Despite falling in recent weeks (a confirmatory “told ya we were in a bubble!” moment for many investors), the sharp rise in the share prices of major technology companies over the past six months has understandably caused many people to claim we are in a repeat of the 1999 tech bubble. There are certainly similarities:

  • Rapid increases in the share prices of technology-related companies and sell-side valuations based on TAM (total addressable market) and revenue growth as opposed to profitability (There are legitimate questions about whether current accounting standards adequately capture the economics of technology companies, but that does not mean investors are not straining to justify valuations).
  • A hot IPO environment where all companies (both real and fraudulent) are able to raise money.
  • Outperformance of “growth” stocks relative to “value” stocks.

Before discussing the merits of owning tech stocks, it is important to discuss our approach to investing in stocks. Our strategy is to invest in outstanding market-leading companies and hold them as long as they remain dominant. The reason for this is simple: most investors do a good job of understanding a company’s competitive advantages but underappreciate the innovation and culture that creates new products and drives growth. It is only by holding these companies for the long-term that the investor gets to fully benefit in all of the future growth. At Baskin Wealth Management, we do not sell stocks simply because they have gone up. This approach has served our clients well over time.

Our view is that there is simply no comparison between the world-leading market positions that Apple, Amazon, Facebook, Google, Microsoft, and Netflix have and the frenzy that existed in 1999. On the first layer, the valuations are far more rational: Facebook, Apple, Google, and Microsoft (Netflix and Amazon clearly stand out on the list… feel free to contact me if you wish to discuss the rationale for these two) each trade at fairly modest premiums to the broad market index (which itself is not trading at an outrageous multiple!) with superior growth and balance sheets. This is a far cry from the +100x multiples that Cisco and Oracle got at the peak in 2000.

The reason these companies are trading at reasonable valuations despite their massive size is that there has never in history been companies that are so profitable; and what enables their massive profitability is still not widely appreciated.

The internet as a uniquely disruptive force

Apart from all the other benefits and conveniences that the internet has brought to daily life, the internet is a truly once-in-a-generation disruptive technology that allows everyone to connect with each other around the world without any friction at all. Instead of having to go to Best Buy and haul a new TV home, Amazon will ship you one for free with just one click. Instead of having to wait until the next morning to read the newspaper, you can instantly find out what’s going on in the world through Twitter or Facebook.

By its very nature, the internet is global which means that any internet-based company should have a global presence. This has led to a winner-takes-all situation where the global platform has scale advantages that are simply impossible to overcome by a new entrant. Google can provide more information through the Google search engine and YouTube video content than any local competitor. Netflix’s global reach means it has more shows for its subscribers as well as far deeper pockets. Facebook allows you to contact and share photos with friends and family all around the world. Because these are largely information-based businesses, there is no need for significant capital expenditures on things like factories. More importantly, consumers and suppliers want to be part of these services due to their global reach (a blogger wants to be found on Google), making each service even more essential. This is an important concept called Aggregation Theory as described by Ben Thompson.

What does this mean practically? Any company that wants to sell on the internet, whether it be furniture, clothing, toys, or shampoo, must use Google, Facebook, or Amazon advertising in order to reach the maximum possible audience. The advertisers then have to compete with other companies for superior ad placement through higher and higher ad rates, which turns into pure profit for Google, Facebook, and Amazon. In economic terms, this means that these three companies end up extracting nearly 100% of the economic profit generated on their platforms. Likewise, new software companies host their software products on cloud services run by Amazon, Microsoft, and Google, and reach potential customers through Microsoft’s LinkedIn, Google, or Facebook. To the extent you believe that digital and e-commerce will continue to grow, this means that these major platforms will continue to gain a large slice of the economics without having to make any substantial investments.

Where does Apple fit in to this?

Apple’s unique position is that it creates the hardware (the iPhone) that enables the use of internet services. By controlling the physical user experience and access to applications, Apple is at the top of the entire consumer technology ecosystem and, under CEO Tim Cook, has flexed to gain an increasing share of the economics as a result of their control of the device. This, more than Apple Music, Apple Pay, or Apple TV+, is the true driver of Apple’s services revenue narrative, and it is increasingly clear that Apple is uniquely able to change the fortunes even for other FANG companies. Here are a few examples:

  • Netflix, Amazon Prime, or Spotify not allowing you to sign up via the iPhone to avoid the 30% cut.
  • Google paying $12 billion plus a year to Apple to remain as the default search option.
  • Microsoft xCloudand Google Stadia not getting approval to distribute through the App Store.
  • Facebook suddenly losing the ability to know the effectiveness of its targeted ads for iOS apps.
  • And this list goes on.

It is little wonder that Google, Amazon, and Facebook spend so much time and effort trying to create their own hardware businesses.

Regulation risk is the only risk

With Apple and Google controlling the hardware platforms, Facebook and Google controlling the information distribution, Amazon, Facebook, and Google controlling product discovery and e-commerce, and AWS, Azure, and GCP controlling the cloud infrastructure underpinning all the apps that exist on mobile, this ecosystem will continue to gain an increasing share of the profitability that results from the shift towards a digital society. As much as it sounds good conceptually to not put all your eggs in one basket, it’s a different story if those eggs are simply bigger, better, and more delicious than the other eggs.

Given the global scale of these companies, the only real risk that exists is regulation risk, whether it be breaking up Facebook and Instagram, preventing Google from competing against its suppliers, or forcing Apple to allow 3rd  party marketplaces. There is certainly plenty of interest from regulators right now, and time will tell what happens.