slide instructive,

GrowthInInternetSmartphones

First the obvious: I think we all have to agree that the average 1999 dotcom investor  got the growth fundamentals right, as the number people online has increased more than six-fold since the turn of the millennium. Nevertheless, the IT sector index has gone nowhere since then, with heavy volatility in between, proving once more that in the long-run valuation matters.

I note, however, that the bulk of the growth is already behind us, i.e. the effect is already in the (accounting) numbers. For, projected growth of online users is a mere 5 percent annually until 2020 – decent, but I feel the market expects more. Further, it is entirely possible that this growth in users will not translate into commensurate revenue growth (in aggregate) curtesy of falling prices for end products/services.

Mr. Horowitz knows that 5 percent growth is nothing that gets Silicon Valley excited, so he focuses on smartphones where user growth, according to him, can be expected to be significantly larger due to the convergence process between people online and smartphone users. By 2020 everyone who is online will also own a smartphone, he predicts.

As I mentioned in the introduction, I know nothing about the tech industry; I do not know how reliable these statistics are or how the variables are defined and measured. However, I do know – and I am certain this is true for most of my readers – that everybody and his dog around me already has got a smartphone suggesting little room for convergence. The same is true for most emerging markets I have visited. See for example what the situation in China looks like,

ChinaSmarkphonemarket

There are now already 550 million (!!!) Chinese who access their internet through their mobile devices (I assume this is mostly smartphones). That’s almost twice the entire US population (light blue line). How many more smartphones does China need in Mr. Horowitz’s opinion?

As I already suspected: a lot of the beneficial effect of internet/smartphone penetration are already in “the numbers”. It is very likely that the future will be dominated by the cannibalizing fight for market share.

No discussion of a distorted market would be complete without discussion about the “suckers”, i.e. the dumb money that can be persuaded into buying at what insiders know/feel is ludicrous pricing. Indeed, many observers of public markets (stocks, bonds) do not think we are in a bubble yet, precisely because they cannot clearly identify the naïve market participant (hint: he/she has a PhD and despite his unlimited buying power, no experience whatsoever in practical decision making).

Because in the last tech boom retail baby boomers were the marginal buyer, many are waiting for the retail investor to come back for technical confirmation. Since history does not repeat, but merely rhymes I think they are waiting in vain: more than a decade of below-average interest rates have squeezed the middle class who is strangled by record high taxes and private debt, with no money left for “investment”.

So much for the public markets.

What about the private (mostly tech!) markets where Dan Primack, the author of the article, detects even larger signs of froth?

From the presentation,

Suckersintech

When I read “non-traditional investors” I felt relieved and astonished that the sucker theory is so robust – Q.E.D.

 Conclusion

Andreesen Horowitz presentation is great becaue it gives us an excellent introductory overview on the tech industry. Going through the slides (there are many interesting slides I haven’t discussed) you get a sense of what moves and motivates the key players in the field.

However, my reading of the slides confirms my view that valuations in the sector are lofty and expected growth likely to be way overstated. I think there IS a bubble in tech (as well).

 (Disclosure: long MSFT and CSCO)

Advertisements

2 comments

  1. I don’t disagree with the sentiments, although I think the mega-cap names aren’t really that crazy. There does seem to be a lot nonsense in private markets and a lot of B and C-grade start-ups raising funding, and its not hard to see the season 2 premier of Silicon Valley on HBO as a potential top. At a minimum, I definitely get a kick out of the deal terms offered by the private secondary markets and the utter lack of transparency/stiff fees/liquidity terms (its a shame you can’t buy puts on these guys because it would pretty much be the best short tech bubble play w/ some free optionality from a potential SEC crackdown)

    As for the unicorns, my quick take:

    In the current market, AAPL, MSFT, & GOOG are pretty much ‘value’ stocks (I still own some AAPL). FB even is probably not even that expensive given how locked in they will be for at least the next few years.

    You’re definitely paying forward a fair bit for all of that growth, but I do believe that they’ll have a very hard time not winning the lion’s share of brand advertising from legacy TV in the coming years. They’re increasingly critical distributors of online media that no publisher can afford to ignore and have built an almost uniquely immersive platform that will probably generate more value than any of these other businesses in the next 12-36 mos.

    I also think they’ve got a great deal track record and that the WhatsApp acquisition will in time look as smart a buy as Instagram has proven to be. I’m not surprised the Street gives them 30x+ earnings. If there is a large-cap tech stock that goes to 100x earnings this cycle it will probably be them.

    AMZN is definitely a tougher nut to crack given the general lack of transparency. At the end of the day unless AWS or some of these other side bets end up becoming wildly profitable its hard to see such a deflationary model as being worth >2x sales, which seems to be the lazy multiple they are reflexively given for their top line growth. AMZN’s low returns on capital are part of the company’s DNA so I’m not sure why this shouldn’t just trade like WMT.

    I don’t know. This is a fairly unique sector in many ways, and at least some of these businesses are quasi-monopolies (the amusingly included-in-the-above-chart Comcast for sure!). I still feel like China will be the first nut to really crack this cycle around.

  2. Nick,
    agree that there are frothier markets than (public) tech. As disclosed I have owned MSFT and Cisco (actually forgot to disclose that I have been long Intel too) and am holding on to them.
    Tech will probably be the last to go down in this cycle and you know my views on China…

    I just found it interesting to see how people justify lofty valuations. Usually, I would just be sceptical as I know anything about the industry (same for biotech f.eg.), it is just that for some of the slides the flawed thinking was obvious…

    Whether FB did the right choice to aquire Whatsapp I do not know and I do not use any of these things (I quit FB as I found it distracting and unnecessary, but my consumer preferences are definitely not representative), my analysis is just based on the numbers and I doubt one can make a decent return by buying and holding these stocks.
    Interestingly, there is even a slide in the presentation where Horowitz (unintentionally?) essentially makes a similar point…
    There is also a slide in the presentation that suggests FBs ad revenues have rolled over, if I remember correctly…

    China is obviously the gorilla here 🙂

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s