Buy This Dip?

Buy This Dip?
By Peter T. Treadway
April 21, 2014

The Innovation Economy begins with discovery and culminates in speculation… And so at each stage the Innovation Economy depends on sources of funding that are decoupled from concern for economic return.

Throughout the history of capitalism, financial bubbles have emerged and exploded wherever liquid markets in assets exist… The central dynamic is that the price of the financial asset is separated from any concern with the underlying cash flows – past, present or possible future – generated by the economic assets it represents.

William H. Janeway,  Doing Capitalism in the Innovation Economy.

Instagram isn’t worth a billion dollars just because those thirteen employees are extraordinary. Instead, its value comes from the millions of users who contribute to the network without being paid for it. Networks need a great number of people to participate in them to generate significant value. But when they have them, only a small number of people get paid. That has the net effect of centralizing wealth and limiting overall economic growth.

Jaron Lanier, Who Owns the Future?

The Pause and Then Some

In my last blog entitled Time for a Pause?  I expressed some misgivings about the excesses that were starting to appear in the tech/biotech sector. I wasn’t calling for a collapse of these stocks but a less dramatic “bump” in the road. Well, since then it has been quite a bump with the tech/biotech sectors getting hit on almost a daily basis.

I don’t have any idea how long or if this decline will continue, although I do not see a repeat of the devastation of 2000.  A lot may depend on the current crop of quarterly earnings reports. Up until now, buy the dips has been the correct strategy, but this time the dip may be a little deeper. Allow me to make several points:

1. The consumer hardware side of the tech sector is waiting for a “new toy.”  When I first started spending significant amounts of time in Hong Kong, it seemed like every young person on the MTR had an iPod. Now it’s a smart phone. Yes the global market for smart phones is still robust but it is slowing down and becoming commoditized. The innovations that are on the immediate  horizon, such as larger smart phone screens are to use management guru Clayton Christensen’s now classic terminology, now of a sustaining rather than disruptive nature. Disruptive innovations get eye popping valuations.  Sustaining innovations—while certainly a necessary part of technological change– do not. Especially with the degree of global competition that’s out there. Two potential disruptive consumer innovations are “the internet of things” and “wearables”. Intel, for example, just made a big deal of the internet of things on its latest quarterly earnings call. But so far these categories are mostly just words. In terms its current earnings, the internet of things is not really a big deal for Intel. People aren’t running out to buy new killer products in these areas because there really aren’t any… YET.  But the companies are trying. No company wants to be the next SONY. So companies are hard at work in the innovation process. Apple hired several key fashion executives in the last year. Is Apple going to offer a pave set diamond smart watch?
2. The cloud has been a major item on the business side. Amazon (with its Amazon Web Services) and Salesforce.com got the jump on the competition. But now everybody – Google, Microsoft, Oracle, IBM, etc. etc. – is getting into this business.  And nobody has a unique product like the Windows Operating System gave Microsoft that makes them standout. And then there’s the leader, Amazon, with its aversion to profits and its hunger for market share. A recent Wall Street Journal article was entitled “A Price War Erupts in Cloud Services as Amazon, Microsoft and Google Battle, Users Reap Benefits.” I think that says it all. The real beneficiaries of the cloud revolution are the users – the solid boring multinational corporations and banks which will reap the rewards as the tech giants compete.
3. Nobody really has a good idea of how to value fast growth tech/biotech stocks. Consequently, their valuation is subject to investor mood swings from bubble to bust and back. As knowledge companies so much of their value is not visible on their balance sheets. Take networks, for example.  Metcalfe’s law states that the value of a network grows by the square of the size of the network. But where is that on any balance sheet? Of course academics will argue that an asset’s value is always equal to the discounted value of projected cash flows. But as anyone who has constructed models based on this methodology knows, a few “minor” tweaks in assumptions about such items as the cost of capital or future margins or sales or terminal values can yield dramatically different valuations.  Jaron Lanier (quoted above) has gone so far as to argue network value is primary in the valuation of tech stocks. He goes on to argue that the users in the network (and that would include all those whose activities qualify for inclusion in Big Data) should get paid for the value they add. Good luck on that. Lanier asserts that the immense network value today (including Big Data) is making billionaires of the owners of the new companies, but paupers of everyone else.
4. From the perspective of the CEOs of some of the major tech companies, paying billions of dollars for companies with few employees and sometimes no products may be a rational decision. In some cases, their companies’ cash hoards are trapped for tax reasons off shore and these acquisitions are partly paid for with their companies high priced stock. (And of course for a young CEO/founder paying out dividends is not cool. It is what old people do.) But from the viewpoint of the economy as a whole, these acquisitions may not be the most rational use of capital. In the imaginary world of a perfect capital market undistorted by taxes, a company’s excess cash flows back to shareholders who presumably will reinvest it.
5. I have been assuming (hoping) that Putin’s territorial acquisitions will stop at Crimea and that the Ukrainian crisis will eventually fade from the headlines.  But so far the crisis continues.  Nobody – maybe even Putin – knows what Putin will do next. I think it’s obvious that the crisis is a negative for the US stock market.
6. I repeat my view that the Fed taper is of minor significance. Except maybe in the financial media talk shows. Let me ask. Have there been any significant changes in either US or Japanese ten year rates once the dust settled after the original announcements of Fed tapering or the Japanese QE program? The answer is no. Why hasn’t this expansion of high powered money under QE been inflationary as the monetarist models I studied long ago in graduate school predicted? As Gary Shilling and many others now argue, inflation doesn’t happen in an environment of deleveraging.

Valuation and the Hong Kong Shanghai ‘Through Train’

China has announced a revival of the so-called Through Train policy which would allow Chinese and Hong Kong investors to invest directly in each other’s stock markets. The Through Train concept had been promised several years ago and then dropped. The new policy does not kick in until next October and unfortunately it looks like the Chinese are going to screw things up with lot of restrictions and regulations. Still it’s an important step forward. Regulations can be changed. Restrictions can be dropped.

A true Through Train has the potential to be a very positive event for valuations in the Hong Kong stock market. Today it is illegal for a citizen of the People’s Republic of China to invest in stocks outside of China. Considering that China’s most efficient and best run private (as opposed to state owned) companies trade in New York and Hong Kong, this is a bizarre situation and one that I believe is a negative for valuations of Chinese tech stocks. Moreover, there are approximately 1.3 billion citizens of the PRC, many with excess savings looking for a place to go other than their current alternatives of overpriced housing, below market government bank savings rates, stocks of  capital devouring state owned companies and risky shadow banking assets. The Through Train has to be a strong long run bullish factor for Hong Kong stocks.

This leads to a related subject—Hong Kong vs New York. Most of the best Chinese tech companies like Baidu and Sina have listed on either NASDAQ or the NYSE in New York. Only a handful of Chinese tech companies—Tencent and Lenovo being the most prominent examples—have listed on the HKEx.  The US is preferred despite having to set up a convoluted ownership structure set up to get around Chinese laws, despite the fact that New York is geographically and time-zone-wise on the opposite side of the  world from China, and despite the burdensome Sarbanes Oxley/ lawyer intensive legal environment in the US.

The apparent decision by Alibaba to list in New York is a big blow to Hong Kong. Actually a whole parade of Chinese tech stocks seems to be on tap for New York although the market’s recent setback has obviously rained on this parade. Still, it was beginning to look like Hong Kong was being relegated to being a regional market for low tech and state owned Chinese companies. Letting Alibaba “get away” was a terrible blunder on the part of Hong Kong. But Through Train if executed properly would be a game changer. It is only natural that the best Chinese companies would at least want to have dual listings, with one of them in a Chinese stock market. Through Train, much more than the 1997 political Handover to China, makes Hong Kong a Chinese stock market but without giving up its tradition of British law and the English language and no capital controls.

Will Hong Kong take advantage of this? And will the Chinese government really allow a legitimate Through Train to happen? To be seen. My guess is that if Mainland Chinese investors had a right to buy Hong Kong stocks unimpeded by Chinese government regulations and exchange controls, that Hong Kong would drive Chinese tech stock valuations, not New York.