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MW UPDATE: These 5 tech stocks are in a dot-com-like bubble (and they aren't all FAANGs)

8/8/18, 08:44
By David Trainer, Kyle Guske II and Sam McBride

Beware of Amazon, Netflix, Salesforce, Tesla and Spotify

Although the overall stock market looks reasonably valued (https://www.newconstructs.com/5- ... nother-tech-bubble/), there are pockets of extraordinary risk where stocks with 2000-bubble-like valuations lurk.

Specifically, there is a "micro bubble" in certain tech stocks, where valuations reflect expectations for future cash flows that would require unrealistically high margins, growth, and market share. These expectations might not be so "bubbly" if not for the fact that the current margins and cash flows of these companies have trended at very low or negative levels for years.

5 tech stocks in a micro bubble

Figure 1 lists the five tech stocks we put in our first micro bubble. They share a few key characteristics:

-- Low or negative return on invested capital (ROIC (https://www.newconstructs.com/ed ... n-invested-capital/)) and free cash flow (https://www.newconstructs.com/education-free-cash-flow/)

-- Unrealistically high valuations: all 10 companies either have negative economic book values, or they have a PEBV above 20

-- Expectations that they achieve heretofore unseen dominant market shares

These are five of the largest micro-bubble companies. Briefly, here's what makes each of these companies part of the micro-bubble.

Amazon

Fun fact: Amazon's(AMZN) $885 billion market cap is higher than Walmart(WMT), Home Depot (HD), Oracle (ORCL) and Disney (DIS) combined. Investors are betting that Amazon can grow to dominate multiple industries while earning significantly higher margins than it does now.

Amazon has finally shown an ability to earn a profit, but it still must grow net operating profit after tax (NOPAT (https://www.newconstructs.com/education-net-operating-profit/)) by 30% compounded annually for 19 years to justify its current valuation. See the math behind this dynamic DCF scenario (https://www.newconstructs.com/wp ... 8/AMZN_DCF_1850.png). For comparison, only six companies in the S&P 500 managed to grow NOPAT by 30% compounded annually for just the past 10 years. Maintaining that growth rate for nearly double that time frame would be an extraordinary feat.

Amazon prefers to point investors to free cash flow, but its reported free cash flow numbers are an illusion (https://www.newconstructs.com/3-reasons-amazons-cash-flow-trap-2/). In reality, the company continues to experience significant cash outflows.

Investors who focus on understanding true cash flow and fundamentals know the disconnect between actual cash flow and the market's expectations for future cash flows borders on the absurd.

Netflix

Netflix(NFLX) has become one of the leading creators of original content, but it's done so with an unsustainable cost structure. As this excellent video from The Ringer (https://www.theringer.com/video/ ... -netflix-make-money) explains, Netflix earns an accounting profit, but only because its reported content costs understate its actual content spending by about 50%. The company continues to lose billions of dollars a year and grows increasingly dependent on the high-yield debt market.

Felix Salmon of Slate recently published a piece titled "Netflix Can Either Become the Dominant Media Monopoly of the 21st Century or Go Bust (https://slate.com/business/2018/ ... -price-dropped.html)." The market values Netflix as if it will be that dominant monopoly when, frankly, there's a very good chance it goes bust. Risk/reward for this stock is so bad that no investor with any respect for fundamentals can own this stock in good conscience.

Salesforce.com

Salesforce(CRM) has racked up losses for years while pursuing growth at any cost. The theory behind this strategy is that the company will eventually be able to cut back heavily on its marketing and R&D costs while maintaining its recurring revenue stream.

Even if this strategy does work, which is far from certain, the company is currently valued at 10 times revenue, or double the valuation of Oracle. This hasn't dissuaded bulls, as Salesforce generates classic tech bubble-style headlines like "Ignore Salesforce's Valuation (https://seekingalpha.com/article ... lesforces-valuation)." In other words, they want investors to ignore fundamentals.

Tesla

Tesla(TSLA) currently has a higher market cap than GM (GM) despite selling about 1% as many cars in 2017. What's more, GM is already ahead of Tesla in self-driving technology (https://www.newconstructs.com/th ... s-coming-for-tesla/) and rapidly catching up when it comes to electric vehicle production (https://insideevs.com/within-18- ... ased-off-bolt-tech/).

Elon Musk keeps promising that Tesla will revolutionize the auto industry, but so far Tesla hasn't shown an ability to navigate the manufacturing logistics (https://www.nytimes.com/2018/04/03/business/tesla-model-3.html) that the established auto makers figured out decades ago. The company's valuation is blind to fundamentals and seems entirely focused on the cult of personality that has built up around Musk.

Read:Tesla confirms intention to go private, sending stock up 11% (http://www.marketwatch.com/story ... -private-2018-08-07)

Spotify

Spotify Technology (SPOT) wants to disrupt the music industry, but so far it remains beholden to the Big Three record labels that own 85% of the music streamed on its platform. The market thinks of Spotify as a trendy tech company, but as we wrote in our report on the stock, the economics of its business are more similar to the movie theater industry (https://www.newconstructs.com/ho ... rs-pay-for-spotify/).

Spotify's leverage against the record labels is further weakened by the rapid growth of competitors like Apple Music (https://www.forbes.com/sites/car ... nd-spotify-for-now/)(AAPL). It's hard to see how Spotify can justify the growth expectations implied by its valuation unless it could pull off the unlikely feat of taking over ownership of its content from the labels while holding off competition from other streaming services (all without having to overspend like Netflix has).

Again, we see a company where the valuation reflects the best-case scenario with little to no tether to fundamentals.

How to bet against the micro bubble

Investors that want to bet against these micro-bubble stocks can short them directly, but that can be expensive and risky for these momentum-driven companies. As the saying goes, the market can stay irrational longer than you can stay solvent.

Another way to profit from the busting of this micro bubble is to invest in the incumbents from which these companies must take major chunks of market share. When these micro-bubble stocks fall back to earth, a great deal of capital should be reallocated to the incumbents.

Macro bubbles vs. micro bubbles

Today's market has some micro bubbles, or smaller groups of overhyped stocks trading at ridiculous valuations.That makes it very different from the tech bubble, which was a macro bubble, a marketwide phenomenon that distorted the valuation of the entire market.

A few new features are shaping the market now and explain why today's bubbles are unlikely to spread to the entire market, at least for the foreseeable future:

-- Politicians and policy makers are focused on preventing macro market crashes. Today's politicians and policy makers are heavily shaped by both the housing bubble of the mid-2000s and the tech bubble of the late 1990s. They will likely do everything in their power to prevent recurrence of such cataclysmic events on their watch.

-- Rising influence of noise traders. Noise traders, who make investment decisions based on noise and have no regard for fundamentals, are an increasingly influential force (http://mitsloan.mit.edu/shared/ods/documents/?DocumentID=4486) in today's market. Roughly a quarter of all U.S. adults with internet access are retail online traders (https://www.forbes.com/sites/kum ... -mean/#64b3a4334db6). That's around 50 million investors who don't have professional trading (much less investing) experience and might be more susceptible to buying into "story" stocks without understanding the fundamentals. There's power in those numbers.

-- Overhyping "transformative" technology. The splintering of online media has led journalists to overhype nearly every new technology and trend in a relentless competition for clicks. For example, despite the "Retail Apocalypse (https://www.businessinsider.com/ ... se-in-photos-2017-3)" narrative, brick-and-mortar sales still account for 90% of retail sales, and Walmart earned nearly three times more revenue than Amazon last year. In reality, very few new technologies are as transformative as we like to imagine.

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08-08-18 0844ET