The latest Greenlight Capital investor letter written by hedge fund manager David Einhorn caught my eye earlier this week. It sees were are not alone in the head scratching at many tech company valuations with the respected fund manager also joining the bear camp and putting out a number of tech company shorts. A quick glance at the chart below reveals pretty clearly just how divergent the index has become from its long term trend.
During the 1990s investors also piled headlong into tech stocks, irrespective of the likelihood of these companies ever having a profitable quarter. They pushed multiples to epic price-to-earnings ratios that had not been seen before and have not been seen again. Until now… Indeed, at the turn of the millennium, such was the level of irrationality that a company merely needed to incorporate a dotcom in their name in order to experience a large rise in their stock price.
According to Mr Einhorn, one of the most important ingredients of a bubble is the rejection of traditional valuation methods. When investors start measuring businesses on a clicks-per-user, average daily visits, number of users, assets-per-click basis etc etc, it is really a substitution for the “anal”ysts not being able to find real value and thus needing to look for some alternative measures to try and justify the valuation.
In current cases where there are actually some profits, PE multiples are being pushed to extremes. If there’s something we could learn from the tech bubble however it is that these dotcom businesses are volatile in their metrics. Todays “hot” social network company can be tomorrows toast – remember Myspace, boo.com etc? A company may have 50 million users today and in six months lose more than half of them…
Internet users are always looking for the latest “big thing” with there being very little loyalty amongst them. What this means is that when discounting future expected cash flows for these companies that we should actually be using very high rates and not low ones as is currently the case! If, let’s say, 5% is an appropriate discount rate for a stable Dow stock, in certain cases with early stage tech stocks you may need a 33% rate to capture the ever-changing nature of the business. Amazingly, what we see now is Netflix at 192x, Linkedin at 784x and let’s not even talk about Twitter! It is true that the tech market is not as overvalued as in 2000, but there are a good many companies that are trading far, far above what a rational investor can even remotely begin to justify.
A second ingredient that contributes late stage to a bubble and that was highlighted by Einhorn is when short-sellers are forced to cover their positions and so push prices on even further. This is precisely what has been happening during the last few months, with the “most shorted” stocks in the index outperforming the main market by a wide margin.
The third ingredient Einhorn alludes to is IPO hype and which all but the blind would realise we have been seeing globally in recent months with huge first day IPOs pops for many recent listings. Remember these pops come on top of already rich valuations…
All the above points to a likely very bad ending for the tech boom seen these last couple of years. the last bubble, many shares declined more than 90%, when investor’s expectations came back down to earth traditional valuation models were re-applied. This will inevitably happen again. The problem of course is timing and trying to position for this event without killing your account. For the fearless like Einhorn, shorting a basket of momentum stocks may be the way to go however, we prefer to play it via options through short call sales and legging into Put spreads on the most overvalued plays and the wider Nasdaq market.