2018 hasn’t been the best year for tech.
First there was the privacy scandal with Facebook, Inc. [NASDAQ:FB].
Political consultant, Cambridge Analytica, gathered information on users through surveys. They also found a loop hole to pull out data from those users’ friends.
This, in turn, sparked fears about privacy on social media.
Not only did Mark Zuckerberg have to spend hours listening to senators’ concerns, but Facebook’s stock tumbled more than 17%.
Then we saw — and continue to see — trade tensions mounting.
Trump’s motto: We will stop China stealing our technology.
As a result, China’s biggest tech firms have stalled. Alibaba Group Holdings Ltd [NYSE:BABA], Tencent Holdings Ltd [HKG:0700] and Baidu, Inc. [NASDAQ:BIDU] have all flattened uncharacteristically.
In fact, Tencent is down double digits, while Alibaba and Baidu are below double-digit gains for the year.
Source: Yahoo Finance
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And now look at what’s happening to Google. The European Union is slapping the search giant with a US$6.8 billion fine.
The most crowded trade (large tech) could soon become the greatest opportunity.
Bet on certainty
Ask yourself, why do companies like Google trade on such high multiples? At time of writing Google traded on a price-to-earnings (PE) ratio of 31.
Not excessive you might say. But assuming earnings remain constant, that’s a 3.2% earnings yield.
If bond prices decrease further (increasing bond yields), you could make the same return without taking any risk.
The logical explanation is that investors believe Google will grow earnings into the future. And I’d have to agree with that.
You see, companies like Google have a special quality. They give investors an incredible sense of security.
In Thursday’s Money Morning, I talked about interest rates and how they affect stock values. Here’s an excerpt of what I wrote:
‘Imagine paying $100 for a business. Assuming it produces a $25 profit annually, you’ve got yourself a 25% return each year.
‘If this is how we determine return, it’s not that hard to assume the value of a business (and therefore a stock) is the sum of all its future profits.
‘And because a dollar today is worth more than a dollar tomorrow, we also need to discount these future profits. You can thank inflation for that.
‘This is where interest rates come in.
‘They are an integral part when creating a discount rate.
‘As you saw earlier, interest is the return you can make while taking on no risk in a savings account.
‘So, if you can generate a risk free 3% you’ll probably want more when buying a business or stock, which may or may not pan out.
‘It’s why most investors like to add a premium on top of this risk-free return.
‘Maybe an additional 9% compensates for this risk? If that’s the case, your discount rate will be 12% (3+9).
‘Using our example from above, a business earning $25 for five years is worth approximately $105 today. I use the word approximately because in reality we cannot say for sure that a business (or stock) will produce $X annually.’
For companies like Google, estimating those future profits is a lot easier. That’s because we have a high degree of confidence about Google’s future prospects.
Google is the most popular search engine in the world. Unless people stop googling things, then it’s likely they’ll continue to hold their number one spot for years to come.
And because of this certainty, investors are more willing to buy Google versus some other risky investment.
OK, but how does this help you?
Well, you can use this to your advantage.
If you believe a stock has proportional ownership in a business, and you’re certain Google will grow earnings over time, then you can take advantage of short-term moves.
Facebook is a good recent example.
Analysts were worried about Facebook users deleting their accounts in mass after privacy concerns (fat chance of that). They then made the assumption of lower ad revenues and promptly sold the stock.
Facebook dropped more than 17% in days, but rose just as quickly. Had you bought the stock in March, you’d be up about 36% today.
OK, so they’re not life changing returns. But it beats the ASX 200 record since 2013.
What’s the point…?
Knowing which bets are certain and uncertain comes in handy when faced with volatility.
If this trade war continues, or something else pushes the market downwards, you know exactly which names to look at and whether they’re worth buying and holding.
My hope is that we will see the market slide further this year. With any luck we’ll see it tumble, littering bargains all over the place.
Just remember which ones are the certain bets.
Editor, Money Morning