Blame the Fed for scale of tech stocks retreat

On Tuesday Alibaba Group Holding filed its offer memo for listing what could be the largest technology debut in history. Alibaba, which dominates e-commerce in China, is expected to raise more than $15bn. But, if demand is strong, it could exceed Facebook's $16bn offer in 2012. Alibaba, which was founded by Jack Ma, a one-time English teacher in Hangzhou, not far from Shanghai, has both scale and market power.

At the same time, the recent tech-focused sell-off has gathered pace this week. Twitter is now down about 60 per cent from its high, illustrating how quickly companies which were once the coolest can lose that status. Moreover, companies which come up with disappointing earnings are getting punished. When Fireeye, one of the best regarded new security companies, reported earnings a few days ago that fell short of Wall Street expectations, its share price dropped and is now over 70 per cent down from its peak.

Meanwhile, in a letter at the end of April, David Einhorn, founder of Greenlight Capital, informed his investors that he decided to short a basket of bubble stocks. "Now there is clear consensus that we are witnessing our second tech bubble in 15 years," he wrote. "What is uncertain is how much further the bubble can expand, and what might pop it."

In fact, today many investors are both weary and wary, because of the effect of easy money in lifting all asset prices. They think the stock market is at least fairly valued and possibly overvalued. So if they are to make money they have to take more risk, which is exactly what the Fed is telling them to do.

Easy money and the pursuit of returns lead to run-ups in stock prices of companies with high growth rates, which then become a momentum play, until a correction inevitably sets in.

Nobody really knows how far this correction will go because there is an inherent uncertainty to begin with, thanks to that artificial element in pricing. This correction can feed on itself precisely because the run-up in prices wasn't driven by pure conviction in the first place.

Many of these new young social media and software services firms were trading on extremely high multiples of revenue that assumed both very big addressable markets and a lack of competitive pressure. Among the reasons Mr Einhorn provided for his scepticism about tech valuations today is the rejection of conventional valuation methods, "intolerable" mark to market losses for short sellers and huge first day pops for companies that "use the right buzzwords and attract the right venture capital companies."

Mr Einhorn added that the companies he will short are those that have potential to fall 90 per cent if and when the market begins to judge them on traditional metrics.

Venture capitalists of course would dispute much of his thesis. They point out how much has changed since the last tech bubble. They rightly cite the transformative impact of mobile devices, which have made the internet far more accessible than 15 years ago.

Still, what makes it hard to evaluate the competing claims of sceptical hedge fund managers and those who back these new companies is that technology companies can have very short life cycles. Moreover, precisely because the internet has become global, companies face more intense competition. How does an investor value a company today when it is so difficult to assess the competitive dynamic in future?

Consider what some of the most sophisticated global investors are doing, in part because of easy money. Since last year, Bader Al Sa'ad, the head of the Kuwait Investment Authority, has become a frequent visitor to Silicon Valley. He has already been an investor in tech companies but previously through funds such as that of Russian specialist Yuri Milner rather than directly. On one of his trips to the west coast last year, he met Patrick Soon-Shiong, the founder of the NantWorks group of companies. Impressed, the KIA invested $100m in its cloud-based healthcare IT company NantHealth. The company could list later this year.

Alibaba illustrates all the reasons why tech investing can make sense. It has been around a long time and has a solid management team. It has scale. And it is evolving. Its Alipay unit, for example, has 180m users. It is now challenging the banks by pooling money from its customers and giving them far higher returns than they get from bank deposits.

It is never easy to value such a large, diverse and fast-changing Chinese business using conventional metrics such as earnings multiples, but the backdrop of investors wising up to how QE has skewed markets will make it harder still. For that blame the Fed, not the hedgies or the venture capitalists.

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