We highlighted coming into 2018 that investors faced an inflection point in the ‘zeitgeist’ for US web stocks, which have been engaged in a form of classic rent seeking and regulatory arbitrage as they built natural monopolies in which the user is the product. We have been secular bulls on global tech over the past few years (although broadly preferring the Chinese to US internet names since 2015 on more diversified business models) but the blind faith of some portfolio managers I’ve met this year has seemed almost cult like. At one meeting last month, an investor whose biggest single holding (in a value fund) was Facebook informed me after an hour of debate that Zuckerberg was a business genius who would prove our bearish thesis wrong, end of.
Perhaps, but he’ll have to do better than the self-servingly sanctimonious ‘building a community’ mantra to restore user and more advertiser faith. Of course, even if revenue growth and margins now almost certainly disappoint, Facebook is at least highly solvent and cash generative. Tesla isn’t without a significant capital infusion by end summer and is still struggling to scale up manufacturing, as evidenced by the disastrous Model 3 launch. The last car so badly built in the factory that it had to be effectively reassembled by dealers was the Soviet Lada, exported to Europe to earn hard currency in the 1980s. At least the Russians could knock out (literally) serious volumes.
Our tactical portfolio has recently been short the US web names, even as tech-focused stock funds have attracted net inflows equivalent to half of those seen in all of 2017. The almost viral, social media inspired retail frenzy that infected crypto in Q4 moved on a handful of leading tech names despite extended valuations priced for execution perfection. Just as belated regulatory action has slammed the crypto sector, so it will for several leading web names. The end of crypto and ICOs as an advertising revenue stream for Google/Facebook is a risk to H2 numbers as it will be for the GPU chip names as coin mining approaches marginal profitability.
There is no question that companies such as Microsoft retain strong earnings momentum (and Microsoft’s ‘software as a service’ reinvention via Office 365 cloud subscriptions etc. has been mirrored by many other legacy software names such as Adobe). There are plenty of attractive themes in tech but the vulnerable areas to an investor exodus are those with unsustainable business models. and extreme positioning. It’s now widely accepted that ‘weaponized AI’ was used to micro-target voter groups based on interpolating preferences from their social media activity in both the US Presidential and Brexit votes, but intrusive data trawling looks far more widespread than yet realized, including via Android phone records.
I’ve compared social media in research notes to digital nicotine or casino gaming, with the adverse addictive fallout only now becoming apparent. However questionable ethically, until now this activity has remarkably remained almost wholly unregulated. Indeed, the same psychological design features that casinos use in slot rooms to maximize ‘time on device’ and engagement are embedded in multiplayer games, Facebook timelines etc. As that view of the negative externalities becomes widespread, ESG investors will likely begin reducing exposure.
Just the threat of regulation will drive up compliance costs which will be a medium-term earnings growth drag (the employment of thousands of outsourced ‘screeners’ over the past few months checking for offensive content to appease advertisers is just the start). The aggregation effects that fuelled social media/search and e-commerce platforms drive natural oligopolies if not monopolies, albeit with market power difficult to identify within a classic consumer welfare anti-trust framework.
Facebook was misunderstood in the sense that it was an inherently weak business model than the consensus believed in just how much relevant user data it could collect directly for advertisers. Unlike say Google, that forced it to rely on elaborate inference to discover user tastes and needs. It had to collect, share and ‘harvest’ as much behavioural and relationship related user data as possible beyond its own network via its Graph API partnerships until 2015. Most users when they agree via a single click to the complex disclaimers on apps simply can’t understand the implications of the agreements they are entering into and as with sectors from banks to airlines, consumer protections will now gradually be legislated, with the EU’s GDPR rules from May the first step.
With personal data privacy now becoming a priority for many, ‘self-sovereign identity’ systems are emerging to make it easier to take back control. These imply that individuals control the data elements that form the basis of their digital identities, not unaccountable private companies. This digital equivalent of a wallet contains verified pieces of our identities (passport, biometric etc.) which we can then choose to share with third-party apps and sites on a selective basis. This type of online identity uses standard key cryptography, enabling a user with a private key to share information with recipients who can access the encrypted data with a corresponding public key.
By allowing individuals to control their online reputation and privacy, self-sovereign identity may ultimately become the most valuable and widespread blockchain application and would make it much harder for data hackers (or harvesters) to access sufficient data to interpolate income level, political beliefs etc. That would erode the business model of the ‘Apex Server’ web giants, but for software companies not based on stockpiling user data, decentralized identity should be a boon for customer acquisition and management.
In a recent blog post, Microsoft announced that it would start supporting decentralised identification technology within its existing verification application. Apple is also likely to take advantage of Facebook’s humiliation with a privacy focused product – its iOS phones have been immune to Facebook’s trawling of SMS and call records on Android devices for close contacts on the social network. Indeed, tech investors need to start thinking of data privacy winners and losers across the sector in a regime shift for the Silicon Valley ‘consumer as the product’ advertising led revenue paradigm.