Winner Take All?

April 2018

The following chart recently caught our attention. It shows the number of movie tickets purchased per capita over a span of time in the U.S. It illustrates a drastic decline in attendance at the cinemas in an abbreviated period of time.

We have redacted parts of the chart because we want you to take a stab at identifying the time period shown. You, reading this right now, benefit from factual knowledge about how the entertainment industry has actually evolved. You know that cinemas have been competing for eyeballs with Netflix, YouTube, and HBO for some time. So putting that knowledge to use, try to identify the date range shown.

Are you feeling confident in your answer? Even with the power of hindsight, we would have found it difficult to identify the time period on the x-axis. We also would have found it difficult to quantify the size of the historical decline in terms of tickets sold per capita. So you can appreciate how challenging this task becomes when an investor is trying to anticipate how the future of an industry is likely to evolve once it faces new competition.

The Markets are Euphoric about Technology

The flip side of one industry’s decline is that new winners emerge. For instance, the following chart shows how much Netflix (NFLX-NASDAQ) has grown since 2001: its revenue increased at an incredible 37% annually over this time. And this growth has rewarded long-term shareholders handsomely: Netflix’s share price has increased from just over $1.00 at the time of its IPO in 2002 to approximately $300 today (despite generating very little profit; more on this later).

Source: Bloomberg

Unfortunately, we can’t go back in time and invest in Netflix at $1.00. But clever entrepreneurs haven’t stopped founding new tech companies. And one of these tech companies may eventually grow to become the next Netflix. And that company could make us rich!

At least that is the optimism that many of today’s tech investors seem to hold. The next chart shows that inflows of investor money to tech-focused funds is at its highest in 15 years, at 25% of assets under management.

Here are some other fun facts about how much euphoria is surrounding today’s tech sector:

  • The combined market capitalization ($1.5 trillion) of Apple (AAPL-NASDAQ) and Google (GOOGL-NASDAQ) is larger than the combined market capitalization of all European and Japanese financials ($1.3 trillion);
  • The ratio of the market capitalizations of the tech-heavy Nasdaq to the blue-chip-focused NYSE is at its highest level since the dot-com bubble;
  • Technology and e-commerce companies now contribute almost 25% of the S&P 500’s earnings per share. For comparison, tech companies contributed 25% during the dot-com bubble and financials contributed 30% during the U.S. housing bubble;
  • Of the 250 sell-side analyst recommendations for Facebook (FB-NASDAQ), Amazon (AMZN-NASDAQ), Apple, Microsoft (MSFT-NASDAQ), and Google, there are just five “sell” recommendations;
  • Netflix is currently trading at 217x trailing earnings. Put another way, if the company didn’t grow earnings at all above last year’s levels, it would take 217 years to pay back today’s investment in the equity. Amazon is currently trading at 308x;
  • Tesla’s (TSLA-NASDAQ) market capitalization is $50 billion, comparable to Ford’s (F-NYSE) $46 billion. In 2016 Ford delivered 6,700,000 cars; Tesla delivered 76,000. In the same year Ford generated $152 billion in sales; Tesla generated $7 billion.

In summary, investors are really, really enthusiastic about the prospects of tech companies going forward. But how accurate will these future projections prove to be?

Predicting the Past

Let’s revisit the question about movie ticket sales we posed off the top. As the original chart, shown below, illustrates, the x-axis spans the 86-years starting in 1929. It was the introduction of television into the home that marked the biggest paradigm shift for the movie industry. By comparison, competitors such as Netflix have barely had any impact.

Imagine being an investment analyst specializing in the entertainment industry in 1952. The war ended seven years ago and people are wholeheartedly embracing the latest fad: staying home and making lots of babies. While at home, people now have a revolutionary entertainment option at their fingertips: television. In fact, Hockey Night in Canada just launched on television, so people can now watch Gordie Howe’s sick dangles from the comfort of their davenport. Coinciding with television’s rising adoption, we see the rapid decline in movie ticket sales per capita. What conclusion is an investment analyst to draw? Will all movies soon be consumed via television? Are theatres dying?

Of course, with the benefit of hindsight we know that theatres continued to thrive for decades after the introduction of television. Hollywood began to escalate the scale of blockbusters they produced, and people began to spend billions of dollars going out to the movies. But you can appreciate how this was far from a foregone conclusion in 1952. The emergence of a new technology – television – certainly had the potential to make theatres obsolete. And if you were an investment analyst in 1952 trying to project a theatre’s future cash flows, your odds of getting it right were incredibly small.

Today’s Tech is No Different

The same complications face today’s investment analysts who try to predict how emerging technologies will evolve. Sometimes a new technology emerges in a winner-take-all manner; think about how Google crushed WebCrawler and AltaVista. But other times the incumbent technology can still remain viable, albeit at a diminished level of profitability; physical sales of music (CDs and vinyl) represented the largest source of revenue for the global music industry until 2017, 20 years after the introduction of downloads.

In between the two extremes is a great deal of grey area for technology analysts. We believe that bullish investors in today’s tech darlings like Netflix, Amazon, and Tesla are ignoring this grey area and instead focusing solely on the upside potential in a winner-take-all scenario. Even if these investors are proven correct, their upside may be limited: current market valuations are already implying lofty expectations for these tech companies. But what if these investors are wrong? What if the incumbents manage to stick around and make life difficult for the upstarts? It has happened before, and we suspect it will happen again.