Is there another dot-com bubble?

As billionaire investor George Soros once said, “Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.” In Australia, a biotechnology bubble was clear by December 2013, evidenced through the spectacular rise in the share prices of emerging healthcare companies, most of which had never generated a dollar of profit. Notwithstanding the opportunities that remain present in the sector, it was clear that euphoria had taken hold and that the market was mispricing the risk associated with unproven technologies, business models and management teams.

Our attention was first piqued in regards to this sector by the phenomenon of North American biotechnology companies opting to raise capital from Australian investors. On a deeper examination of the sector domestically and abroad, it became clear that Australia is a relatively immature market in comparison to the US, with local investors demonstrating a marked preparedness to rely on predictions from company management rather than scrutiny of clinical data.

For a long/short equity investor, such extremes in mispricing can provide the some of the most compelling investment opportunities. We are able to capitalise on such distortions and profit when sense and reason prevail or, in an extreme case, where fear overcomes euphoria and bubbles burst.

The performance of Australia’s emerging healthcare index has diverged from offshore trends and is actually struggling after a spate of overpriced companies came crashing back to earth, including QRxPharma, Pharmaxis and Prana Biotechnology. Our portfolios have been beneficiaries of this recent divergence.

In the United States, the biotechnology and digital technology sectors are showing all the signs that they are already in, or rapidly heading towards, bubble territory. In response to the increasingly stratospheric valuations for US companies in these industries, Federal Reserve Chair Janet Yellen took the extraordinary step of singling out these sectors as areas of concern during her testimony to Congress in mid-July. “Valuation metrics in some sectors do appear substantially stretched – particularly those for smaller firms in social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year,” she said.

Dot-com bubble 2.0

Digital disruption is changing the industrial landscape at an increasingly rapid pace. A recent study by Deloitte estimates 65% of the local economy is facing significant disruption over the next three years. This presents opportunities for entrepreneurial start-ups as new technologies create innovative solutions for customer problems in affordable and convenient manners. For established corporates, this presents both opportunities and risks. There are new opportunities and channels to customers, but there is also a threat that their established businesses could be superseded.

Some of the key themes we’ve observed in the technology sector include the cloud, micro-transactions, mobility, big data and social gaming. While each new thematic encompasses a raft of opportunities, many of the recent start-ups have little or no corporate history and seem to have  done little more than capitalise on the right buzzwords.

One clear lesson from the first dot-com bubble was that investors bought the blue sky but failed to fathom the difficulty in monetising new products and the speed at which pricing power is eroded. It would seem that investors may have forgotten this lesson in dot-com bubble 2.0.

The cloud is changing the economics of technology companies in three key ways. First, monetisation is driven by consumption, with low switching costs. Second, the risks have skewed more to the vendor with the consumer now expecting to pay less up front and more in recurring fees. Last, the growing “consumption gap” is limiting the ability of technology companies to grow profits as consumers and businesses are pushing back on paying for features they don’t require, illustrated in the figure below. 

Source: Consumption Economics - The New Rules of Tech

The behaviour of the consumer has changed considerably, with the iPhone and App Store proving to be highly disruptive forces. Apple led the market in empowering its end users to make their own decisions and pay only for the applications they want. It hasn’t taken long for this mindset to filter through to enterprise.

While some of the opportunities in these sectors are undoubtedly exciting, we are now witnessing what we believe is a bubble in stock prices. As seen in the figure below, when margin debt as a percentage of GDP reaches 25-30%, it delivers a negative signal to the market. There is probably no better indicator of herd behaviour than margin loans, which indicate this cycle is peaking.

Providing further evidence that investor enthusiasm is becoming irrational, the flurry of private companies taking advantage of lofty valuations by floating on the share market is culminating in an initial public offering (IPO) boom not dissimilar to that which occurred during the last dot-com bubble. In the past 12 months, Australia and New Zealand have digested roughly $15 billion in new floats, with more coming to market in the next few months. To put that in context, in the four years leading up to 2013 there was roughly $3.5 billion per annum in new issuances.

Valuations for tech companies are being based on the promise of potential growth from online services that are building huge audiences, while consideration of the risks is being overlooked. Most investors see an opportunity very quickly, but naturally struggle to temper their enthusiasm with the reality that technology companies can become extinct just as quickly as they emerge, and that monetising an opportunity can be harder than winning the audience.

The excessive valuations we are seeing offshore are spilling over into some local industries. For instance, segments of the telecommunications, education and media industries are extending into bubble territory. The initial public offering market is overheating with many low-quality businesses listing on high valuations.

Watermark is actively scouring the abundance of new companies and buoyant industries, trying to determine companies where investors have mispriced the risks. The strength of the Watermark process is that we can capitalise on our identification of these opportunities. Having been rewarded as a result of identifying similar themes in biotech over the past four years, we are monitoring what appears to be the dot-com bubble 2.0.

Josh Ross is an analyst at Watermark Funds Management.