07 JUN


Asset Allocation , Topics , Tristan Abet

The clothes don't make the man

The US is currently experiencing an exceptional period from a microeconomic point of view. Aggregate corporate margins are at their highest levels ever. Although the global data mask broad disparities in terms of sectors and, more particularly, between large and smaller companies, the fact is that wealth created in the US over the past few years has chiefly benefited shareholders rather than employees. This observation opens the debate regarding the distribution of added value and the decline in the share of wages in GDP.

Equity markets celebrated the explosion in profits by returning similarly remarkable performances among the indices over the past few years. The fact that equity indices climbed at almost the same rate as profits would imply that there is no real valuation issue in the US. This highly consensual approach nonetheless disregards the fact that financial risk is not necessarily reflected in high valuations and that healthy profits can also be an indicator of high financial risk. This is exactly what occurred over 10 years ago when banking stocks were trading on the lowest price ratios in the market. Low valuations did not prevent the banking sector from collapsing over the following few quarters. A bubble can be hidden among profits rather than within valuations.

A bubble in terms of profits is generated by unsustainably wide margins, generally triggered by an exceptional economic cycle. Today, although there is a profit bubble, we believe that it is linked to the technological and social shock over the past 10 years, rather than a result of cyclical factors. The tech revolution has created new sectors in which critical mass has rapidly become a key advantage. Similarly, digital transformation among western companies has led to an unprecedented transfer of profits from traditional sectors, such as the printed press and retailers, towards the 3 digital giants Amazon, Google and Facebook. Clearly, large-scale substitution of business activity and profits has effectively taken place rather than the so-called destructive creation theorised by Schumpeter. Furthermore, premiums gained by the initial entrants have proved to be extremely high due to the herding mentality among consumers. The notion of winner takes all now applies to several sectors and is reflected by highly profitable monopolies, including Facebook/Google in the advertising sector, Microsoft/Amazon in cloud storage and Visa/Mastercard in payment technologies, along with Nvidia/AMD in graphic card drivers and Expedia/Booking.com in the tourist industry. There is therefore strong concentration within these sectors which provides the few dominant players with hefty pricing power.

The enthusiasm among financial market professionals for these stocks is understandable. They will continue creating wealth as long as their regular profits are not threatened. It is interesting to note that investors are now enthusiastic about the next generation of disruptive stocks, which will create a monopoly among the ashes of the companies which have failed to climb onto the technological and digital bandwagon. A new feature however is that these disruptive companies currently generate enormous losses rather than mega profits. The latest IPOs among highly emblematic stocks at sky-high prices may be a sign of excess within the markets. For example, Snap, Dropbox, Pinterest, Zillow, Uber and Lyft cumulated 5.3 billion dollars of operating losses over the past 12 months although their market cap exceeds 130 billion, which is more than Lagardère, Air France, Iliad, Valeo, Suez, Eiffage, Telecom Italia, Accor, Bouygues, Ryanair, STMicroelectronics and Carrefour combined. It is also worth highlighting that these European companies together employ over 1.4 million staff, whereas the 6 US groups listed previously employ “only” 38,000. In other words, the work of 38,000 employees among disruptive US sectors carries the same value as the 1.4 million staff in traditional European companies. This fact is another illustration of the current euphoria surrounding these sectors, which are supposed to be revolutionising the world. The question is whether this makes any sense. The next test will be the IPO of WeWork, which is rumoured to be valued at close to 50 billion dollars, whereas the company posted a loss of 1.9 billion last year.