Schroders: “dark side” to tech giants’ winning performance during COVID-19

While many businesses struggle to survive under the global lockdown, the largest technology companies remain afloat and in some cases are even thriving. Microsoft has reported a surge in usage of its cloud computing service Azure, as millions of people work from home. Amazon is hiring an additional 75,000 workers, on top of the 100,000 it hired last month, to cope with increased demand for its online delivery service.

However, there is a dark side to their deepening grip on society. As smaller businesses and start-ups flounder, this pandemic will likely make the largest tech firms even more powerful than before. Trends that they were already benefitting from are accelerating, such as network effects, high barriers to entry and increasing market concentration, writes Sean Markowicz, strategist in the Research and Analytics unit at Schroders, a global investment manager.

Tech has held up far better than the rest of the market

Unsurprisingly, the “FAMAG” stocks – Facebook, Amazon, Microsoft, Apple and Google – have significantly outperformed broader market indices as a result of stay-at-home orders. At the time of writing, Amazon and Microsoft were up 28.5% and 13.3% respectively this year, while the US stock market index, the S&P 500, was down 11%. A better performance comparator is the equal-weighted S&P 500 Index, which tracks the performance of the average US company. This has fallen by 19.4%, almost twice as much as the market-capitalisation-weighted index.

This indicates that the largest stocks were outperforming smaller ones. Although Facebook underperformed the other FAMAG stocks and the S&P 500, it outperformed the average company.

Cash is king

For many businesses that have been forced to shut, sales have literally collapsed to zero. So what matters now is not so much revenues, but whether a company has stockpiled enough cash to survive the global lockdown. On this metric, the FAMAGs are relative winners – most of them have above-average cash buffers, relatively few short-term liabilities and strong cash generation capabilities. This is true relative to both the broad market and the rest of the technology sector.

Microsoft is sitting on $134 billion of cash and cash equivalents, which is enough to fund 2 years and 4 months of its contractual obligations (e.g. short-term debt, wages and other accounts payables). This is significantly higher than the median $6 billion cash balance and cash cushion of 0.88 years (10.5 months) for the S&P 500. Microsoft is also better able to translate its sales into cash compared to other companies. For example, its operating cash flow to sales ratio was 38 meaning it collected $38 of cash for every $100 of sales. This compares with only $22 for the S&P 500.

In contrast, although Amazon has a substantial amount of cash on hand, it is dwarfed by its relatively high operational costs and near-term liabilities. But given the surge in its stock price this year, investors are not placing much weight on this. After all, sales are expected to hold up relatively well compared to most companies and it can also easily tap other sources of liquidity if needed, such as short-term borrowing.

To safeguard against future shutdowns and cut costs, companies are also looking to shift their computing workloads online so that employees can access their data from home. This would be a boon for major cloud server providers such as Microsoft and Amazon.

Increasing market concentration should be ringing alarm bells

If the FAMAGs all fell 10%, that would mean that all remaining 455 stocks in the S&P 500 would need to increase by at least 2.5% just for the whole index level to stay the same. This is how important the largest tech stocks have become.
A market this narrow should give cause for concern. Investors seem to think that these companies are unstoppable. But what happens when these companies stop doing well? These outsized gains could lead to outsized losses.

They also face a number of pressures which could have a longer-term negative impact on their business models. Regulatory concern over their growing power is at the epicentre. Over the past 18 months, the FAMAGs have already faced a barrage of criticism over their anticompetitive behaviour. The bigger tech becomes, the more likely they will become more heavily regulated. History is replete with such examples. At some point, this could have serious implications for their growth prospects.

Despite the shock that the pandemic has cast on the business world, the FAMAG stocks have emerged as relative winners. Their superior balance sheet strength combined with increased demand for their services has been clearly reflected in their stock prices. Lifestyle shifts could stick after the crisis is over, while failing businesses could open up opportunities for expansion. If that happens, the FAMAGs could emerge even more powerful than before.

This, however, does not mean that regulators will look the other way. If anything, it increases the likelihood of action being taken at some point to suppress their market control. There is also the poor track record of dominant firms maintaining their dominance over time. Given their high benchmark weights, it could drag down the whole market if confidence in them collapses for any reason. The closer a portfolio’s weights are to the benchmark, the bigger this risk, and passive strategies are most exposed.

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