What Price for Growth?

Cloud computing and social media are bringing a level of disruption and innovation not seen in the technology sector since the dot-com era. The troubling aspect is that valuations for many of these companies seem just as stretched as Internet stocks were back then. We think investors may be paying too much for the growth inherent in these companies.

No one disputes that cloud computing and social media are game-changing technological developments. Using software as a service in the cloud, as opposed to purchasing packaged software and downloading it on an internal server, provides considerable value for businesses. The model behind the cloud is cheaper, creates a friendlier user experience, and allows software developers to update software more rapidly.

Meanwhile, social media provides the best avenue for reaching millennials and also creates more targeted advertising for businesses than many traditional advertising methods.

These stories are easy to understand and embrace … perhaps too easy. In a slow-growth economic environment where investors are hungry for growth, we believe many investors have gotten caught in the hype-cycle around cloud computing and social media, chasing any and all stocks tied to those themes regardless of price.

Consider that tech IPOs with a market cap greater than $75 million have had an average one-day return of 37.2% this year. Many of these companies, especially those with the greatest single-day pop, are tied to either cloud computing or social media. In some cases, we think the IPOs for these companies are trading at market capitalizations beyond the revenue potential of their entire addressable market on the first day.

That nearly every tech IPO associated with trends such as the cloud and social media has risen so much suggests investors are chasing all of the companies. A few of these companies will likely be successful. The dot-com era gave rise to Amazon and eBay, after all, but there were many more failures than successes along the way. New technology giants will emerge from the latest hype-cycle, but we think they will be limited.

Stretched valuations are not limited to IPOs. Companies with negative earnings in the Russell Midcap Growth Index have returned 47.5% in the first three quarters of 2013, compared to 25.4% for the entire index. The data hold true for small-cap indices as well. Companies in the Russell 2000 Growth Index with negative earnings returned 42.7% in the first three quarters, compared to a return of 32.5% for the entire index. Not surprisingly, many of those companies with negative earnings are associated with the hyper-growth industries that have been in favor.

Similar to the dot-com era, we believe investors are focused too much on revenue, or revenue potential, largely because many cloud, social media and software application companies are not yet earning much. Many of these companies trade at multiples of revenue that more commonly are seen as multiples of earnings. These companies would need truly exceptional multiyear performance to get the type of revenue growth and margin expansion to justify the valuations. There is a high probability that many, though not all, of these companies will stumble along the way.

We believe investors should be careful not to chase too many of the technology sector’s high-fliers. As the market chases these hyper-growth stories, other companies are overlooked. Several companies tied to less-glamorous areas of the technology sector such as tech hardware or business services still offer growth potential and a much more reasonable price, in our view.

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