Tech’s ‘network effect’ will create its own constraints on demand
We are certain you would have read about Meta Platforms’ (previously Facebook) spectacular meltdown last week. The stock lost more than US$230 billion ($390 billion) in market value, the biggest single-day loss in US market history, in the immediate aftermath of its weaker-than-expected earnings and outlook guidance. That is equivalent to S$310 billion, or RM960 billion ($308 billion), which, incidentally, is more than half the total market cap for the entire Bursa stock exchange. At the time of writing, its shares have fallen nearly 32% in less than a week.
Many tech companies have enjoyed lofty valuations over the past decade — on the back of historic low interest rates (cheap money) and the promise of strong top-line growth as technology disrupts many traditional industries. Meta’s Facebook social media platform rode high on this phenomenon. Its user base grew very rapidly, thanks to the vaunted “network effect” — where each new user adds to the value and experience of all other existing users. You are on Facebook because all your friends and family are on Facebook. The platform collected massive amounts of user data and is, thus, able to very effectively provide targeted marketing for businesses — winning advertising dollars from other traditional forms of non-digital advertisements, including print media. There was plenty of pain for the disrupted and, perhaps for some, Facebook’s meltdown last week is a schadenfreude moment.
We may now be entering the next phase, where disruptors are increasingly being disrupted themselves — as regulators and competitors catch up and/or companies are cresting the top of their S-curves. This, we think, is Meta’s biggest problem today — after years of strong growth, the pace is levelling off as its core business matures.
For the first time in the platform’s 18-year history, one of the key metrics, total users for Facebook — its biggest profit generator — declined in 4Q2021 from the preceding quarter. Its huge user base may have peaked and many of the younger generation are turning to competitors such as TikTok.
Indeed, the same “network effect” that tech platform companies relied on to generate their historical growth trends on users and revenue, their unique selling proposition — the ability to capture an ever-larger share of the total addressable market and at lower and lower marginal cost — may now be the very reason that constrains future growth potential. The fact is that people do not necessarily want to be the same as others. They want “uniqueness”. And here is where the opposite effect of mass customisation, made possible by technology advancements, will kick in. We think this is especially true of social media platforms such as Facebook, though likely less so for utility platforms such as payments.
Of course, the S-curve is not static — businesses will create new cycles of growth over time. Meta is still growing users overall, for its family of apps (Instagram, Messenger and WhatsApp), and it is driving users to its version of TikTok in Instagram Reels — but monetisation is lagging. Meanwhile, increased anti-trust scrutiny is further making it hard for Big Tech to grow via acquisitions. Meta is also betting — and spending — huge on the metaverse as its next big growth driver (a new S-curve). It may or may not pan out. Quite frankly, we cannot yet envision how the metaverse will evolve. Any payoff remains far into the future.
The other big worry for Meta is the impact from changes in Apple’s iOS privacy settings. Since last year, Apple has required all apps to ask users whether they consent to being tracked. No surprise here that the majority are answering in the negative. This change limits Facebook’s ability to collect data and makes it more difficult for ad targeting and to measure their effectiveness, a metric that is particularly critical for advertisers. We suspect that Facebook will eventually adjust and adapt to the change, just like fellow social media app Snap did. The latter’s shares jumped sharply higher last week, after reporting a strong quarter-on-quarter rebound in revenue. That said, we think companies that lack direct control over their interface with customers will always be at a disadvantage. And this is why we think Apple has a much stronger value proposition, in the popularity of its devices and “walled garden”.
Also newsworthy is Amazon.com’s US$190 billion surge in market value, on the very next day after Meta’s wipeout, which marked the biggest-ever one-day gain for any US stock. These huge swings in Big Tech are driving heightened volatility in the broader market, underscoring investor jitters as a multitude of worries come to a head. Investors appear lost. In the absence of a clear sense of direction for the broader market, they are simply reacting to each individual corporate earnings results — on a daily basis.
Persistent supply chain disruptions and labour market tightness are resulting in rising cost uncertainties for companies, where margins depend on the ability of each company to pass on and/or absorb the higher input prices. For now, many are raising selling prices, thanks to robust consumer demand. The resulting price inflation is adding to uncertainties, however, in terms of how future demand (sales) will be affected and how aggressively the US Federal Reserve will respond with interest rate hikes and monetary tightening.
The impact on share price is further magnified because of current high valuations, particularly for high-growth, tech stocks. We have explained, in several past articles, why interest rate hikes have an outsized effect on the valuations of these companies.
Volatility is quite likely to persist as investors adjust to a new era of higher inflation and normalisation of monetary policies. The Fed is all but certain to kick off its normalisation cycle with the first post-pandemic interest rate hike, in March — some are even expecting a hike of as much as 50 basis points. Analysts at Bank of America are forecasting seven rate hikes totalling 1.75% for 2022, from no hike just a few months back, plus another 1% in 2023. That would bring short-term rates to between 2.75% and 3%. Clearly, the market is scrambling to catch up and, in the process, perhaps going overboard.
For one, we think price increases will stabilise soon. Furthermore, QE (quantitative easing) was an unorthodox policy to increase liquidity at a time when interest rates were already cut to near zero. Is it not possible that the reversal will be equally unorthodox — that is, the direct withdrawal of excess liquidity, or QT (quantitative tightening), instead of simply hiking interest rates in rapid succession?
As we explained a couple of weeks ago, rising interest rates should, mathematically, have a greater impact on valuations for bonds than stocks. But bond prices have fallen only moderately thus far, indicating that the bond market — historically shown to be less sentiment-driven and more rational — does not believe that steep rate hikes are inevitable.
Realistically, the US and Europe cannot tolerate sharply higher interest rates, given their prevailing public debts, following record spending during the Covid-19 pandemic. And it is not just about interest costs. A steep rise in interest rates will result in currency appreciation that will hurt exports
and growth.
Raising interest rates and reducing fiscal spending are the conventional ways to cool the economy and tamp inflation. But they may not be appropriate measures, given prevailing supply chain challenges and the large pool of unemployed people (voluntarily or otherwise). Case in point: Instead of cutting back on fiscal stimulus, the spending would be better targeted. For instance, it could be directed to new areas such as green energy, which does not add to demand for the same goods and services and compound prevailing upward pressure on prices.
On a positive note, we take it as a good sign that the stock market is self-correcting the worst of its excesses, much of it driven by excessive liquidity and speculations. There is likely to be plenty of hand-wringing among stock-market investors in the months ahead. Despite heightened market volatility, though, we remain upbeat on the US economy. Balance sheets for both consumers and businesses remain on solid ground. Rising wages will support consumer spending. Corporates, on average, are flush with cash and resuming raising dividends and share buybacks. Earnings are still expanding, even if growth has peaked from pandemic lows. Interest rates will rise, from near zero currently, but by far less than feared — and will remain low by historical standards as inflation moderates over the coming months. Rapid technology advancement is disinflationary and a secular trend.
As such, we are staying near fully invested, but made several switches. We disposed of our holdings in General Motors Co, PayPal Holdings and JPMorgan Chase & Co and reinvested part of the proceeds in battered cybersecurity tech company CrowdStrike Holdings. The Global Portfolio gained 2.1% for the week ended Feb 9, led by gains from Airbnb (+11.7%), Singapore Airlines (+7.2%) and Amazon. com (+7%). The notable losers were Alphabet (-4.3%), Mastercard (-3.9%) and Home Depot (-2.5%). Last week’s gains boosted total returns since inception to 62.3%. This portfolio is outperforming the benchmark MSCI World Net Return Index, which is up 59.3% over the same period.