There’s a bubble in tech stocks that looks familiar

Unreasonably high stock prices alone are insufficient to make a real bubble uneconomic or unsustainable. Dangerous bubbles develop when irrational prices inspire widely held irrational beliefs and the behavior necessary to rationalize those prices. Unfortunately, that is exactly the situation that the technology sector currently finds itself in.

The tech bubble that ended rather abruptly in early 2000 inspired bizarre beliefs about the “eyeball metric” as a predictor of earnings and the “new economy,” in which earnings wouldn’t really matter. The housing bubble created the notion that home “owners” with zero capital invested in their houses would be just as unwilling to default as traditional homeowners who made a 20% down payment and had much more to lose.

In the present case, neither negative interest rates nor the asset inflation traceable to those rates make for a bubble. Certainly bond prices appear unreasonable, and the government policies driving them are uneconomic. For the most part, however, investor and business reaction to these policies has been reasonable. Confronted with a controlled, manipulated price, people have had to adjust.

I believe that the stocks at the convergence of technology, online marketing and media, including social media – also known as Web 2.0 – represent the biggest, most dangerous bubble of our time.

I do not know exactly how to calibrate behavior for degree of reasonableness and pervasiveness. But I can think of a number of examples that in combination plausibly cross those thresholds.

The Whitebox quantitative analysis and research group recently did word counts for 8,000 public company Form 10-K filings over the past few years, focusing on these words: social, platform, monetize and cloud. Each of these buzzwords, alone or together, suggests a claim to be operating in that converging Web 2.0, tech, online marketing and media space. Firms from Amazon to Zillow build “platforms,” often operating in the “cloud,” which they seek to “monetize” through growing use of “social” and other media. The results are displayed in the chart below.

In every case, use of these buzzwords increased dramatically from 2008 to 2014. Today, a meaningful percentage of public companies are repeatedly using these buzzwords in describing their businesses. Perhaps not as many as the number of top executives who squeezed “.com” or “eyeballs” into their vocabulary before the tech wreck of 2000, but a lot have done so.

As in the dot-com days, we believe overuse of these buzzwords suggests three likely categories of companies:

1. Companies making insincere or ineffective attempts to catch a trend, and thus wasting capital chasing a bandwagon they will never get aboard;

2. Companies that are going all out to capitalize on Web 2.0, but may find their margins brutalized by massive competition, collectively destroying massive amounts of capital; and

3. The winners — but just as with Web 1.0, many of the winners likely will produce far less cash flow for investors than their current valuations imply, again destroying capital.

Even more than in the heady late-90s dot-com days, we believe all too many of today’s CEOs appear unserious and unrealistic. More and more executives appear to be infomercial-style promoters rather than serious leaders.

Tweets are by definition unsubstantial. What does it suggest about a CEO’s sense of his own job that he has a meaningful presence on Twitter?

In April, hedge fund manager David Einhorn, the founder and president of Greenlight Capital, shared with the world via social media a video of Jonathan Bush, the CEO, president and chairman of the board of directors of Athenahealth Inc., accusing him of picking organic growth numbers “out of his ass.”

And speaking of numbers, the gap between adjusted earnings and GAAP earnings — roughly the gap between “truthy” and “true” — is widening. And, as in the days of the previous dot-com bubble, investors seem increasingly willing to put a great deal of weight on more or less entirely made-up numbers.

After reporting its earnings, Amazon saw the price of its stock skyrocket, adding tens of billions of market capitalization. Were investors bullish because the company made money? No. It actually lost money. Investors were wowed because the profit margin on one of its newest, most trendy Web 2.0 business divisions was better than expected. This firm has almost $100 billion in revenues and evidently slightly more than that in expenses. Many, many billions of these expenses are indirect. How these expenses are allocated to different divisions is largely a matter of management discretion. Thus, the profit margin in this hot new division is whatever management wants to tell the analyst community it is.

Investors apparently cared more about an obviously made-up margin in one division than the fact that that Amazon, now a couple of decades old, still has not figured out how to deliver cash earnings to investors.

GAAP is the acronym for generally accepted accounting principles. “Generally” is a significant understatement. The principles of accounting are close to universally accepted. Nobody seems to dispute principles such as the idea that revenue should be recognized in the period it is earned. It is not unusual or specific to accounting that sound general principles can be difficult to apply to specific ambiguous or complex situations.

That is not the situation with adjusted earnings. Stock-based compensation is typically one of the larger adjustment items. Many people agree that stock-based compensation is, in fact, compensation, and that compensation is an expense. In some cases, companies actually buy back the stock they issue, which from the company perspective makes stock-based compensation and cash compensation absolutely identical. Yet many companies, not just tech firms, routinely drop stock-based compensation from “adjusted earnings.”

Some of the biggest social media firms are spending and hiring like crazy. They are growing, and they are taking market share from other media. How much of their growth, however, is recycled bubble money?

In the original tech bubble, billions of dollars went to hundreds of new companies, usually with a dot-com in their name. These companies bought servers from Cisco. In this bubble, we believe it’s probable that more than $100 billion has gone to the app-oriented companies. We know about Uber and Airbnb. There are countless others whose funding is facilitated by early-stage venture-capital groups like New York Angels. These companies take their venture money and buy Web services from Amazon and advertising from Google and Facebook.

The jargon of the current tech bubble echoes the language of the last. “Monthly active users,” very generously defined, are the new version of “eyeballs.” Proponents cite network effects and first-mover advantage, exaggerated now as then, as the reasons to invest now or be ever left behind.

I do not know when the current tech bubble will burst. I do not know if there will be a final upswing bringing more markets to 2000-level valuations. Six months ago, I believed that because this bubble looks so much like the first tech bubble and not the 2008 housing/financial bubble, the post-bubble period would look like the tech wreck and not the Great Recession. Today, I am less certain that the knock-on effects of the bubble popping won’t be as disastrous as the latter.

Andrew Redleaf is the founder of Whitebox Advisors and Whitebox Mutual Funds.