US Technology Stocks – Trimming Exposure

Over the last decade, the US economy has seen one of its best decadal equity market returns in its history. One of the core factors driving these returns has been the performance of the technology sector. In fact, if one looks at the US markets, ex Mag-7, the US equity markets in its shape would resemble a lot like Europe with companies like Exxon, JPM driving the markets, which people would be aware are not known for their growth.

So why would we think the rotating out of technology would be sensible today?

One of the characteristics of technology and software and the influence it has, is, it’s one of the few industries that operates at an 80-90% GM with a potential of a winner-take-all characteristic. More importantly, because it’s a consumer market, the TAM will be wide by its very definition.

Today, we are witnessing one of the major innovations happen in front of our eyes (the last such would be the advent and adoption of the Internet which eventually led to mobile). Typically, technology has not been capex intensive, especially on an annuity basis (which is one of the reasons the growth and RoE are high at the same time). However, the innovation around AI, for the first time, is going to require significant investments (in capex) to deploy at scale. It’s one of the reasons incumbents have chosen to build LLMs in-house (like Meta, Amazon) or go acquisitive (like Microsoft with Open AI). Venture Capitalists have also been at the forefront of funding, thus far, rightly so, because of the implications of the disruption this will create over the next decade.

However, unlike past technologies, the incumbents, should have a natural advantage in this case, as the upfront capex required to fund the LLMs are going to be significant for the next few years and it is going to be hard to determine the right to win, immediately. This is one of the reasons I believe the VC industry is going to find it hard to make any material IRRs currently as the best case outcome today for many of the companies is to get bought out (which will be reserved to a countable few).

Thus far, it was clear that Open AI has a clear edge in terms of the model and the monetisation of the product which is ~10x the next competitor. However, Open AI has chosen to go for the subscription-based model and charges the users for the LLM. More importantly, they continue to be closed in terms of the developer eco-system and try to gain regulatory capture.

In the most recent letter that Zuckerberg wrote (this is a must-read for everyone), he speaks about the evolution of Open-source and why Open-Source AI is the way forward. His Llama models continue to make significant progress in terms of the model output and should be able to leap-frog Open AI soon. Moreover, if the letter is anything to go by, he need not charge at all and make the LLM free in the eco-system.

The significance of this step, as things evolve, is analogous to what Android did for its OS in order to ensure it spreads its moat across the world. The essence of this was brilliantly captured by Bill Gurley in his blog in 2011.

If the evolution of AI has parallels to this, which is likely, all of the tailwinds for technology and software which were significant for public market investors would begin to turn into headwinds (Software has always been low capex, high margins, significant accretion to cash flows turning all of this into an extremely high RoE Business. Moreover, the macro of low interest rates meant, technology companies could borrow below 3%, and buyback equity hence delivering the IRRs that was once in a decade. Today, all of this has reversed. While software and technology are inherently deflationary over the long term, we very well may be entering an era where technology businesses are going to take us into an inflationary spend based environment. The risk-reward, given the macro, has turned unfavourable: a prudent investor would be better off trimming risk and taking chips off the table.

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