Perspectives: Opinions from our network of advisors, investors, operators and analysts on the risks and opportunities they see.

Two large Sovereign Wealth Funds (SWFs), Saudi Arabia’s Public Investment Fund and Abu Dhabi’s Mubadala Investment Company, have reportedly raised questions about the high valuations of technology firms benefiting from capital commitments by SoftBank Vision Fund, which draws over two-thirds of its funding from the Gulf giants.

Michael Shaoul, Chairman, CEO and Portfolio Manager at New York-based Marketfield Asset Management, has questioned the tech sector’s prospects, and says that despite a swoon in fourth quarter of 2018 money continues to “crowd into small-cap names” in volumes that he believes defy fundamentals.

Michael Shaoul spoke with Karma Network Contributing Editor Michael Moran about why he’s concerned that supply will exceed demand for the tech names seeking to go public in 2019.

Michael Moran: You have been sounding the alarm for several quarters now on the tech sector, where Amazon, Facebook and others have led market growth in recent years. What’s going on?

Michael Shaoul: I think you’re seeing a split within technology. There’s been a lot of those mega-cap companies that really (were) going to have an incredible share price advances, 2016, 2017, first off of 2018. They declined a lot in the fourth quarter and the bounces are not that impressive.

But you know what is impressive? There are a bunch of older technology companies like Microsoft and Intel (that) are sort of classic names of the late 1990s. Not all of them, but a number of them have been able to break out to new highs and I think that there’s some evidence of rotation away from overly popular names – the Facebooks, Googles and Amazons, you know – into sort of what I think of as the seat of safety: more mature business models.

And then, at the same time, there is more aggressive capital that seems to be crowding itself into some of the smaller-cap names — you know anything to do with 5G Strong, anything to do with the cloud and internet security is still strong.

I would have anticipated a kind of narrowing of participation and a shift of leadership and, as it happens, you’ve seen both of those. But the question now is what happens to that small group of mega caps? Is the next significant move downward? Or do they simply pull things down for six, nine, 12 months and then the next big move will be higher valuations.

My gut tells me it’s going to be the former. I don’t think events like Q4 of 2018 come out of nowhere. And this happened even as some of the concerns about trade and the central bank policy both got better.

Michael Moran: How much of this swoon among the big names is driven by the furor over data governance and privacy issues at places like Twitter and Facebook?

Shaoul: There are two competing issues. One is that corporate strategy is harder and harder to implement, the larger they get. This is imperial overreach almost and some of the big names have suffered from that. The other is the risk of regulation, which has certainly raised itself. I would say that both of those are two sides of the same coin.

Quite apart from the over-popularity of these names within equity portfolios, from the business perspective they are starting to get so large that they’re bumping into each other and they’re bumping into wider issues in economies and within societies.

You know even this sort of rather bizarre beauty contest that Amazon set in motion as it was looking for its second headquarters site is relevant. Amazon had half of the United States jumping through hoops. As soon as they chose New York, they met reality. I wouldn’t say half of New York, but at least a very, very vocal minority actively did its best to change that decision. And they managed to do so in the end. To me this is all part of a general signal that it’s going to be very very difficult for these companies to replicate the success of the past ten years or so.

Looking forward, a best case is that they start to become much slower growth but still good businesses. The worst case is they need to go through some sort of strategic adjustment to come out of the other side and you know you can come out the other side.

Microsoft is probably the best example of a large technology company that clearly lost its way at the end of the 1990s, its last cycle, but kept its core business going and managed to reinvent itself. It took a number of years before it was able to do so and it missed some very large and profitable trends in the meantime, but it was able to come out of that. On the other side, look at a company such as IBM. IBM never really rediscovered its poise since its missteps of 20 years ago.

Michael Moran: So does this environment make it harder or easier to dig down into the ecosystem and find the next winners? Because there are plenty of people trying to do that. Last week SoftBank decided to join a $400 million investment in another a UK digital banking startup, OakNorth. Is that foolhardy if this is the end of a cycle?

Shaoul: I think it’s much harder to make sound judgements right now. Particularly if you’re talking about private investments as opposed to public investments. There’s plenty of evidence that suggests that if there has been an excess of investment this time around and it’s more likely to be than private equity and public equity. That’s because public companies have been allowed to mature to a much greater extent within the private sector this time around and valuations in the private sector are created by a form of laddering where the same pool of investors often invest in multiple rounds of high valuation. There’s nothing legally wrong with that, of course, but you do get a sort of captive audience. This far into the cycle, there’s plenty of signs of excess investment, and excess competition.

It’s very difficult to say with private capital. We don’t have the same information available to us both in terms of prices and corporate performance to be able to fully judge. What I believe will be the most interesting thing for 2019 in technology is going to be the number of large technology companies, service companies, that use technologies such as such as Lyft, which is already in the line to go public. At what price are they able to go public? How does their equity perform in the after-market, particularly at the key point that the insider lockout’s are taken away. That will really tell you about technology valuations.

It’s going to be a very interesting battle between supply and demand, and I do have concerns that supply will overwhelm demand in some of these cases. There are some very highly valued businesses which are very successful under certain metrics, such as you know the revenue growth or market penetration. But they are decidedly unsuccessful at generating positive cash flows and how the public market decides to absorb it. I think it’s going to tell you a lot about the patience of public markets of those kinds of businesses. I won’t tell you I know, because I don’t. Every cycle has its own characteristics and this particular characteristic is very different.

Don’t get me wrong, this is not the situation we had in 1999, in the late 99 or early 2000s, where a whole host of really small immature companies went public, very small amounts of money, had big cash burns and disappeared within 12 to 18 months. It was relatively easy then to look at the cash flow numbers and the amount of money being raised in say the IPO markets definitely closed and they didn’t have access to debt markets and you kind of knew that that was sort of an evaporation game which is which is exactly how it played out.

This time around, companies are much bigger, the shareholders who have invested have much much deeper pockets, and it’s not just SoftBank. It’s co-investors or sovereign wealth funds and very large VC funds.

And yet I think one has to be cautious that so many of these very successful businesses may have transformed the way the urban life and suburban life is conducted, yet still haven’t come close to the point that they could be expected to make money. Increasingly, they are subject to the same kind of regulatory forces.

I could say plenty of worrying things about the company like like Google or Facebook. But at the same time, I respect the fact that they produce such tremendous cash flows to their shareholder base. With some of these private companies about to come public, they are generating significant regulatory concern. In the case of Uber, Lyft and taxi substitutions, there’s a lot of tension between the long-standing municipal base of taxi drivers and the new entrants in a city like New York.

You know, the city is looking to use these companies as a revenue base, it just introduced congestion charging. I think you’ll see a wave of other cities you know doing the same thing. It’s a tough combination to be a very successful business and significantly cash flow negative.

There is a time at which a public market is going to expect that to change. And I think the patience of a public market is going to be a very important part of this puzzle and the point at which the public market says ‘no, we’ve had enough!’ .

You know, that’s the point at which the cycle changes and it’s never the same again, and we haven’t reached that point today. We might not reach that point this year, but if you look at the size of the lineup coming and the kinds of companies that are lining up to go public and the overlap between between one another, I would say that’s one of the big risks for technology investors in 2019.