Nicholas Rilley, Butterfield
It is striking how Google has gone from being a company with “don’t be evil” in their code of conduct, to one represented by an empty chair at a recent Senate hearing on internet companies. The origin of the phrase “with great power comes great responsibility” is unclear, but it has recently been used to describe the obligations of the large technology companies. The Economist has even created yet another acronym, ‘BAADD’, to describe the effect of the concentration in the industry, meaning: big, anti-competitive, addictive and destructive to democracy.
The key questions from an investment perspective are to what extent these criticisms are justified and what are the potential costs.
It is worth recalling how these companies became so large and profitable. Firstly, they are global companies, so comparisons of their size relative to the GDP or stock market value of a single country can be cast aside. Secondly, globalization has allowed companies in developed markets to focus their operations on the high value-add areas of research, design and sales, while at the same time optimising their global supply chains to lower operating costs.
This combination creates a capital-light business model with high profit margins and returns on capital, which lowers their cost of capital. This has allowed them to buy competitors, take risks in new ventures and achieve dominant positions in the fast growing online market, particularly mobile. However, the key reason is that they have each created one or more great product or service that has captivated tech-savvy consumers.
Concerns have come into sharp focus this year for three reasons: misuse of user data, political interference and the quest of economists to explain low wage growth. Technology has also been topical in financial markets given such strong performance, such that we entered the year with the seven largest stocks globally all being technology companies.
Washington turned its attention to the technology sector after news of the Facebook data scandal involving Cambridge Analytica and evidence arose of political interference in the 2016 election. Until then, the sector had largely escaped political scrutiny in the U.S., as the Democrats enjoyed a sympathetic sector and the Republicans have historically not been supportive of regulation. Europe on the other hand has been more proactive.
Large technology companies unquestionably have significant influence over much of what happens online, from search, messaging, shopping and social media. Their claim that they are neutral platform companies has been widely questioned, but transitioning to a media company responsible for content is where it gets contentious. While it is acknowledged that more needs to be done to prevent illegal activity, the COO of Facebook sums up the platform/editor debate with “we cannot become arbiters of truth ourselves.”
What we do know is that companies such as Facebook are spending money on improving internal controls, such as hiring additional content moderators. Facebook has guided the market to a mid-30s operating margin, down from the mid-40s, which led to a 19 percent one-day fall in the stock price. The recent hiring of ex-Liberal Democrat leader Nick Clegg as head of global policy and communications demonstrates how seriously they are taking these issues.
When it comes to data privacy, essentially consumers have been providing their personal data in exchange for services. The concept of digital property rights has been around in Silicon Valley for a while, but is beginning to enter the mainstream. There is much apathy among users, but ultimately there is likely to be a market in personal data, with users having to pay for the online services that they currently receive “for free.” Any market will eventually find an equilibrium price, but the challenge becomes “what is this service really worth?”
Economists have questioned whether large companies dominating certain industries, so called monopsony power, are holding down wages. The theory is that without sufficient competition, wages are lower than they otherwise would be. While there is some empirical evidence here, the real challenge seems to be job polarization in developed markets due to globalization, rather than company specific factors. However, we have seen companies such as Amazon raise their minimum wage so this should help alleviate political pressure.
Overall, comparisons of large technology companies today with the late 1990s bubble are well wide of the mark given the difference in profitability. While headwinds are increasing, particularly regulatory risk, ultimately success will be determined by whether companies can continue to deliver great products and services which someone is prepared to pay for, one way or another.
Sources: Bloomberg, Gavekal, The Economist
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.