FRI 29 APR 2022
The crash in trash (profitless technology companies) has been brutal year to date and from the peak in February last year (-40% year to date and -62% from peak). Profitless tech and the infamous ETF have also materially underperformed the NASDAQ and equity markets more broadly. Earlier this year we suggested that a proper rise in the discount rate would likely cause a correction of biblical proportions (excuse the ARKK pun) in levered and expensive growth stocks. While there has been a large re-calibration in future short term interest rate expectations and liquidity, the irony is that the large drawdown in profitless technology has occurred with only +25 basis points on the funds rate (so far).
The good news, as we noted last week, is that the rise in short term policy interest rates are close to being fully priced. The Fed Fund Futures are now priced for more than 300 basis points of tightening by the northern summer 2023 and around 250 basis points by the end of this year. Put another way, the fixed income and money markets are now priced for a modest overshoot around a credible estimate for the terminal funds rate. Moreover, the nominal 10 year Treasury yield is probably close to fair value if inflation pressure starts to moderate or macro growth conditions deteriorate looking forward.
As we often note, a behavioural episode is typically characterised by; a rapid and violent movement in price; focus on a single story; and occasions when price is potentially inconsistent with fundamentals. The first element – rapid price action – helps distinguish something from a cyclical, emotional or short term overreaction and a legitimate fundamental structural problem.
Our sense is that the correction profitless tech is not an emotional overreaction, but warranted based on the absence of credible growth and the material rise in the discount rate. While there large correction in price has reduced the valuation anomaly for some, our own short basket of profitless tech (“hope-at-a-ridiculous multiple”) has improved from 10 times sales to 6 times sales currently. The current multiple would still leave the sector only modestly below NASDAQ 2000 peak valuation levels. We would advise against clients looking to bargain-hunt in the sector.
Rather, our sense is that the environment still favours companies with strong cash flow and low balance sheet leverage. To be fair, that might imply a more favourable outlook on some of the mega-cap tech in the United States or in Asia where there are major companies with net cash on balance sheet and low double-digit earnings multiples.
In conclusion, the good news is that there has been a material re-calibration in positioning and consensus beliefs in the profitless technology sector. However, our sense is that macro conditions could remain challenging if there is an overshoot in the discount rate, especially for companies with high balance sheet leverage. Moreover, profitless tech is still arguably expensive on multiples of sales or the hope and dreams of future growth. If duration or interest rate risk is near a peak, we would still has a bias for profitable companies, especially in this region where expectations and valuations are depressed.
**We have had a number of questions on the large impulsive move in the Japanese Yen and the implications for global rates. We will address that next week. Very briefly, most of Japan’s debt is still held by domestic institutions and a country that has its own central bank and currency has unlimited capacity to buy its own debt. However, inflation is a major constraint. If inflation and inflation expectations became unanchored via a reflexive or self-reinforcing collapse in the yen, that would be a challenge for Bank of Japan and the current policy regime. It could lead to Japanese institutions repatriating foreign assets. However, the major risk for Japan is likely when they require foreign capital to fund debt.