Big Tech’s Regulatory Reckoning Coming Soon? Probably Not
2017 has been a year for the big, dominant U.S. technology companies: the advertising duopoly of Alphabet [NASDAQ: GOOG] and Facebook [NASDAQ: FB]; the e-commerce juggernaut of Amazon [NASDAQ: AMZN]; and the most valuable consumer products brand on the planet, Apple [NASDAQ: AAPL].
It’s been their year in several senses. From an investor’s perspective, their stocks have been outstanding performers. While other parts of the stock market have also driven the rally, big tech have been the headliners — particularly as hopes for tax reform and infrastructure spending dimmed, and with them the prospects of some hopefuls in the financial and industrial sectors.
Even as GDP growth has been accelerating throughout the world’s major economies, global fund flows have been expressing desire for secular growth stories even more than cyclical growth stories. Factor in the new optimism about business and regulatory conditions in the United States, and it is easy to understand why buyers have been eager to snap up shares of U.S. tech giants. The most recent quarterly results from GOOG underscored the appeal: a 19-year old company still growing like a start-up (with earnings expected to grow more than 50% this year, and a suite of truly transformative technologies preparing for prime-time).
Some other ongoing structural shifts in market characteristics are helping support the giants as well: particularly, foreign buyers eager to have exposure to reliable U.S. growth themes, and the relentless flow of funds into market-cap weighted index funds. These funds reward the largest companies, boost their stock prices, and enhance their position in the indices still further.
Winners of the Fourth Industrial Revolution
Mega-cap tech firms are also riding secular trends characteristic of the fourth industrial revolution which we have written about often in these pages: digital connectivity of people and devices, the rise of the cloud, mobile internet, e-commerce, new media, and artificial intelligence. The fourth industrial revolution built on the third (computerization), as the third built on the second (electrification, the automobile, and mass production), and the second built on the first (steam, fossil fuels, and rail transport).
All of the “big four” firms were architects of fundamental fourth-revolution technologies and platforms in early, critical phases of their development. GOOG, internet search; AMZN, e-commerce; FB, social media; and AAPL, the quintessential connective device, the smartphone. Their first-mover advantage has translated, through network effects, into all-encompassing platforms whose utility to consumers is now so profound and pervasive that it’s difficult to imagine the rise of competitors in the spheres they dominate.
Growth, Maturity, and Regulation
New technology has always and everywhere disrupted the representatives of earlier stages of technological development. Those incumbents were themselves former innovators, who after a generation or more of success and establishment had been tamed — transformed from raucous, disruptive, high-flying growth engines into staid and regulatedmainstays of the economy.
The history of railroads and electrification are instructive in this regard. Both sectors enjoyed periods of historical development in which their leading companies, as well as many ancillary firms caught in the same technological updraft, were the hottest growth prospects in the U.S. economy. Just as everyone today wants to own the stocks of the disruptive tech giants, there were decades in the 19th century during which everyone wanted to own railroads — and for much the same reasons.
Cornelius Vanderbilt, Tech Mogul
As these industrial leaders grew, they became powerful; and as they became powerful, they became inevitable magnets for the attention of politicians and activists. In contemporary language, other stakeholders — primarily the public and labor — eventually succeeded in claiming more of a share of the fruits of their growth. This effect was occurring at the same time as these industries were becoming more mature, and the confluence of maturity, market saturation, and government regulation meant simply that the mantle of growth would pass to new upstarts. Thus the long cycles of technological development have progressed since the advent of liberal capitalist democracies at the end of the 18th century.
This Time Will Not Be Different
This brings us to the second major reason why the big U.S. tech stocks have been on everyone’s minds in 2017. This year, many observers have felt a “shift in the weather.” Until now, tech was seemingly immune to serious political pressure, aside from Microsoft’s [NASDAQ: MSFT] near-death experience with antitrust regulators in the early aughts. The disruptors of the fourth industrial revolution had been eagerly eating their competitors’ lunches for two decades, to the delight of consumers. The delight of politicians went where their constituents’ satisfaction directed, and while the old guard fumed and protested, they could get no regulatory traction.
European regulators probably initiated the change of mood, challenging big U.S. tech firms on both data privacy and tax avoidance concerns. The 2016 U.S. presidential election served to darken the public mood on big tech still further. FB faced persistent allegations of election bias from both sides. There was a lack of transparency about political advertising and efforts by foreign interests to disrupt the campaign and enflame tensions among American voters. The tech giants continued to protest that because they were platforms, and not media companies like newspapers and broadcast networks, they should not be subject to the same kind of regulation as their old-school competitors. But the public feeling began to turn against them.
Meanwhile, AMZN’s purchase of Whole Foods Market, and the apparent final capitulation of brick-and-mortar retailers, made anti-trust regulation begin to seem not as outlandish as it had been until now — even if the real case, in current legal logic, remains weak.
After all, in politics, where there’s a will, there’s a way. Never mind the pronouncements of Steve Bannon that big tech should be regulated like utilities. Even largely free-market news and opinion journals like The Economist have begun wondering aloud whether the new characteristics of the data-centric tech giants warrant a new anti-trust approach — for example, one that would put users’ data in their own hands and force companies to pay them for it in cash if they want to use it.
Most of the big tech firms have strongly ratcheted up their lobbying spending in 2017, and we have watched them appear on Capitol Hill to try to placate the concerns (and grandstanding) of lawmakers. One can almost hear the silent plea in the background — “Please don’t take our profits away.” Whatever the cogency of the regulatory case, you can be sure that where there are profits as handsome as those of America’s tech giants, rent-seekers and regulators will not be far behind. And these are, indeed, some of the most profitable companies in America.
Until now, those profits have rewarded shareholders. But the writing is on the wall: in the future, regulation will mean less reward for shareholders, more reward for the government purse, and an end to the golden age of the leaders of the fourth industrial revolution. However, we’re sure that by then, the first shoots of the fifth industrial revolution will be beckoning to insightful and imaginative investors.
Timeline, Timeline, Timeline
This is the key for investors to remember.
Particularly in the present stage of the long bull market, it’s easy to get spooked. There are many long-term arguments out there which have served to keep investors out of the market for much of the bull run that began in March, 2009.
Many of those arguments are valid. In theory, we share some of them. We have lived through many market cycles — many bull markets, and many bears. So we are not at all oblivious to the risks posed by secular changes — such as a wholesale shift in the way America’s tech leaders are dealt with by government, and the loss of the esteem in which they have largely been held by the public. These are real risks that will translate into slower profit growth, lower multiples, and lower stock prices, even before heavy-handed regulation actually comes into force.
The bottom line, however, is that these risks are not imminent. Rather, what is happening now is the opening salvoes of what will become a prolonged battle. Competitors and politicians sense weakness, and are beginning to mobilize.
However, big tech’s run could continue until the next recession and the bear market that comes with it. As our regular readers know, we carefully watch trends — interest rates, corporate profits, inflation, global growth, manufacturing trends, business and consumer sentiment, and more. We believe that many fundamental indicators suggest that the bull market could last another one or more years. Indeed, historical data suggest strongly that the bull is now entering its final phase, in which it will generate some of its strongest returns. Big tech will likely be major participants in that final stage of the rally, given the nature of the secular forces driving their growth, and the only nascent state of the political forces organizing against them. Still, the political climate surrounding tech should be monitored very carefully, in case dramatic developments threaten to accelerate the timeline of change.
As a final note, we’ll also mention some tech giants on the other side of the ocean: ones we have written about frequently, the tech leaders of China. What is interesting to us in this connection is that China’s political economic landscape is so different from that of the U.S. China’s big tech firms came into existence in an authoritarian political environment. Alibaba’s [NYSE: BABA] Jack Ma has a longstanding personal friendship with China’s president, Xi Jinping. Such personal connections are a critical part of how business is done in China. Where American tech firms beginning to encounter an encroaching government will have to reassess and react, it’s par for the course to their Chinese counterparts. Therefore, as long as the global rally continues and intensifies, and Chinese internet stocks remain in demand, growth-oriented investors should pay close attention to it.
Investment implications: In spite of their strong performance thus far in 2017, we believe that big U.S. tech firms may be able to continue their outperformance for the duration of the current bull market. In spite of the first signs of a shift in the regulatory regime around big tech, that shift will probably not really gather steam for several years. The situation merits close attention in case that timeline accelerates. Investors should also consider the stocks of China’s leading internet-related firms, which grew up under a heavier political hand and are well-used to operating in such an environment. Please note that principals of Guild Investment Management, Inc. (“Guild”) and/or Guild’s clients may at any time own any of the stocks mentioned in this article, and may sell them at any time. Currently, Guild’s principals and clients own GOOG, FB, AAPL, AMZN, and BABA. In addition, for investment advisory clients of Guild, please check with Guild prior to taking positions in any of the companies mentioned in this article, since Guild may not believe that particular stock is right for the client, either because Guild has already taken a position in that stock for the client or for other reasons.