Beware The Era Of 'Debtstolation'

Authored by Bill Blain via MorningPorridge.com,

“The lone and level sands stretch far away…”

Apple is just $150 bln short of hitting the “magical” 2 trillion dollars market capitalisation.  It’s the clear Most Valuable Firm in today’s market, and just about equal in value to the entire value of the US Russell Index of small companies.  Everyone is very aware of the big tech stocks have led the remarkable stock market rally since March.  Facebook, Amazon, Microsoft, Apple and Google have massively outperformed.  Record high stock indices are due to these stocks. 

(Let me state right at the start of this morning’s comment that I own stock in a number of tech firms including Apple, Alphabet and Microsoft.)

The market loves tech. Surging tech prices offer hope to the other parts of the market most impacted by the current crisis. Stock analysts are finding reasons to be positive - for instance, take this line from a US Investment Bank’s equity strategy note: “Markets anticipate better days ahead. Although the timing is uncertain, the stock market is expressing confidence the pandemic will end with a vaccine and better treatments in the interim.”

I’ve read a number of equity strategy notes suggesting Tech prices should now plateau, and it’s time to be buying the stocks that have underperformed, an implicit expectation that surging tech prices will lift all boats as the virus tide finally comes in. In fact, expectations of a vaccine are now so hyped (see the latest from Russia), I would go as far as to expect a successful vaccine could even prove to be this market’s “Sell the Fact Moment”!

Such a vaccine moment could well focus investors back onto the fundamentals, forcing them to understand why Tech is doing so well while the rest of the global economy is heading for crisis. There are good reasons why some stocks perform and others don’t – it’s a lesson we’re in danger of forgetting when Central Banks are promising to do whatever it takes to avoid a crash. There are a screed of news stories and analysts putting neutral recommendations on names like Apple assuming there must be limitations on further Tech price upside. 

I don’t know why there should be. Tech companies are winning the ongoing stock market popularity contest, and are likely to continue doing so. It’s very basic. Tech makes new stuff, (goods and services), for which there is surging incremental demand. They sell new stuff to new buyers. 

Compare and contrast to industries that become mature and demand flatlines. The car business is a great example: selling more cars is difficult - the whole industry is actually about persuading people to replace their cars. (Unless its Telsa, where you tell the buyer the car will soon be able to drive itself home.. when? Tomorrow. Always tomorrow.) 

Steel and oil companies are entirely dependent on demand for their products – which largely depends on global activity. In contrast, Tech creates its own demand – which is why earnings growth has been entirely driven by the Tech firms. Big Tech makes new stuff (goods and services) that people/companies are buying into because they don’t already have it. 

At the very start of the pandemic I used as Apple as an example of a stocks likely to weather the COVID crisis well. I expected the company would lose significant sales revenue (which didn’t actually happen), but that if it saw a fall in demand, but any lost sales would simply be purchases delayed. Revenue would not be permanently lost – if people couldn’t buy an iPhone in June, they could wait till August. 

The rest of the tech sector has the similar advantages – online offerings meant shuttered shops or working home spelt opportunity for them. Smart companies knew they couldn’t ignore social media advertising. Working for home put Zoom in front of us all, but the big winner has been Microsoft’s cloud platform. The bottom line is tech is outperforming because its outperforming. 

It might not last forever. I suspect Zoom will prove a short-live flash in the pan. It can’t really be worth 200x forward earnings or 40x this year’s sales when there are so many video conferencing alternatives from Teams etc.. And.. to be honest, its simpler and easier just to use the phone. Some tech companies will fall, and others will thrive.

But tech is fundamentally different from the rest - compare and contrast with the sectors most impacted by the virus. A holiday or flight is time sensitive and when cancelled the revenues are permanently lost. A new car purchase delayed still leaves a massive capital cost to be paid by the manufacturer and dealer – leading to increased debt. 

Large parts of global stock markets are massively underperforming... because they are underperforming. Its going to get worse as they deal with the costs of delayed deliveries, foregone cap-ex, supply chain breakdown, unpaid rents and crashing returns. Many companies are struggling with increased debt – it’s kept them afloat, but leaves them with a massive leverage burden, which will seriously impact their ability to grow, innovate and introduce new products. Even before the crisis began we were looking at 20% of US companies as effectively “zombies”. 

There is a very simple equation – higher debt = lower growth. 

Right across commercial enterprise companies have been forced to take on debt to weather the pandemic. This is happening at a time when a demand-shock – from massively increased unemployment – looks nailed on. The result will hamper growth for these companies and across economies, potentially for the next decade. It’s a recipe for stagnation at a time when the economic threat is deflation rather than inflation. We need a new word to describe it: Debtstolation?

Going back to Tech… 

I have something of a love-hate relationship with Apple. I love my bright shiny things – this morning’s missive is written on a Mac Pro, I am wearing an iWatch, and my iPhone is always in my pocket.  But when I read that Apple’s CEO is now worth over $1 trillion on the back of managing Steve Job’s firm for the past 9 years it reminds me… Apple hasn’t really innovated or produced anything new - except lots of profit and stock upside - since Jobs died.  

The reason Apple is so valuable today is that it makes stuff that people want to buy.  The point to worry is when it loses cachet – when the iPhone is just another smart phone, when iPads are playing catch up with whoever launches the first roll-up and go touch-screen, or perfects a smart-glasses computer. When Apple is no longer the Bright Shinny thing – but just another tarnished manufacturer of tech tat… well, you will have sold it years before that…  (clue to the future: I don’t wear Apple ear-buds, there are better alternatives out there…)

It’s worth bearing in mind the most valuable companies today are unlikely to be so in a few years time. Tech matures. The life cycle of most Tech Behemoths is fairly short. Eastman Kodak – in the news for all the wrong reasons today, was the third largest US firm just 50 years ago. At the top of the list was something called IBM…