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February 21, 2014 7:55 pm
A ramp of IPOs were announced this week, after the strongest start to the year for US flotations of real businesses since 1997. Meanwhile, Facebook bought messaging company WhatsApp for $19bn, marking the strongest start to a year for technology deals since the peak of the dotcom boom in 2000.
It is easy to hark back to dotcom insanity. Facebook valued WhatsApp at $345m for each of its 55 staff, or $42 a customer (some of whom pay as much as $0.99 for the service). More companies are valued on hope than any time since the aftermath of the dotcom implosion.
Should investors be worried? The short answer is yes. To understand why, it helps to see that this is not merely about Silicon Valley enthusiasm.
Investors are desperate for growth stocks. Five years of weak economic expansion in the US – and double-dip recessions in Europe and Japan – all but wiped out cyclical, or economically sensitive, growth. Companies able to tell a story of growth regardless of what the economy does are valued.
The exact opposite was also true: companies telling tales of growth, such as Facebook, Regeneron Pharmaceuticals or Tesla, have zero dividends as they invest to chase profits in the far distant future. Those offering high dividends but no or low growth, such as utilities, pipeline companies and tobacco stocks, were pumped up by investors looking for higher income than they could earn from government bonds.
As Savita Subramanian at Merrill Lynch says, “the valuations kind of make sense; the things that have been scarce over the past five years are growth and yield”. (She thinks both of these are overvalued relative to companies offering a mix.)
The scale of the demand for growth companies was shown by the reaction to Facebook’s purchase of WhatsApp. Rather than thinking that an all-powerful chairman and chief executive unfettered by corporate governance had just wasted $19bn of their money, Facebook shareholders cheered on the deal, pushing the shares up 2.3 per cent.
This is not because WhatsApp brings dollars through the door. Rather, it brings a lot of users – and in the social media space companies are being valued on the basis of a “land grab”, the idea that network effects mean the biggest takes all. How to turn users into money is something shareholders are happy to resolve later.
This thinking has shades of the dotcom bubble, when price per click and price per user briefly became respectable valuation metrics.
Yet, the froth remains contained – so far. There are currently 14 companies in the US’s top 1,000 priced in hope: they trade at more than 10 times sales and book value and 20 times expected earnings. All can tell excellent tales of growth, and their stories seem far more solid than, to take perhaps the highest-profile dotcom disaster, Pets.com.
They are dominated by three sectors: social media, biotechnology and online shopping (with payments systems benefiting from retail’s shift to the web). There are good reasons for all of them: Facebook is highly profitable, biotech approvals are easier and are producing medicines, and online is clearly the future of shopping. Electric carmaker Tesla has also made the list, promising to shake up an industry.
Still, it is telling that the number of these very expensive stocks this year hit the highest since the bursting of the dotcom bubble. That does not mean we are living in a renewed bubble (the chart shows just how much worse things were in 2000). But neither does it mean these stocks are correctly priced.
Investors should focus on fundamentals and ignore the froth. On this basis, equities as a whole look expensive – hence all the IPOs – but the most speculative stocks look particularly expensive. Some of these companies may replicate the share price trajectory of Google, Microsoft or Apple in their heyday; but as a group they are pricey.
Individually, each trades according to its outlook for growth, which matters far more than its current profitability.
But overall the group has been pumped up by the lack of growth elsewhere. If the economy moves up a gear, there will be no shortage of cyclical growth opportunities. Very expensive long-term growth stories would be competing for investor interest with cheaper growth from established, well-understood businesses.
Strong demand also tends to create its own supply. There has been a deluge of biotech IPOs taking advantage of the easy money available; the more shares that are created, the more demand will be needed to sustain valuations.
Bears face the sad fact that overpriced stocks have a nasty habit of attracting more buyers, as those who missed out on the doubling – or more – of prices in a year rush to join in. If the dotcom and biotech bubble is being revisited, we are only in 1999. In a true bubble, shares would double or triple from here in a few months, before popping. Painfully.
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