Technology and internet (tech) stocks now account for around 30% of US stock market value and 20% of global stock markets’ value. SA’s sole major tech firm – Prosus/Naspers – represents around 20% of our market.
What is driving this?
Network effects. In a 1996 Harvard Business Review article entitled ‘Increasing Returns and the New World of Business’, economist Brian Arthur wrote that knowledge-based industries (tech) work differently to traditional processing industries, “increasing returns are the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage.”
Think of Facebook in the 2000s as it strove to gain users – first targeting campuses before spreading its net wider with the number of users soaring as the breadth of the Facebook community became better and better. Over time, users began to lock-in to Facebook and abandon other social media sites. If locking-in happens en masse (e.g. Microsoft’s dominance in PC software), tech products tend to establish monopoly positions in their markets.
Network effects partly explain why the five largest global companies by market cap are tech firms (excluding the recent listing of oil business, Saudi Aramco, now the biggest global company).
Researching the tech sector requires a different mindset
Most of us were schooled in the Benjamin Graham (Intelligent Investor) approach to understanding traditional processing companies. Think of this as the US East Coast approach to investing, where balance sheets are important and income statements lend themselves to calculating price-earnings (PE) ratios and returns on equity.
We spent less time on the somewhat racy West Coast (i.e. Silicon Valley) approach of user growth, lock-in and delayed monetisation of fast-growing tech companies. Here the balance sheets didn’t seem to have many tangible assets and income statements were expensing vast amounts of money on research and development.
Frankly, traditional financial statements don’t provide a particularly insightful view on a tech company. Investors struggle to be good at both East and West Coast approaches to investment partly because they don’t realise they require different mindsets.
Deciding where to invest
Since the 1970s, three major tech trends have emerged, which typically change every 20 years or so. The 1970s and 1980s was the time of Integrated Circuits – which facilitated computation at a level never seen before, enabling a boom in PCs.
The 1990s and 2000s was the era of Digital Networks as computers and other devices became connected through various networks (fibre optic, wireless etc.). This facilitated offshoring and arguably boosted a strong period of globalisation.
According to Arthur, the 2010s and 2020s is the era of ubiquitous Sensors, providing enormous amounts of data to fuel artificial intelligence. Computation, Connection and now Intelligence (AI) – arguably, the last of these major trends (i.e. AI) will have the greatest impact on the workplace.
We are also monitoring quantum computing – a field of computing that will succeed classical computing (i.e. today’s computers). Google recently claimed its experimental quantum chip completed a specific calculation dealing with random numbers in 3 minutes and 20 seconds. Google researchers estimate it would have taken the world’s most powerful supercomputer 10,000 years to reach the same result.
Google, Microsoft, IBM and some smaller players are vying for an early lead in this new tech category. It is possibly too early to pick a leader here, but it’s a category to watch as quantum computing will have profound implications for solving complex calculations about climate change, etc.
The short version?
Network effects are prevalent in tech, partly explaining why tech firms are the five largest US companies by market cap. Tech shares have performed better than the broader market over the past decade but, unlike the late-1990s tech bubble, it has been driven by strong earnings growth from the underlying companies. While market forecasts suggest this will continue in the years ahead, Alphabet, Amazon, Apple and Facebook are likely to face increased regulation in the future, which may curb certain of their activities. That said, the tech sector continues to be a lucrative area for investors prepared to take a long-term view.