Is this a bubble?
The digital revolution is changing our lives and businesses in so many ways
Some market participants fear that the success of the digital giants in dominating the performance of stock markets in recent years is another bubble. All nine of the world's largest companies by market capitalisation in the world index are now technology, social media and communications related, and eight of them are American. The other is Taiwan Semiconductor, supplying many of the needs of the US companies and investing heavily itself in the US.
Some remember the distant days of 2000 when Nasdaq fell away dramatically after a great bull market based on hopes of the digital future to come. The index fell 78% from its March 2000 peak by 2002. The index in early 2000 had become overextended, forecasting events some years off and getting too far ahead of business realities. The market rated highly companies that still had not turned a profit, and in some cases, became over enthusiastic about the potential of companies that still had very little by way of sales. The markets rightly sensed that digital technology was something big but just got too euphoric. It was too soon to see the real winners, and too soon to be able to buy into many companies that would generate plenty of cash and profits from these new ideas.
Today is very different. The US giants have grown large by winning hundreds of millions of customers and by delivering strong turnover and profit growth. Today, fears are that the speed of technological development could drive down their margins and divert their business as new competitors and breakthroughs emerge. Some fear that their huge commitment of capital to massive expansion in storage, computing and service sold as AI will not prove as profitable as the businesses they have today.
The main digital companies have been producing great results to date
The bull case remains strong for the group of top companies as a whole. This is not just a sector bet, it is an assumption that the digital sector will subsume many other sectors as they develop cheaper, better, faster business models for everything we do. Amazon is a tech company that has a big share of the retail market. Meta and Alphabet provide social media and search services, but they also have taken much of the traditional advertising market. Microsoft is a software company, but it is embedding itself into a wide range of business services like accounting, legal, security and customer handling.
Tesla has been the most subject to severe competition. Pioneering electrical cars, Tesla is now being overtaken in this area by Chinese competitors offering cheaper and more accessible vehicles. This has caused greater volatility in Tesla shares. Tesla is hitting back, promoting robots and the automated vehicle. If they succeed with driverless cars, they will revolutionise everything from taxi companies to car finance. There will be far fewer cars owned by individuals and companies. There will be professional fleets of automated vehicles circulating in each area for immediate hire. There will be less need of car parks and home garages. Car purchase finance will be largely replaced by finance for auto car fleet companies.
Can they grow further?
Usually, as companies grow, the inverse of compound arithmetic catches up with them in the form of diminishing returns. They run out of new customers to add and of new things to do. Management can become defensive, easing into managing decline as new competitors and new products emerge. So far this has not happened to the giants. The scope for their business growth stems from their ever-widening geographical spread into poorer countries, who see digitalisation and the mobile phone as the way to accelerate their development. They are also growing by making their products and services relevant in ever more areas of traditional activity. Most businesses now see the need for a web presence to advertise their goods and services, for a fully computerised back office, for online ordering and service delivery and for more automated plant where they are making things. We are seeing more robots and drones linked into computer and cloud databases.
The digital sector overall will continue to grow at a fast rate. The incumbent large companies have many advantages: they can afford the huge costs of creating much more data storage and processing capability. They can also buy up troublesome competitors before they have reached too large a scale.
It is true that Apple's growth has slowed some as the company has not launched a radical popular new product to match the iPhone or iPad. It has nonetheless been able to sell dearer and more complex replacement phones to its customers and to build a big service business. Alphabet has kept hold of a good percentage of the search market. Amazon has been building a large cloud and web business alongside its success in online retail. Meta has found new target markets for its various social media offerings.
Governments are getting more interested in regulating these businesses. The industry and its supporters see some of the moves as a restriction on free speech as regulation is focused on better child protection and enforcement against hate speech and false information, with associated costs. Meanwhile the companies themselves are reducing their staff as they adapt their AI inventions to streamlining their own overheads.
Stock market valuations
All this makes stock market valuations difficult and subject to volatility. The market does not just have to worry about whether the digital giants themselves will be subject to margin erosion, over extension of capital and new competitors but it also needs to understand the impact on traditional businesses, still vulnerable to an online, robotic or AI alternative.
The digital giants so far have made good use of free offers to hook people into their services. They have often charged businesses and let the ultimate customer off lightly when it comes to direct charges on them. They have financed a lot of activity by taking over most of the advertising. They have charged people for software when they buy a new device that uses it. Now they are also increasing the annual charges for use of apps and software or introducing charges for the first time. There is more scope to take more of our money as digital repackages and as AI conquers more of our lives. So far, the public has driven the pace of change by taking up so many mobile phones and wanting to use them for everything from shopping to photography, from keeping in touch with family and friends to accessing their money.
It appears premature to sell these leading tech stocks because they have done well. The best bet for growth and future prosperity comes from more digital innovation and robots, from more AI and cloud storage. The US is growing so much faster than Europe which lags in spend and adoption. But, as investors, we all need to watch carefully to see if more fleet of foot and cheaper competitors do manage to emerge and survive; and to see if the giants can maintain their enormous energy and innovative drive.
About the author
The Rt. Hon Sir John Redwood has been a long-standing member of the EPIC Investment Partners Advisory Board.
John is a well known commentator on governments and economies, with long experience of investment markets. Trained as an analyst at Robert Flemings, he moved to N.M. Rothschilds where he became a Manager and Director of pension and charitable funds and Head of Equity Research. He was seconded to become Head of the Downing Street Policy unit before chairing a large, quoted UK industrial business. He served as an MP and a government Minister.
In 2007 he set up Pan Asset with a colleague, an investment management business that pioneered active/passive funds and models in the UK. Following the sale of the business to Charles Stanley, a quoted investment manager in the City, he became their Global Chief Strategist advising on non-UK markets and economies. He also ran a demonstration fund for the FT, writing articles about it and illustrating the use that can be made of ETFs in portfolios.
He is now an adviser to EPIC, providing insights into the big investment issues of the day from the debt and spending problems of the major governments to the green and digital revolutions which have so much impact on equity markets. He is a Distinguished Fellow of All Souls College, Oxford, where he helps with their Endowment investments and gives occasional lectures on modern economics and politics.