Lessons from Cisco and the Dot-Com Era Technology stocks, epitomised by Nvidia's stunning rise, have led the market recovery in late 2023 and into 2024. The recent rally has been concentrated in the so-called "Magnificent Seven" mega-cap tech names. Nvidia's share price in particular has skyrocketed on booming revenues and optimism around its central role in powering AI. However, the sharp gains have also been accompanied by volatility, reflecting a high degree of uncertainty over the sustainability of current valuations. The key question is whether tech companies can deliver the consistently high growth needed to justify elevated multiples. Most analysts feel Nvidia needs to maintain 30%+ annual growth for several years to support its current price-to-sales ratio of 40x plus.

‍

‍

There are instructive parallels to the dot-com boom and bust. Cisco Systems was a stock market darling in the late 1990s, with its price-to-sales ratio hitting 70x at the peak on the promise of its network equipment powering the buildout of the internet. While Cisco's revenue growth was extremely impressive, expanding from $1 billion to $6 billion annually, it proved unable to meet the market's inflated expectations. When the recession hit in the early 2000s, Cisco's revenue growth slowed sharply. And while sales recovered, investors were no longer willing to award the company anywhere near peak multiples. Cisco gave back all its gains, with the stock languishing for years after. The fundamentals were strong but not strong enough. The lesson is that even if companies like Nvidia continue to post robust growth, stock prices may have gotten ahead of themselves. Any disappointment could lead to a painful re-rating by the market. Volatility is likely to remain elevated as investors try to handicap realistic future growth in a challenging macroeconomic environment. None of this invalidates the extraordinary long-term potential of AI and cutting-edge technologies. But in the near-term, inflated valuations mean high expectations are already baked into share prices. There could be a meaningful downside if reality falls short, even if the fundamental growth story remains intact.

‍

While many investors may not remember much about the Dotcom bust and the circumstances leading to it, the market is likely reflecting echoes from that era, it is a timely reminder that the most obvious scenario is not always the most likely! The current rally has been heavily dependent on momentum in a narrow group of tech stocks. A healthy broadening out of market gains would be a welcomed development to improve the durability of the uptrend. In the meantime, prudent investors should brace for a potential wild ride in tech. Over the next weeks we will be meeting with quite a few international equity managers of different stripes and we will be pushing them on this issue. Note that in the above chart the market started discounting the slow down in Cisco’s revenue a full year before ifs was reported. Note also that current prices probably require the company to grow earrings at an unprecedented 30% per annum for almost 10 years, by which time it would be out earning Apple (assuming the latter also grew earnings at an impressive 10% per annum along the way). That is possible but it must be very much the upside scenario and there are others that are arguably more likely. If long term interest rates fell by, say 2%, maybe this number could be more like 25% per annum but to put that in context only Amazon has managed that feat and only on the top line (at the expense of earnings). And even then there have been some bumps along the way. These are the threads that we will be pulling on in manager conversations over the next few weeks in order to substantiate whether current market valuations and the degree of polarisation in the market could be justified.