Equities

The year was 1999. Keanu was stuck in a matrix, the Backstreet Boys "wanted it that way" and, as The Artist Formerly Known as Prince had so eloquently predicted several years earlier, people were partying like it was, well, 1999.

Not the least of these party-goers were those speculating on dotcom stocks in the US, who did not yet realise that the party was about to come to an abrupt and spectacular end early the following year.

Martin Conlon, Head of Australian Equities at Schroders Australia, in a recent webcast pointed to some "scary" parallels between the valuations of US tech issues leading up to the dotcom crash and those among the current crop of ASX-listed tech darlings.

(Source: Schroders)

Even factoring in lower discount rates, Conlon argues that Australian REIT, healthcare, and technology stocks in particular, currently look too expensive.

"There are 100 ways you can cut the valuations of tech – this is one (the above chart). And obviously, here we refer to things like EV to revenue multiples or enterprise value to sales. That is just a benchmark for how much people are paying for the revenue of technology companies," Conlon says.

"You can see now that, particularly in Australia, we are getting very close to the highest multiples that were ever paid in comparison to the Nasdaq at its peak. So, there's a ton of momentum behind it – you can all see that when you come in every day and these stocks go up a couple of per cent."

To further illustrate how stretched these valuations are, Conlon points out that a 2% rise in the share price of Wisetech Global (ASX:WTC) these days is about $200 million – which is about a year's worth of the company's entire sales.

"It is truly scary that a daily price move can be about equal to what a company sells every year. To put that in comparison, that would be the same as Woolies (ASX:WOW) going up 50 billion bucks, which is more than its entire market cap."

"So, those sorts of measures people lose sight of when you're in a boom/bubble. But we look at all the indicators and say, at best, even if these stocks do fantastically well in their global markets in the coming 10 years, we have brought forward enormous amounts of future return into their current valuations, and at some stage, they can't be repeated."

Schroders questions the value proposition of capital providers to businesses which require minimal capital, such as tech and healthcare firms, and the ability to retain the intangible assets which form the basis of current valuations and drive future expected returns.

Rare and unpredictable

As Conlon is quick to point out, extreme valuation multiples require a confidence in the distant future that Schroders believe is unjustifiable. In other words, 10-plus years of growth is "extremely rare and highly unpredictable".

He also says there is no doubt that on an EV/sales basis, Australia's technology companies are now way more expensive than the big market leaders like the FAANG stocks in the US.

"The difference with those stocks in the US obviously is that, for the most part, they're relatively mature now – the Apples, the Alphabets of the world are already globally dominant, and their revenues therefore reflect that," he says.

"The bull argument in Australia is that our technology companies are far less mature and therefore that they can grow revenue far more aggressively. The counter to that is generally they're operating in smaller niche markets, whether it be accounting software or logistics software for Wisetech – the market sizes are much smaller.

"So, while we have some sympathy that there may be growth potential – and we do think things like Xero (ASX:XRO) are good quality businesses – you're still seeing businesses with a few hundred million dollars of revenue with $9 billion to $10 billion valuations, which effectively require them to make $500 million of profit before tax simply to justify the prices now."

And given that these Australian tech stocks are nowhere near that in revenue terms to date – let alone profit terms – investors have priced a lot of years of future growth.

Looking back to 1999, Conlon points out that stocks like Microsoft and Computershare (ASX:CPU) did "fantastically" well for the following decade in terms of growing their profits. However, their stock prices didn't, because they had got so far ahead of themselves that investors needed all that growth to be delivered with no hiccups at all simply to justify what they had already paid in those boom times.

Material optimism

So, where is Conlon seeing appealing valuations right now? He notes there has been a polarization in the materials sector that is largely attributable to iron ore, where strengthening prices have meant that stocks like Rio Tinto (ASX:RIO) and BHP Billiton (ASX:BHP) are not as attractive as they used to be.

But at the other end of the spectrum, he says the likes of South32 (ASX:S32) and Alumina (ASX:AWC) are offering decent returns given the prices for the commodities they produce are below their long-term averages.

"So, that gives you some feel for where our portfolio positioning is," he says.

Conlon says the reasoning behind his current portfolio overweight to metals and mining is due to the belief that should financial conditions change – for example, if governments deploy something along the lines of modern monetary theory and central bankers put money directly into the economy for governments to spend – this could see very significant changes in people's expectations for inflation and their propensity to accept very low returns on bonds.

"We always believe that the best portfolio hedge for that is your materials positioning. Fortunately, in the Australian benchmark, we are very naturally hedged. As well as a big financials exposure, we've got a big materials exposure – that means if those conditions do change, that provides your insulation," he says.

"We probably are a little cautious on financials and more optimistic on materials because we see that the probability of those long-run conditions continuing to favour yields going lower and lower are declining in probability, and potentially new policies could see inflation pick up, yield curves steepen and conditions change."


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Comments

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David Smith

I think this is a poorly written article, yes the price to sales ratio is almost as high as than at the end of the doc.com boom, but the interest rate around the world was also 6% back then, ie 5% higher than today. A bond paying 6% interest would be worth much more today, than back in 1997. If you just compare bond prices, you would find that they are substantially overpriced today (but if you did a NPV calculation, you would know they are not) And that is not taking into account of the compounding growth of a share with sales growing at 30-40% vs discount rate of 5% vs 1%. When you take into account the interest rate and growth rate, you would know that this is very very different than back at the dot.com boom.