Disruptors get disrupted too - and then they can become value stocks
How many of the 10 technology giants that dominated the US market 20 years ago have become value stocks at some point since the tech bubble burst? The answer may surprise you
This time 20 years ago, the stockmarket bubble in technology, media and telecoms stocks was approaching its maximum circumference. Spiralling share prices (and valuations) meant that, for most investors, there was only one sector for their money – and while the proliferation of ‘dotcom’ businesses may have characterised the era, it was the tech giants such as Cisco, Dell, IBM, Intel and Microsoft that everybody owned.
Well, not quite everybody, of course: deterred by those worryingly elevated valuations, more disciplined followers of a value investment strategy held firm and steered clear of the sector. And although those who did so saw their portfolios lag the market for an uncomfortable period of time, their resolve was more than vindicated when the tech bubble burst so spectacularly in March 2000.
This brief spin down memory lane has been prompted by a general sense of déjà vu as a growing part of the market again congregates around the view highly-valued tech stocks are the right place for their money – and, more specifically, by this interesting Morningstar podcast, which features the thoughts of Research Affiliates founder Rob Arnott on, among other subjects, market bubbles, US tech stocks and value versus growth.
The podcast led us to revisit a note from April 2018 – Yes. It's a Bubble. So What? – which indicated these are issues that have occupied Arnott for a little while now. In it, he considers how the 10 largest tech stocks in the US at the start of 2000 – Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun Microsystems, Qualcomm and HP – which between them accounted for one-quarter of the main S&P 500 index, have fared since.
“Over the next 18 years, Arnott notes, “not a single one beat the market: five produced positive returns, averaging 3.2% a year compounded – far lower than the market return – and two failed outright. Of the five that produced negative returns, the average outcome was a loss of 7.2% a year – or 12.6% a year less than the S&P 500.” In short, he adds, they “did not live up to the excessively optimistic expectations”.
To a great extent, that optimism was built on the idea those 10 businesses (and plenty of others) were managing to disrupt a variety of areas in which they were operating – or, as their advocates liked to say at the time, they represented “a new paradigm”. Yet, as Arnott highlighted in his note, such thinking tends to ignore “the common phenomenon of disruptors being themselves disrupted by newcomers”.
This is an issue we have touched on ourselves, here on The Value Perspective – for example, when countering the view value is no longer effective as an investment strategy. While acknowledging disruption can indeed cause what you might call a ‘profit gap’ or an ‘upside gap’, we would strongly argue it does not negate value cycles and it should not stop value investors from making good returns when value as a strategy turns.
Furthermore, as we wrote in Profiting from tech companies, there is no reason why value investors cannot make money from ‘disrupted disruptors’. In that piece, we highlighted the ‘Gartner Hype Cycle’, which maps the journey of innovative businesses – from ‘Innovation trigger’, up the ‘Peak of inflated expectations’, down to the ‘Trough of disillusionment’, up the ‘Slope of enlightenment’ and onto the ‘Plateau of productivity’.
Yes, as we noted at the time, this may sound like the sort of long and winding road a hobbit might end up taking in Lord of the Rings. At its heart, however, this cycle is an acknowledgement of the way people and markets tend to overestimate the change that is going to happen over the next year or so, yet underestimate the change that is going to happen in, say, the next decade.
In practical terms, here on The Value Perspective, the phenomenon has allowed us to profit from buying Microsoft as it passed through its own ‘Trough of disillusionment’ in 2013. Indeed, since 2000 – and entering in at markedly lower valuations than they were on before the bubble burst – it has also seen us at different times hold positions in six others from that ‘US tech top 10’: Cisco, Dell, HP, IBM, Intel and Oracle.
No-one knows what the next Microsoft will be – or rather the next ‘Microsoft 2013’, which the wider market considered to be a ‘value trap’. If, however, you are patient, do your analysis and only buy into undervalued businesses with strong balance sheets, limited amounts of debt and a suitable ‘margin of safety’, then – no matter what value’s detractors say – you will give yourself a good chance of finding out.
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