Should The Bursting Of The Tech Bubble Scare You?

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Includes: ATVI, TWTR
by: George Christopoulos
Summary

The end of the boom will primarily mean less VC funding for startups.

The foundations underlying the valuations of tech companies are much more solid compared to 2000.

Tech companies are more reluctant to go public, hence containing the spillover of risk.

First-hand knowledge of a company's product can protect investors from bandwagon effects.

If you conducted a poll asking people to name the biggest bubbles in the world economy, tech would definitely rank pretty highly in the list of results. Indeed, it doesn't take a Silicon Valley insider to realize that the amount of money being funneled into startups with little more than vague monetization schemes often appears to belie logic.

So should the prospect of the bursting of this bubble scare you?

If you are a startup founder looking to raise VC funding, probably. If you are an investor trading in tech stocks, probably not, at least not in the long run.

While short-term volatility can be expected given the recent developments in international markets, the larger picture for tech stocks is much more encouraging, especially when comparing it to the craziness surrounding the dot-com bubble. The essence of the fundamental difference between then and now was effectively summed up by Marc Andreessen, co-founder of Andreessen Horowitz, in his profile piece for the New Yorker:

The argument in favor of concern is cyclical-busts follow booms. The counterargument is that stuff works now. In 2000, you had fifty million people on the Internet, and the number of smartphones was zero. Today, you have three billion Internet users and two billion smartphones. It's Pong versus Nintendo. It's Carlota Perez's argument that technology is adopted on an S curve: the installation phase, the crash-because the technology isn't ready yet-and then the deployment phase, when technology gets adopted by everyone and the real money gets made.

It goes without saying that this doesn't mean that there are no overvalued tech stocks, far from it. It does, however, mean that this time around the foundations underlying the valuations of tech companies tend to be much more solid, and hence the degree of systemic risk is significantly reduced. Much of this risk is, incidentally, prevented from spilling over in the public markets, given that companies are increasingly reluctant to go public, relying instead on large amounts of private funding. 59 tech companies went public in 2014. To put this into perspective, bear in mind that this number was 258 back in 1999.

While an end, or at the very least a slowdown, of the current tech boom can be expected, this will not be without its benefits, Farhad Manjoo of The New York Times argues, since it will enable established startups to reduce their costs associated with salaries for engineers and office leases which make up a big part of their budgets.

So what does the end of the boom mean for tech investors? In part it means that there will be a shift in mentality, which will parallel the approach that will be adopted by VC's: User growth per se will matter less when compared to concrete monetization strategies. In other words, the era of 'get big first and figure out how to make money later' will come to an end.

The question is: how do you judge a monetization strategy? While on paper a plan may appear solid and several articles may concur, the only way you can shape a strong independent opinion is if you use the product yourself. Luckily, when it comes to tech companies, the product is often free.

Take Twitter (NYSE:TWTR) for example. Its stock price climbed from its $26 IPO price to $70. 'Everyone is using it so it's bound to make money', seemed to be the rationale. However, for me, as a Twitter user, this appeared absurd. You see, the way Twitter deploys ads, mainly via sponsored tweets, seems to go against the appeal of the product. What I like about Twitter is that my feed includes a constant flow of organic, user generated content. If you heavily contaminate this with ads, then I don't think I'm going to be opening Twitter as often as I used to. According to Twitter CFO Anthony Noto, the company now plans to include ads every 20 tweets. Madness. By the way, at the time of writing Twitter is trading a bit below $28. But hey, everyone is using it!

On the other hand, let's look at Activision Blizzard (NASDAQ:ATVI). Last November a friend of mine told me about a relatively new online card game named Hearthstone. He said it was free to play, and that it was the type of game that appeals to non-gamers so I thought I'd give it a shot. A couple of months in I realized that Blizzard's choice to make the game free was a stroke of genius. It had created a new community, and, once hooked, a user was very likely to spend money on new packs and expansions. Meanwhile, a whole ecosystem had begun to develop around it. As time went by I discovered streamers that had tens of thousands of fans and tournaments that gave away growing amounts of money. The fact that Blizzard provided new, and often actually interesting, resources for players on a regular basis meant that people were willing to spend money all year round. Freemium strategy at its best. As a consumer, I felt this was a strong product. Since November the stock has climbed from $21 to $28.72 at the time of writing, partially driven by Hearthstone's rapid earnings growth.

In conclusion, while tech stocks are in no case immune to broad-based disturbances in the markets and many tech companies will eventually prove incapable of living up to the potential currently incorporated in their valuations, the inevitable slowdown of the tech boom will probably have much less of a dramatic impact than what is expected by investors spooked by the ghost of the dot-come bubble. Having first-hand experience of a product may help protect investors from the bandwagon effect often surrounding tech stocks and provide them with the ability to evaluate true value. And true value is immune to bubble bursts in the long-run.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.