The continued strength of the stock market is being embraced by some investors, eagerly anticipating the long-awaited resumption of normality after the Covid era. Many others of a more skeptical disposition are watching in disbelief as they see a bubble of historic proportions continue to grow. This latter view is also being stoked by some apparently egregious examples of excessive speculation in certain technology stocks: the inexorable rise of Tesla and the DoorDash and Airbnb IPOs this week to name a few.

It’s important to bear in mind that there are some good reasons for the valuations of high growth technology businesses to be higher than in the past. Most fundamentally, the internet has changed the nature of competition in many markets, especially those relating to information technology. As I explained in this post, successful online businesses now benefit from attractive economics and huge scale advantages that lead to greater profitability and more rapid and sustained growth than was previously possible. It has also become clear that the current low inflation, low interest rate environment will be around for some time. This means that long duration assets, like high quality growth businesses, should be more highly valued. Finally, it also seems to me that high quality growth businesses tend to have been materially undervalued in the past anyway.

Collectively these points imply that valuations, as captured by simple metrics like price to earnings and price to sales ratios, should be considerably higher than in the past. The challenge is that it is both complex and speculative to judge how much higher, particularly for long duration assets. The high degree of uncertainty in these developments makes it hard for the market to respond efficiently. Changes to the overall narrative occur gradually and through the self-reinforcing mechanism of investor sentiment. Consequently, I would expect the market to be initially slow in adjusting (as has been the case so far) but ultimately to overreact in the form of a bubble. The trouble is that it’s hard to perceive it happening in real time. Avoiding boiled frog syndrome as valuations slowly heat up is tricky when there aren’t any clear benchmarks.

So with that overall context out of the way, what’s the situation right now? An obvious place to start is with poster-child, Tesla. I have no qualms in agreeing with the many suggesting that the valuation is bonkers, particularly in contrast to other competing car manufacturers. Even Elon Musk seems to acknowledge the valuation is too high.

However, other than Tesla I struggle to find many examples of where the valuation is clearly crazy. There are a few but if you zoom out and look at the technology sector as a whole, I think it’s much harder to say whether we are in a bubble from simply looking at valuations. For the handful of tech giants, valuations don’t seem that high at all given the quality on offer. It seems hard to argue these stocks are part of a bubble. For software businesses more broadly, my views on valuations are little changed from this post – it’s hard to generalise overall. The valuations of these businesses clearly demand a lot from the future, in some cases too much. But the future should be valued highly and still looks sufficiently promising for others. There is little sign that many businesses are yet hitting inflection points where growth starts to decelerate.

There are some signs of bubble-like behaviour. Bubbles occur due to self-fulfilling nature of beliefs about future price rises. Investors are sucked in by their fear of missing out and buying the dip starts to look like a foolproof strategy as the market seems to recover without fail. The rise in Tesla’s share price does seem to be driven by self-reinforcing speculation as the FOMO sucks in new investors. Similarly, the buying frenzy for the already highly valued Doordash and AirBnb IPOs this week has a certain bubble-like quality too. There are likely several other examples too.

From what I can tell various investor sentiment indicators seem to suggest we are in a period of extreme bullishness overall eg I often see reference to the CNN Fear and Greed Index. However, I don’t think these sort of indicators have much predictive power other than in the very short term. I believe these short term bullish readings are a reflection of the vaccine-prompted Covid recovery trade currently underway. I talked in my last post about why I don’t think this should be interpreted as signs of a bubble bursting or a regime change from growth to value. Indeed growth stocks have held up pretty well since then. More broadly, I think the experience of recovering so quickly from what appeared to be a cataclysmic crash will probably go some way to reinforcing the buy the dip mentality that fuels bubbles. I don’t really get the sense that conditions are currently ‘euphoric’ but this is hard to judge.

Overall, I maintain my view that it is still too early to be talking about a bubble bursting. However, the bubble-like behaviour we are seeing for some shares does seem to be consistent with the early stages of a bubble forming. If this is the case then based on the dot.com experience I’d speculate that it would take at least a couple of years for the bubble to broaden and really get going before it bursts. Many investors are suggesting that this feels like ’98 or ’99 ie a year or two before the dot.com bubble burst. This seems like a sensible view to me, but I guess my concern with it is that it is a consensus view based on a direct analogy to the last major bubble we faced. I expect things will turn out different this time but it’s hard to predict how. My best guess is that more skepticism this time round may mean any bubble-formation needs to be more drawn out with some false dips along the way. Expectations of tighter monetary policy may also be a catalyst but this still looks some way off yet.

I don’t believe I can really predict when a crash is going to occur and use that to time the market. I think the main thing to concentrate on at the moment is diversification across long and short duration assets. I want to have a high enough allocation to long duration that I benefit from an incipient bubble forming but not too high that I get crushed by it bursting. Given my strategy is to only invest in high quality, in practice this probably means I need to focus on making sure a large enough proportion of my investments have valuations that can be justified by shorter-term growth.

I’ve made just one trade since my last update, selling Impax for a 50% profit and buying a new position in Fortinet. I sold Impax principally on valuation grounds – the multiple seemed to be getting pretty rich for an asset manager. The timing of my sale of Impax has turned out to be quite unfortunate with the share price rocketing up not long after I sold.

Fortinet

Fortinet is a large US listed network security business, with a market cap of about £15bn. Fortinet sells via distributors and is Is well-diversified globally. Historically it has been focused on smaller businesses but more recently it is competing more for larger enterprises.

I’m no expert in network security and in researching Fortinet have found it pretty difficult to understand the technology other than at a very high level. It doesn’t help that the industry is replete with jargon, acronyms and marketing guff. The limitations to my understanding of the technology does increase the risk of investing here. However, there seem likely to be some good opportunities in such a rapidly growing sector so I’m keen to get involved and build up my understanding over time.

The overall idea is straightforward – to protect networks from unauthorised access or other threats. It includes various different services: firewalls, email security, anti-virus, encryption and network management. However, dig a little deeper and it seems that there are different approaches to network security that are evolving fairly rapidly over time along with the wider move to cloud computing.

Fortinet’s network security services are sold by subscription and delivered through an integrated platform either hosted on its proprietary hardware or virtually. Its approach has been to provide a well-integrated and holistic ‘one-stop shop’ for network security that is relatively easy to implement and then develop over time (known as Unified Threat Management ‘UTM’). This is particularly attractive to smaller businesses who are Fortinet’s bread and butter. More recently, Fortinet has been expanding into complementary areas of networking and is a leader in providing software defined wide-area network (SD-WAN) solutions.

Quality

• Business economics: Fortinet has good business economics. Its capital expenditure is fairly low and it has consistently generated very healthy cash flows and profitability. Purely based on financial metrics it looks much more attractive than its less profitable rivals.
• Track record: for a cyber security business, Fortinet is a relative veteran, founded in 2000. It has a strong track record of consistent and rapid growth in revenues and profits since becoming profitable over a decade ago.
• Competitive advantage: understanding the extent of Fortinet’s competitive advantage and the possible threats it faces over the coming years has been particularly difficult given the complex nature of network technology. There are a wide range of competitors from the networking giants like Cisco, other traditional cyber security businesses like Check Point and Palo Alto, and newer businesses offering cloud-based solutions like Zscalar and Crowdstrike. All offer quite differentiated solutions with various pros and cons, the significance of which appears to vary widely from customer to customer. I’ve found this quite difficult to disentangle but what I’ve read gives me some comfort that Fortinet does have some edge in its niches of UTM and SD-WAN solutions. This seems to be supported by Fortinet gaining market share in these areas. That said, in the long term the risk of Fortinet’s business being undermined by disruptive innovation is a concern.
• Growth prospects: the growth prospects look excellent. Network security is a high growth sector and has benefited substantially from the move to home-working resulting from Covid. If Fortinet can continue to maintain and improve its market share it should do well.

Price

Fortinet’s last results were good. The share price has dipped over the last few months and I’ve taken the opportunity to get involved at what seems like an attractive valuation.