Tech bull market driven by lockdowns and monetary stimulus …

Twenty years ago, the Y2k.com bubble burst after technology stocks had appreciated by more than 630 % over the five years before, an advance of more than four times the overall market. The poster child stock of this bubble was Cisco which reached a market cap of USD 550 bn, trading at 35x trailing sales. The shares subsequently lost 90 % from peak to trough, and never recovered Y2k levels. Many other highfliers of that period disappeared completely or continue to linger around at much lower levels.​

This year, technology shares were leading the 2020 rally by advancing 38 % versus the overall market being only up only 14 % year-to-date. In a pandemic, the need for more digital tools to communicate, interact and transact has been a strong tailwind for the industry. Over the last five years, the tech sector has risen more than 200 %, roughly three times the market.

Figure 1. MSCI IT versus MSCI World, Source: Bloomberg

That leads to the question if this is just another bubble: an echo-bubble of what has happened twenty years ago as a new generation of investors entered the market? A new generation without bad memories of the post-2000 sell-off and excited by the digital acceleration stories so plentiful these days.

​Comparing the respective numbers over five years, a 200 % increase till 2020 for technology versus 630 % in the Dotcom bubble, it looks at first glance that this time there is still a long way to go to reach the excesses of 2000. Back then the sector traded at 81x trailing earnings versus “only” 36 now. However, focusing on the tech sector alone disregards companies from other industries such as Amazon which are also tech-driven businesses.

… is translating into outsized tech stock gains
 
The cheerleaders of the 2020 advance have been the FATMANG* group, the FAANGs plus Tesla and Microsoft. Tesla is probably the poster child of this rally, up 14-fold over the last five years and trading at 21x trailing sales. The FATMANG basket has advanced 58 % this year and 390 % over the last five years. The group is trading now at 108x trailing and 56x forward earnings. Given the tremendous growth of its members, its market cap share of world equities has tripled from 5 % to 15 % since 2015 (see figure 2).

The key reason behind this increase: There was no earnings growth outside of FATMANG as figure 3 documents. With growth being scarce, investors flogged to these companies and paid up for them.




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​Figure 3. Source: Bloomberg, HCP Asset Management

​This means nothing else that very few stocks have driven earnings growth for world equities over the last years and have also propelled market indices higher. If any of those giants were to struggle in the future, it will likely have a strong impact on the major indices.

Key risks to consider
 
For next year, analysts forecast for the first time in a while a significantly stronger earnings growth outside of FATMANG, namely 26 % versus 20 % for this tech leader group, and 13 % for the overall tech sector (see figure 4). While this is because of a lower base in 2020 for non-tech shares, it may lead to a rotation away from FATMANG in 2021.

Figure 4. Projected earnings growth, Source: Bloomberg

With these companies continuing to grow their share of the market, regulatory concerns have become louder. While this so far has been mainly a European issue, we now see such developments also in the US as well. Key clients (e.g., Fortnite, Expedia) have voiced concerns about the dominant position of the US tech giants. The US has little interest in hurting the industry which has been the key success for them over the last twenty years, but the more smaller US companies get negatively impacted, the more likely regulatory action will be.
 
We could possibly see some of the following actions: Facebook may have to spin off Instagram and WhatsApp. Google may have to part from YouTube, Chrome and Android. Apple may be forced to cut the fees in their app store. Amazon may have to spin off Amazon Web Services, and Microsoft its cloud business. Furthermore, any data regulation may severely change the whole dynamics of every advertising business. Hence, investors need to very carefully monitor the upcoming regulatory action. We may first see only monetary penalties but would not be surprised that some of the above more drastic actions will be implemented.
 
The FATMANG basket has started to underperform since the US election. While it is early days, it may be a sign of things to come.

SPACs, IPOs and New Kids on the Block 

The drastic increase in money supply with measures such as M2 being up 24 % year over year has been leading to an asset inflow into financial markets.

Figure 5. M2 stock, Source: FRED

​The popularity of retail investing has increased tremendously over the last decade, spiking in 2020.
Ever lower fees, lockdown boredom, a lack of sports betting and casino gambling, fintech developments and new regulation allow and motivate more and more people to open their own online trading accounts. Retail investors historically represented 10-14% of the market. Now their share almost reached 20% on average and 25% on peak trading days.

​Figure 6. Bloomberg Intelligence 02.12.2020., FT.com

Figure 7. Source: Jay Ritter, University of Florida

​IPOs have been seeing their best year since 2000. For those who cannot wait for the proper due diligence of an IPO, the possibility of a reverse merger via a special acquisition company or SPAC has become immensely popular. Companies such as Nikola or Virgin Galactic chose that latter way. IPOs such as Airbnb saw their prices popping 100 % on day one, and the Renaissance Index of IPOs had its best year since 2000. It looks like a lot of companies which only recently claimed that being private is the best in the world, used the opportunity to become a publicly listed firm.

Figure 8. Renaissance IPO Index, Source: Bloomberg

​New disruptors such as Snowflake trade at 100 times forward sales (see figure 7 for the trend in price-to-sales ratios for IPOs). Snowflake can grow into its valuation as its sales are projected to increase seven-fold over the next three years – implying a more “normal” sales multiple of 15 by 2023. We all know that new disrupting companies shall be valued off their market opportunity and not near-term sales, but we have identified currently fifty companies trading at more than 20x forward estimated sales. Not all will be winning, and a lot is priced in as their combined market cap is already USD 1.7 trn.

Table 1. List of companies trading above 20x forward sales, as of 14.12.2020, Bloomberg

Of course, we see a digital acceleration driven by the pandemic. However, the buyers of technology also need a budget, and typically transformations take longer than hoped by the sellers. Hence, projected growth rates may not be realized, leading to valuation resets in these highfliers. Another key risk is that in case the stock market sees a melt-up from here, the Fed will be forced to pullback monetary support, especially in the light of more intense inequality discussions.

 It is not about value or growth
 
The pace of technological innovation will, however, lead to a demise of business models which cannot adopt. There has been an intense discussion when value will turn around and start to outperform growth stocks again. A company valued cheaply on the market but not able to adapt, will stay a value trap and eventually die. The key differentiation for stock pickers in the coming years will be to identify those companies which benefit most from the digital transformation by implementing the tools necessary for this shift. 

The narrow leadership has helped passive asset management
 
Who needs an active asset manager if you simply buy the FATMANG basket and outperform markets? With these names taking a larger percentage in the indices, passive management is supported – until everyone is in and the trend turns. Or until these companies start to underperform the market in terms of earnings growth...

Conclusion
 
The market has been driven mostly by a very small number of tech giants over the last years, even if it got broader recently. In this viewpoint, we highlighted the risks to a continuation of that trend. This is a risk particularly for passive investors and index huggers.
 
On top of that, speculative action in markets has increased, and regulatory changes are becoming more likely. Hence, investors need to weigh those risks going forward carefully, keeping in mind the potential rotation away from tech. At HCP, now entering the fifth year of our strategy, we believe that our focus on high free cash flow and good balance sheets is also a measure of risk control.
 
The digital innovation push triggered by the pandemic may very well lead to an increase in productivity, leading to a new wave of growth out of this crisis and propel the market further up. We are looking forward to a stabilization and healthy recovery of cash flows and earnings in 2021.

​EXECUTIVE SUMMARY

• Post-crisis debt levels are exploding, for corporates and governments
• More and more companies become zombies, as loose monetary policy triggers an 80 % increase in corporate bond issuance yoy
• While debt service levels are currently low, debt still must be paid back at some point (or refinanced)
• Current debt levels are likely toxic for economic growth
• Good balance sheet companies are outperforming – the HCP investment thesis

 
 
Pandemic triggered stimulus …
 
Global equities plunged over 30% in early spring due to the COVID-19 pandemic, but since then staged a miraculous recovery, fueled by an unprecedented monetary and fiscal policy response. However, the story does not end there. The longer-term effects of the lockdown and fears of a second wave create uncertainty, potentially leading to permanent job losses and a negative impact on economic output. The answer from governments is more stimulus, especially infrastructure programs – financed by debt.[1]
 
In March, the Federal Reserve announced that it would use up to $300 billion to support the flow of credit to companies – on top of the $700 billion budget for Treasury and mortgage-backed securities – by issuing loans and purchasing investment-grade corporate bonds through an SPV.[2] Fallen angels, corporates recently downgraded from investment grade, were included in an extension of the program shortly after that.
These actions saved many companies and the economy from the worst impacts of the pandemic. However, they also led to a debt bonanza. As a consequence, we see an increase in the indebtedness of corporates and sovereign states - from a level that was already historically high.
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​[1] https://www.schwab.com/resource-center/insights/content/2020-mid-year-outlook-corporate-bonds
[2] https://www.federalreserve.gov/newsevents/pressreleases/monetary20200323b.htm

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                       Figure 1. Sources: fred.stlouisfed.org, apps.bea.gov, HCP Asset Management

… which is translating into dramatically higher debt levels 
 
To see the big picture, it is worthwhile to first look at the starting point before the pandemic: already high and increasing levels of debt. Figure 1 shows the rise of US corporate debt, including loans, as a percentage of the US GDP, marking recessions and the sharp increase and subsequent decline of debt levels. At the start of 2020, before the pandemic hit the world, US corporate debt was already close to 50% of US GDP.
 
The trend of increasing corporate indebtedness is not a US specialty; it is a global phenomenon. Figure 2 demonstrates the increase of global net debt to EBITDA (proxied by the MSCI World Index), hitting an all-time-high of 2.7x in the 2nd quarter of 2020.

                        Figure 2. Sources : Bloomberg, HCP Asset Management

During the pandemic, as part of the fight to save the economy and most importantly, jobs, many companies issued new debt securities taking advantage of the FED’s promise to purchase corporate bonds. New issuance of corporate bonds increased by 79% in the first eight months of 2020, compared to the same period last year. Between March-August 2020 US firms issued new bonds for over $1.2 trillion, 15% of which fall in the high yield category according to the data of SIFMA, the American trade association. Issuance of junk bonds hit a new record with over $50 billion in June, beating by far the last monthly record of $40.8 billion in September 2012.[1]
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[1] https://www.marketwatch.com/story/sales-of-junk-bonds-hit-record-in-june-as-debt-saddled-corporations-rush-to-raise-cash-2020-06-30

               Figure 5.

Zombie companies on the rise!
 
Another reason for worry is the constant rise of zombie companies: Their ratio increased from 2% in the '90s to 8% in 2018, and spiked lately to 18-20%, a number indicating serious, postponed problems.  Reduced financial pressure and low interest rates are the hotbed of zombie stocks, typically associated with weak productivity and debt bubbles. The presence of zombies is harmful to the economy as they use valuable resources unproductively, crowding out more productive companies and slowing down general growth. Based on the above warning signs – increasing debt, missing bankruptcies and zombies -, we should not be surprised to see the numbers of distressed companies rising in the coming quarters.

In government stimulus we trust?
 
The future development of the economy – especially in case of a second wave of the pandemic - depends massively on the injection of further support coming from governments and central banks. The issue is that sovereign debt levels are also hitting records, with record sovereign credit downgrades and defaults at the same time. How are public authorities to finance the economy, keeping promises of stimulus and gigantic infrastructure projects for the long-term?
 
Countries reliant on commodities or tourism are especially endangered. Argentina, Ecuador and Lebanon already have defaulted on sovereign debt this year, equaling the record high of 3 defaults in 2017 by Fitch. The agency downgraded 29 countries in the first four months, out of which eight are now rated CCC or worse, with a low chance to avoid default. Fitch expects more defaults to occur this year and warns that a sharp increase in sovereign debt may be a sign of coming troubles.
 
Sovereign debt relative to GDP of the leading developed countries such as Japan, US, UK, Italy, France – selected as examples – are all increasing. The recent uptick of the ratio shows that the COVID-19 crisis caused governments to increase their debt burden, while GDP is shrinking significantly. Optimists argue that there is more room before all countries reach the levels of Japan, and the Fed is willing to finance the US deficit by buying back the issued debt. Only history will tell how this large-scale experiment ends.

         Figure 6. Sources: IMF and other sources, HCP Asset Management (for Q1, Q2 2020 which are partially estimates).

Balance sheets matter
 
Companies with great balance sheets have outperformed the overall market since its February high and its subsequent low on March 23. The universe of firms with no net debt outperformed the MSCI World by 9 % since the March 23, 2020 low, and even 12% since the Feb 12, 2020 high.[1] HCP focusses on precisely this balance sheet quality; it is at the heart of our approach. We believe that balance sheet quality will become of even greater relevance going forward.
 
Conclusion
 
The global economy is floating on a sea of increasing and deteriorating corporate and sovereign debt – investors need to be very careful. Now up to one out of five companies is estimated to be a zombie and might be the next one to go bankrupt. Governments are playing a risky game, with defaults and downgrades hitting new records in modern history – nobody can tell how long they can keep the economy floating.
 
Today, investors deeply care about sustainability: how is this level of indebtedness to be sustained or managed long term? However, how is the current level of debt compatible with good governance, the “G” in ESG? ESG must also incorporate the analysis of debt levels. Furthermore, how can we expect passive investments to perform well if the economy is floating on printed debt? Active management seems better positioned to pick the right, healthy firms and thus avoiding the most indebted firms. 
 
The HCP strategy is to focus on companies with healthy balance sheets as we believe that in a debt bubble, investors should not give up on quality even if debt service levels are low. As we have shown, the market seems to agree. Learn more about our strategy at www.hcp.ch


[1] Source: Bloomberg, Universe: Companies with net cash and a market capitalization of 1 bn USD or more

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The world has seen unprecedented disruption from technology in many sectors, as major trends such as Cloud Computing, Big Data and Internet of Things converge to what some say is the fourth industrial revolution. Therefore, we are living in really interesting times as the change seems to accelerate.
 
Fourth industrialization impacts asset management
 
Now this trend is also reaching asset management. The Finance sector, in particular the asset management industry, has broadly been slow to adapt this change. The industry has enjoyed comfortable margins for many years and has therefore not been forced to optimize its processes. Operating margins in the asset management industry have been in the thirties for the last years. On top of that, running an asset manager requires very little capital since employees are the key assets and capital expenditures can be low (basically offices and IT equipment). Consequently, the return on invested capital is high. No wonder that we have seen many players from banks over insurers to new boutiques entering the space offering products to clients. This lead to a situation where for example in Europe there exist more equity funds than listed stocks. The industry is furthermore very fragmented with no player having more than a ten percent global market share in terms of assets managed.
 
When technology hits, the change can be rapid
 
However, we have seen technology already making inroads into asset management with examples such as Exchange Traded Funds (ETFs) using technology to easily replicate indices or the rise of the Internet triggering transparency on products, performance and styles. In our view, the industry is just about to see now the full impact of technological change. Despite rising equity and bond markets over the last couple of years, fees already came under pressure, and we see even zero fee funds being offered as core products commoditize. In 2016, all net inflows into US based equity funds went into passive on the expense of active managers, and the trend has continued in the first half of 2017 despite equity markets on a run. In Europe, the trend to passive investments has started later and is less advanced. Roughly 15 % of the net inflows in the first half of 2017 and half of all equity net inflows went into ETFs. In Europe, roughly 6 % of all assets in the mutual fund industry are invested in ETFs, well below the level in the US. In the US, over the last ten years more than US-$ 1 trillion changed from being invested actively in equities to being passively invested. Especially Vanguard as specialist for passive investing is profiting from this trend but also ishares, the division of Blackrock, the world largest asset manager.
 
This trend is hitting margins and we are seeing active managers cutting fees. Given the speed of change, the industry needs to find new efficiencies fast. That is why we finally see the industrialization of asset management coming. 
 
Blockchain technology on the front door
 
In the search for efficiencies, new technologies such as Blockchain could be interesting. Isn't it an anachronism that we can deliver milk in one hour but shares settle three days later? While the technology is still nascent the potential is enormous. In theory, shares may be immediately settled once the transaction is initiated. Reconciling transactions, checking cash status or the identity of the buyer are all examples of applications which will be normal one day on the Blockchain.
 
However, in the short run there are many more inefficiencies in a still very paper based industry which can be addressed. Other industries such as retail have optimized their processes for years by using a modular approach. We expect this to be on the forefront of industry efforts in the coming years versus Blockchain technology to be more a longer term project.
 
Are the tech giants taking over?
 
Are the Alphabets and Amazons about to take over in asset management like they did in advertising or retail? We believe that this is a potential longer term threat if the industry does not act and modernizes itself. However, in the short term those tech giants have easier targets given that the finance industry is highly regulated and requires an approach which varies by country.
 
Uberization
 
Some think that Uberization stands for tech companies replacing banks and asset managers. In our view, Uber stands though for the 'gig' economy, for a highly efficient, mostly outsourced operation that uses the latest technology and increases the efficiency of underutilized assets. Netflix or Apple demonstrated what ease of use means, Tesla shows that your product feels fresher if your car comes with a regular software update. Hence, the Uber Moment of Asset Management will create an avalanche of new, easy to handle tools and new players who are betting on this technology are likely to gain share.
 
Death for funds?
 
The technological change will allow to create fully personalized products. This bears the question if those products are still be funds or other customized vehicles to save money.
 
This is only one example of how drastic the asset management industry is about to change. The new efficiencies to be found will likely be good news for the investors as saving money becomes cheaper in this process. However, very similar to other industries a massive change will end the state of deep slumber asset managers have been in.

The world has seen unprecedented disruption from technology in many sectors, as major trends such as Cloud Computing, Big Data and Internet of Things converge to what some say is the fourth industrial revolution. Now this trend is reaching asset management.
 
Our predictions
 
Our predictions for asset management in this new world are:
 

1. Large mergers in the highly fragmented fund industry driven by a trend to lower fees and therefore a reach for scale.
2. Smaller industry players who really aim to understand their customers and implement 'ease of use' for the clients have the potential to jump ahead in this game.

 
The Finance sector, in particular the asset management industry, has broadly been slow to adapt this change. One reason for this is that the sector is quite conservative but it is also in our view due to financial regulation actually protecting the incumbents.
 
Technology had already an impact
 
However, we have seen technology making inroads into asset management. Let us list three examples:
 

• Exchange Traded Funds (or ETFs) would have been not possible without fast computer technology to easily replicate indices of all types.
• High Frequency Trading obviously uses improvements in communication speeds thought impossible a decade ago, opening an area for new sources of returns.
• The Internet has triggered transparency in the sector, on fees, on performance, on manager changes et al. We are now able to 'prove' that stock picking is not adding value.

 
Zero fee funds coming?
 
In our view, the industry is just about to see the full impact of technological change. Despite rising markets over the last couple of years, fees already came under pressure. This likely has been only the early inning as they say in baseball, and we may see even zero fee funds being offered. Commoditized offerings simply cannot be differentiated by definition and the price approaches the cost.
 
According to Morningstar 70 % of all net flows in equities went into passive products in 2015, hence this trend is affecting the whole industry. Passive funds have typically lower fees than actively managed funds and reached already a 40 % market share in the US fund market for equities.
 
Industrialization next stop
 
Where is threat, there is also opportunity for agile players. The industry is mostly still not using the latest technology, has not cut all the processes into modules and automatized them as the manufacturing sector did many, many years ago.
 
Here, new technologies such as Blockchain could be helpful. While the concept may be close to its peak in terms of the Gartner hype cycle, we see a lot of areas where the technology can be applied. Isn't it an anachronism that we can deliver milk in one hour but shares settle three days later? 
 
Will the Alphabets and Amazons take over?
 
We do not think so as those companies have other, easier targets first. Finance is highly regulated and complex, and you need domain expertise to be successful. However, the asset management industry could profit from implementing the customer centric obsession tech companies demonstrate. Where is the Amazon type recommendation engine for financial products?
 
Uberization
 
Some think that Uberization stands for tech companies replacing banks and asset managers. Yes, firms such as Alibaba have demonstrated their ability to raise $ 100 bn quickly via using their platform. Uber stands though for the 'gig' economy, for a highly efficient, mostly outsourced operation that uses the latest technology and increases the efficiency of underutilized assets. Netflix or Apple demonstrated what ease of use means, Tesla shows that your product feels fresher if you car comes with a regular software update. Hence, the Uber Moment of Asset Management will create an avalanche of new, easy to handle tools and new players who are betting on this technology are likely to gain share.
 
They did not believe it in the taxi and hotel industry before it was too late. Be warned it may happen also in asset management!  
 
There are many more themes we could address here but leave them for a later blog post (please visit www.hcp.ch). For those in Switzerland, please feel free to attend my presentation at the CFA events in Zurich and Geneva this week.
 
Bolko Hohaus, CFA; HCP Hohaus Advisory
 
HCP Hohaus Advisory is a company based in Switzerland focussing on state of the art, innovative asset management solutions.