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Have tech investors suckled for too long?

It’s natural for any parent to want more for their children than they had themselves, but one of the great challenges of any wealthy family is to imbue their kids with a drive to achieve. This is no easy task and often requires tough love. It’s precisely the opposite of what comes naturally.

Many tech companies will never make a profit

If central banks were parents, they have failed in their parental role and succumbed to the desire to see no harm come to their children. Under their tutelage, they have mollycoddled their economies, preventing their collapse or even struggle by breastfeeding way beyond an age that is considered acceptable or appropriate.

In return, the kids have exercised their sense of entitlement and misallocated their resources, often through private equity and VC funds, fuelling a band of companies that disrupt incumbents but can only exist with their parents’ ongoing generosity.

Many new age tech companies are managed and funded by millennials who have never experienced a recession. The companies exist, despite being unproductive and unprofitable, due to the financial teat being available for far too long.

Central banks have compromised real capital

Thanks to well-intentioned central bank parents, real capitalism - that which has been responsible not only for the prosperity of the western world but also its security - no longer exists. Central bank intervention and financial repression, such as the holding down of interest rates below inflation, has represented a tax on savers and a transfer of benefits from lenders to borrowers.

As is typical of wealthy parents, western central banks feared short-term pain for their offspring, and by withholding challenges they have passed the baton of long-term gain to nations that don’t prioritise human rights, meritocracy and the rule of law.

The fear of deflation (officially ‘feared’ as inflation below 2%) has meant that the US Federal Reserve has maintained a below-inflation interest rate setting many years after the recession of 2009 while simultaneously accumulating more than US$4 trillion on its balance sheet. Amid a fall of the US dollar and not wanting to be outcompeted by their own surging currencies, central banks from Japan to Europe engaged in quantitative easings of their own. Both western and emerging nation children have been breastfed for way too long.

The famous investor, Stan Druckenmiller, recently observed that:

“the most pernicious deflationary periods of the past century did not start because inflation was too close to zero. They were preceded by asset bubbles.”

Unsurprisingly, debt has soared, and the assessment of risk has been corrupted in almost all asset markets. Look no further than the oversubscription for 100-year Argentinian bonds, for a country almost guaranteed to default on its debt during the life of the bond.

In the corporate debt market, the vast majority of debt accumulated since 2010 has been used for financial engineering including share buybacks, special dividends and mergers and acquisitions. Precious little has been directed towards productive use and it is indiscernible from the wealthy teen, with little experience, being given the family fortune and asked to go start a company.

With the exception of retailing, bankruptcies have been minimal despite arguably one of the most disruptive periods the business world has ever experienced.

Low rate cash looking for a new home

Private equity and venture capital funds, flush with a tidal wave of money migrating from cash deposits paying punitive interest rates, have fuelled unprofitable companies that make no money for far longer than would have occurred at any other time in history. Only if the purse remains open can many of these companies continue to disrupt incumbents who themselves are shackled by the desire to make profits.

Only when we start descending the other side of this financial volcano will we see the consequences of misallocated resources and wasteful and ill-judged investments that have occurred over the last decade. Throughout history investors have routinely backed the newest, new thing from automobiles and televisions to photocopiers and commercial air travel. But more often than not they have been burnt as input costs fall, suppliers increase and declining retail prices benefit consumers at the expense of shareholders.

The current wave of enthusiasm is built on the premise that millennials have developed, or will develop, technology and business models that disrupt the hegemony of incumbent institutions and oligopolies, whether that be centralised manufacturing (3D printers), taxi companies (Uber), hotels (Airbnb), the oil oligarchs (electric cars) or even car manufacturing itself (car sharing). A concurrent investment fad is represented by the hope that technology will also enable a cleaner and greener world.

But we have to keep in mind that these hopes are only possible because of financial repression.

A closer look at Tesla

All of the above trends converge in Tesla. Perhaps more than any other company, Tesla symbolises the hopes and dreams behind the wave of exuberance fuelling the current boom in tech stocks. It is therefore the poster child of what is possible, and what is so wrong, with current monetary policy settings. Elon Musk has ridden the wave of enthusiasm surrounding new technology and business models, as well as the hopes surrounding a clean green future better than anyone else.

Tesla now sits on a market capitalisation of about US$50 billion (and US$10 billion of debt) despite only delivering about 100,000 vehicles last year and having frequently delayed a promised ramp up in production. Put another way, Tesla is currently worth $500,000 per 2017 vehicle produced. By way of comparison, Ford sits on a market cap of about US$45 billion and sold about 6.6 million vehicles in 2017. Ford is worth about $6,800 per 2017 vehicle produced.

It cannot last. Either Tesla’s car production needs to rise rapidly, or its share price must fall rapidly.

Meanwhile almost every automotive brand has announced plans to offer either an electric version of their current models or an entirely electric fleet within a few years. By way of example, Volkswagen announced at the recent Beijing Motorshow the construction of six dedicated electric vehicle manufacturing plants in China by 2022.

Elsewhere and looking completely different than any other car in its line-up, Porsche has launched a four-door, four-seat car that showcases a raft of new technology including a super-fast charging 800-volt battery system and eye-tracking driver heads-up display.

There is little question that the Tesla changed the world of electric vehicles. Before Tesla’s Model S, nobody wanted to drive an electric vehicle. But the Model S is nearly seven years old and while it is still an attractive car, the subsequent Model X achieved only lukewarm sales and the Model 3 has significant quality issues. Meanwhile everyone else has caught up. That is the basic thesis for why we recently shorted Tesla in our global long/short funds.

And don’t forget a conga-line of senior execs at Tesla have left and a takeover by another manufacturer is probably ruled out by the company’s debt and market cap.

Of course, while funding is cheap, nobody cares about the bad news. It won’t be until the teenagers acknowledge the problem that parents will be forced to deliver some tough love.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is in the nature of general information and does not consider the circumstances of any individual.

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