Are technology stocks in a bubble? Opinions differ. But the sector’s startup baby boom and the rich valuations being showered on so many fledgling firms are worrying. It is important to be more discriminating when investing in disruptive innovation today.
The tech investing scene has never been more youth obsessed. Publicly traded tech companies that are less than four years old are trading at nearly nine times sales—a 40-year high—while the premium to their older counterparts has exploded (Display).
To study this youth movement more closely, we’ve gathered a collection of young tech companies worth $1 billion or more that have either been public for four years or less or are still privately held. (Firms valued in excess of $1 billion account for more than 90% of the Nasdaq’s market capitalization.) Think of this as Nasdaq’s nursery: from this brood will emerge the Apples, Amazons and Googles of tomorrow.
Our basket of young companies currently makes up a third of all technology firms with valuations above $1 billion, a level only surpassed during the late 1990s. But there’s one glaring difference: the number of privately held startups has skyrocketed to 67, or half of our nursery group, versus a peak of eight (or 6%) in the fourth quarter of 2000 (Display). Many investors may be unaware of the important trends developing in this less transparent part of the technology market.
A Funding Bubble, if Not a Tech Bubble
These tech babies are being raised in relative affluence, thanks to an outpouring of venture-capital (VC) funding, which had reached a run rate of $26 billion by year-end 2014. This was the largest annual influx in 14 years and exceeded 1999 levels of $22 billion (though it’s still half the dotcom-era peak of $52 billion at the end of 2000). These youngsters are taking full advantage of the friendly funding environment. Roughly 82% of our private nursery companies have raised capital in the past 12 months, up from 62% for the same period a year earlier.
This funding pipeline is supported by a growing ecosystem of veteran VC leaders, incubators and angel investors, as well as the dramatic shift among return-hungry investors of all stripes into private-equity funds. The major lure is exposure to the next generation of rapid Internet growth. While Internet companies account for just 13% of all older tech companies in the public realm, they make up a whopping 78% of all public companies in our nursery today.
Are Internet Stock Premiums Justified?
We can understand the attraction to all things Internet in this era of truly transformative innovation. Internet stocks have historically commanded hefty premiums to other areas of the tech sector, especially the younger ones with the potential to scale quickly with limited capital on the back of powerful network effects. But we are concerned by the valuations of these nursery companies, particularly in the private market. History shows that the odds of longer-term success for such investments are extremely low.
In our analysis, the publicly traded nursery stocks are selling at more than eight times sales, already a peak outside of the dotcom bubble. The privately held nursery companies, however, are currently valued at an average multiple of nearly 25 times sales. Combined, the valuation comes to 15 times sales, a substantial hurdle for future investment success.
What happens in the VC world matters for public equity markets. These adolescent companies are the IPOs of tomorrow and/or the M&A targets of today’s public technology firms. A privately funded tech bubble can still be a danger if it encourages undisciplined spending sprees among large public companies. What’s more, only 17% of the newly minted tech companies in 2014 were profitable at the time of their IPOs, slightly above the 14% last seen at the height of the dotcom bubble in 2000. To many, this scene feels uncomfortably familiar.
Cast a Wider Net for Innovation
So how can investors capture disruptive innovation in their portfolios? We believe the key is to cast a wider net and to stay benchmark agnostic. Today, the technology indices and the IPO pipeline suggest that innovation mainly exists in the Internet space. Not true. While some successful Internet firms will undoubtedly emerge from this pack, innovation is everywhere—in companies creating new materials for planes (Hexcel), enabling the development of autonomous vehicles (Mobileye), sequencing the human genome (Illumina) or developing batteries for electric vehicles (Panasonic), among others.
A comprehensive research approach can make the difference. A top-down perspective alone might lead to an excessive focus in young, fast-growing Internet firms, despite their bubble-like valuations. But a bottom-up discipline introduces a healthy dose of caution and limits or helps diversify exposure to overvalued parts of the innovation ecosystem. In our view, this is the best way to identify companies with real transformational power—and attractive return potential.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.