More Drama Than Netflix
Investors are falling out of love with tech stocks. Why are the shares plummeting – and will it continue? Milford portfolio managers Mark Riggall and Felix Fok analyse the trends.
25 May 2022
The start of 2022 has brought an abrupt shift in the status quo for share market investors that surprised many.
High-flying technology companies that have been the darlings of the investment world for the past two years have suddenly lost some of their lustre.
The technology-heavy Nasdaq index fell by nearly 15 per cent by late January, the biggest drop since March 2020. What’s changed – and do these companies still represent good investments?
Over the past two years, central banks have put an unprecedented amount of support into financial markets.
They’ve held interest rates close to zero, bought trillions of dollars of bonds via ‘quantitative easing’ (QE) programmes, and concerns over rapidly rising inflation have been ignored.
In a remarkably abrupt change of tone, runaway inflation has suddenly become a focus.
Fighting inflation will need higher interest rates and a potential reversing of quantitative easing, which could include selling bonds back to the market.
This turnaround has led to a significant tightening of financial conditions from central banks around the world.
Why the Nasdaq’s affected
So, what does this have to do with the Nasdaq?
Extraordinarily easy monetary policy has reduced the cost of borrowing for businesses, households and governments.
Governments have spent trillions of dollars handing out wage subsidies to households, in particular the US government.
A lot of this money has found its way into investments, and household investors are chasing ever more speculative assets.
It’s no surprise that cryptocurrencies, unprofitable growth companies and meme-stocks exploded in value in the past two years – they were all fuelled by an excess of liquidity in the financial system.
The tide is going out
As Warren Buffet might say, a rising tide floats all boats. But now the tide is going out.
Buyers of speculative assets are running out of bullets and are turning into sellers. Previously loved high-growth companies have been hit hardest.
But the selloff is not limited to highly speculative stocks.
Huge technology companies did well out of the covid pandemic because online activity has accelerated.
Profits have boomed and share prices have boomed even more – and investors have assumed this profit growth will continue.
This has left many of these companies looking expensive on traditional valuation metrics. In a bull market, investors tend to focus on the growth and ignore the valuation – no price is too high for any company that could be defined solely by the size of the opportunity.
But long-run favourable investment outcomes are often determined not by what you buy but what you pay for it.
High valuations leave little margin for error and the growth path is very rarely linear.
The switch flicks on Netflix
Take streaming subscription service Netflix, for example.
Subscribers leapt from 167 million in 2019 (pre-pandemic) to 222 million in 2021, adding 37 million in the first year of the pandemic and then a further 18 million paying users in the year.
The shares doubled in value over two years to the end of 2021.
However, Netflix’s latest outlook targets only 2.5 million new subscribers in the first three months this year, dampening the trajectory for the rest of the year.
On the day this was announced, the shares fell 20 per cent and in early February were still about 40 per cent off their highs from November 2021.
This sharp turnaround in sentiment was possible because Netflix traded on high current valuation multiples, and growth started to slow down, which led to it expecting a lesser result.
The change in the interest-rate outlook made the drop in valuation worse.
Investors had overestimated how it would perform, because they looked at 2020, which was a growth year when it benefited from lockdowns, stay-at-home orders, and one-off stimulus cheques, so it was condemned to miss expectations.
Still, optimists might argue that the 2020-22 episode was just a hump (first up and then down) in the context of the long-term growth in streaming demand.
That may well be the case, and time will tell. We just might see more twists in its share price than its drama shows for a while.
But not all shares that trade on high (current) valuations should be put in the same bucket.
The key, ultimately, is future earnings and, by extension, valuation over time.
Payment networks buck the trend
Payment networks Visa and Mastercard are examples of large technology companies that trade on high current valuations but are set to see earnings improve as economies reopen.
High-value international travel spending on flights and hotels plummeted in 2020 and has yet to recover fully. This category is now improving too.
Despite the wider selloff in markets, shares of Visa and Mastercard are both up this year. There are opportunities for stock-pickers.
There are still good buys
Broadly speaking, many high-growth company shares still look expensive when compared to the past.
We are also early in the cycle, interest rates will continue to rise, and economic growth will slow, potentially having an impact on profits.
As the world normalises, we don’t yet know what the long-run growth rate for different companies might look like.
On the positive side, there are many high-quality, strong growth companies that have valuation metrics that look reasonable.
Despite the headwinds, good investments still exist. A good story is essential, just don’t forget to assess whether the price already reflects that.
Disclaimer: This is intended to provide general information only. It does not take into account your investment needs or personal circumstances. It is not intended to be viewed as investment or financial advice. Before making any financial decisions, you may wish to seek financial advice. For more information about our financial advice services visit milfordasset.com/getting-advice. Please note past performance is not a reliable indicator of future performance. Please read the relevant Milford Product Disclosure Statement as issued by Milford Funds Limited at milfordasset.com before investing.
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