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Matthew Castel
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Head of Strategy and Global Macro at Logos LP. Experienced investor seeking value in the global capital markets. Twitter:
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  • High Flying Tech Stocks: Back To Fundamentals? 0 comments
    Apr 12, 2014 7:41 PM | about stocks: FB, LNKD, TWTR, NFLX, TOT, QCOM, STI

    Since Jan 1, 2014 the high-beta "new tech" sector has taken a serious hit. Is this just a small correction or a sign of something more significant?

    These stocks are the high-fliers of 2013 - which have been much more volatile than the overall market exhibiting a pattern of high risk and high return.

    Most high-beta names - like social-media players like Twitter (NYSE:TWTR) and Facebook (NASDAQ:FB), streaming video site Netflix (NASDAQ:NFLX) and online professional network LinkedIn (NYSE:LNKD) - are well known to investors as media outlets from CNBC to Fox Business News have religiously covered these exciting names in 2013.

    Such coverage was certainly warranted as these tech names have more than doubled over the past 18 months.

    Yet I believe things may be changing. Instead of holding these overvalued names investors are starting to take profits off the table. Does the dot-com bubble which lasted from 1997-2000 offer us any insights into the current situation?

    At the root of this bubble was a group of internet based companies which capitalized on the "newness" of the internet to excite investors or rather speculators. In addition, an environment of cheap money, widely available venture capital and market confidence lead speculators to ignore traditional valuation metrics such as P/E ratio and an enterprise value analysis in favor of metrics such as unique visitors to the company's website as well as the successful development of new technology.

    Instead of buying companies due to attractive valuations a "bubble" occurred as speculators jumped into assets whose value was rising fast in anticipation of future increases in value. Furthermore, media outlets such as Forbes and even the Wall Street Journal encouraged investors to hop on the bandwagon and invest in such dot-coms regardless of such companies' failure to impress on even the most basic valuation metrics.

    Doesn't this all sound familiar?

    I would argue that in 2013 we have seen an equivalent euphoria. The market environment could be similarly categorized as one in which cheap money has been flowing, confidence has been rising and the short term has been prioritized over the long term. Yet more fundamentally, traditional valuation metrics have similarly been completely ignored in the case of today's new tech stars. Instead, of evaluating the financial strength and value of such companies the market has largely rewarded a positive score on three metrics:

    1) User Base: How many people use the platform and where are these users coming from? Are there more users signing up to the service? At what rate are they signing up relative to their peers and what is the burn rate (users leaving the platform)?

    2) User Engagement: How much time do users spend on the platform and is this number increasing or decreasing relative to its peers.

    3) Intellectual Property: What unique technology has the company developed and protected?

    These metrics in the tech context are important and should be considered in any serious valuation exercise, the problem is that the most important metric of all, the free cash flow to the firm has been largely relegated to the sidelines.

    Interestingly, unlike the dot-com bubble today's tech boom is based on more solid foundations as the building blocks for digital services and products have become more evolved, cheap and more easily connected. Think cloud computing, mobile tech, the increasing availability of the Internet around the world and the proliferation of "platforms"- services that can host startups' offerings (Amazon, Apple App Store, Facebook and Twitter).

    Nevertheless, I would argue that today the selloff in such names is the beginning of a move back to more traditional valuation metrics. One can see this through the 2014 fund flow data. Net outflows continued in the growth sectors: large-cap growth (-$20.2 billion), multicap growth (-$13.6 billion) and midcap growth (-$2.0 billion). Such a move similarly occurred in 2000 when the cheap money started to dry up and investors began to look more closely at the valuation and financial health of such high flying new tech names.

    So what does this all mean to us?

    Think of the other side of the coin explained above. Investors are moving their money from high-beta tech plays into more cyclical value stocks.

    It is these stocks that are likely to outperform the market this year.

    Cyclical sectors are linked to the economy. They notably include banks, energy companies and semiconductors. When economic growth is sluggish, these sectors underperform. When the economy improves, market participants borrow, build and buy more. Thus, such companies are well placed to benefit from robust economic growth.

    Over the past few years, growth has been lackluster yet economists have raised their annual gross domestic product (NYSE:GDP) forecasts recently predicting 3% annual growth in the years ahead. As the U.S. pushes through the 3% mark I see the move described above continuing.

    Sectors to look at now would be banking: Sun Trust (NYSE:STI), energy: Total (NYSE:TOT) and semiconductor: Qualcomm (NASDAQ:QCOM). These names are fairly valued, pay interesting dividends and will see strong earnings growth as the economy pushes beyond 3%.

    Disclosure: I am long TOT, QCOM, STI.

    Themes: value, tech, stocks, fundamental, bubble, flier Stocks: FB, LNKD, TWTR, NFLX, TOT, QCOM, STI
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