With investors factoring in exponential growth rates, Software as a Service (SaaS) firms have been trading on eye-watering multiples. However, Jacob Mitchell, Chief Investment Officer at Antipodes, says that the competitive environment in this sector is deteriorating and that their valuations have no margin of safety.
“For the first time, tech investors are starting to be challenged and a lot of the certainties that have pushed this cycle into that euphoric phase are now going to be questioned.”
In this video, Mitchell uses the example of Facebook to illustrate how the business model and earnings outlook is now looking far less certain than valuations would suggest.
What stands out as being overcrowded in markets today?
Well, I think you've got to address the obviously big stocks. What's going on in the big end of town? Where has there been maybe excess investment? And hence growth can really quite disappoint where people are still extrapolating high levels of growth. Certainly, I think in most things China related, there's already been a big shift down in growth expectations.
Not saying it's unjustified, but it's already happened. You think about what Amazon and Microsoft are doing, and as they get larger, clearly the impact they're having on the companies that compete against them is also becoming more amplified. A lot of capital is being sunk into software as a service, and most SaaS stocks trade on, as you know, multiples of sales, not multiples of earnings.
Increasingly, we see the competitive environment deteriorating. Those companies that went through a couple of billion in sales, and investors expected that exponential growth rate to continue, we just see that they're increasingly running up against either each other or Microsoft, Amazon, Google, et cetera, are pushing down into their vertical.
I think the market is very risky in many of those stocks, because there's no margin of safety. A small change in the competitive environment, it’s not just software as a service, it's also thinking just changes in the regulatory environment for some of the big internet stocks. I think Facebook is a big wake up call. Because people, and investors initially thought the issue with Facebook was this regulatory scrutiny. And it is, but it goes beyond that.
The success of Instagram and now that Facebook owns Instagram, the business model shift is much more towards video and video engagement, it brings into focus how monetisation may change. That's uncertainty for their entire business. I think for the first time, tech investors are starting to be, I think, challenged that a lot of the certainties that have gone through, that have really pushed this cycle into that euphoric phase are now going to be questioned.
I think there's a huge amount of crowding into structural growth, perceived structural growth winners and the weaker ones, the ones where no one's quite sure what the profit margin structure's going to look like at the terminal point, I think the discount rate on those will go up a lot, and hence their prices will come down.
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