Do you want to make big money from technology stocks?

I mean really big money?

Then write to your congressperson and senators and tell them to support current congressional efforts to break up big technology companies.

No, I haven’t been smoking any funny stuff.

Yes, I know that America’s biggest tech companies have seen a collective gain of over 5,000% since the great financial crisis.

But history proves that once companies get as big as an Amazon, a Facebook or a Google, their best growth days are behind them.

It also proves that much, much better future gains can be had by letting the individual pieces of these megacompanies operate on their own, free from the logic of conglomeration. Here’s why…

How the Mighty Are Stumbling

Most people use the price-to-earnings (P/E) ratio to evaluate a company’s valuation.

But P/E is static. It tells us how much you’re paying for each dollar of earnings over the last 12 months.

What you really want to know is how fast those earnings are growing relative to the company’s valuation.

All else being equal, you always want to buy companies whose earnings are growing faster relative to their valuations than others.

To assess that, we use the PEG ratio.

PEG is a stock’s P/E ratio divided by its earnings growth rate. Because the growth rate is the denominator in the ratio, the lower the PEG, the better.

Here are statistics for four companies currently in congressional crosshairs:

Company March 2020 Trailing 12-Month PEG 5-Year Forward Estimated PEG Change 18-Month Price change Estimated Year-Over-Year Earnings Growth 2021
Facebook 0.8 1.15 -44% 105% 30%
Apple 1.58 2.05 -31% 109% 58%
Google 1.25 1.42 -14% 121% 48%
Amazon 1.5 1.41 6% 73% 82%

Amazon is the only one whose projected PEG ratio won’t decline significantly from last year. The other three experienced much faster price growth than their projected earnings growth.

The problem is that investors have front-loaded future earnings so much that the rate of growth of these big boys must slow in the coming years.

The Curse of Bigness

Of course, these companies could grow their share prices by innovating as they have done in the past. But that’s unlikely.

There are two main reasons — other than increasing attention from competition authorities — why big companies inevitably produce ever-smaller shareholder gains as time goes by.

  1. Limiting innovation: Google and Facebook both amassed huge war chests from “platforms” that act as gatekeepers for other companies. But rather than using that money to innovate new products, both have tended to buy out potential rivals to stop them from stealing market share. Facebook bought WhatsApp to prevent it from becoming an alternative advertising and payments platform. Google bought Waze for the same reason. In both cases, the innovative founders of those smaller companies eventually quit in disgust as they realized that they’d been acquired to prevent them from innovating, not to facilitate it.
  2. Distorted capital allocation: Amazon Web Services (AWS), its cloud platform, has nearly half of the total cloud services market share globally. AWS contributes a little over 12% of the company’s revenues but more than half of its operating income, i.e. revenue minus cost of sales. AWS revenue has allowed Amazon to subsidize its e-commerce operations to undercut rivals. By some estimates, if AWS was broken off as a standalone company, it would be 1 of the 10 most highly valued companies in the world, and all that revenue could be devoted to make it grow.

Set My Shareholder Value Free

Who knows how much money the shareholders of an independent WhatsApp, Waze or AWS would have earned over the last few years?

One indication comes from eBay’s spinoff of PayPal. Since their breakup in 2015, the price of PayPal has increased by nearly 650%. EBay shares are only up about 150%.

That’s not to say every potential unbundling could produce the same lopsided results.

But I, for one, would love to see what would happen if a captive business unit like AWS or YouTube were free to innovate and create shareholder value as their leaders saw fit.

Kind regards,

Ted Bauman
Editor, The Bauman Letter