Virtuous Cycle of Network Effects!

On Friday last week, 4 tech darlings (Amazon, Microsoft, Alphabet and Intel) added market cap equivalent of IBM's market cap (close to $150 Billion) in one DAY! It reminded go-go days of dot com era. Almost exact same happened on Flashback Friday back in Apr 2015. So is it different this time compared to 2000? Are these astronomical gains sustainable? One common factor which makes it different this time is: Network Effects.

Network Effects: The network effect is a phenomenon whereby a good or service becomes more valuable when more people use it. We see it in many services or goods we use. For example: land-line phones (more people used these when more people had phone connections), Internet, Social networks, Streaming networks, Costco membership and so on.

The virtuous positive cycle which gets triggered due to network effects is what is in play for many of these technology companies. Let's look at some of them.

Amazon: Back in July I wrote about Amazon "jungle". After that it expanded further by acquiring Whole Foods. Its just a matter of time when Amazon brown boxes would have your prescriptions delivered to you at cheaper prices and before you know you need to refill them. Within Amazon, two examples of network effects at work are: AWS and Prime Membership. AWS is rock-star in Amazon's myriad businesses. At nearly $18 Billion annual run-rate, it's growing 40% annually. That means as standalone business it would be worth more than tech stalwarts like IBM, Oracle, Intel and many more (could be in top 25 most valued companies). More companies use AWS, better and cheaper it becomes which prompt many conventional businesses to move to AWS and virtuous cycle continues. Same goes for Prime membership. Amazon keeps on adding value to Prime membership (I have been member for many years now) like free shipping, Amazon video, music, unlimited photo storage, special discounts, prime day and so on. More members join Prime, the better it becomes. (Amazon must have borrowed this idea from Costco). 

Google: Same network effect is at play at Google. The more people use Google for search, maps, videos the better these services become (which bring in more advertisements). Google cloud platform is not still at scale where network effects have kicked in virtuous cycle. However with hybrid cloud slowly gaining momentum, there is still time for it to pick up (Cisco/Google partnership could help both companies).

Facebook: Facebook is direct and prime example of network effects at play. Many articles have been written on these so I won't repeat them. But what Mark had done is even extra-ordinary. When it sees another platform which could start gaining due to network effects, he does not hesitate to buy it outright (WhatsApp, Instagram, tried to buy Snapchat). Facebook wants to become company of "platforms" of network effects!

Microsoft/Apple: These companies do benefit from "network effects" indirectly. The more people use their products, the better they become. Both had excellent opportunities in leveraging close to Billion users of their products. But now only they have started looking into how they could leverage this into creating "network effects". iTunes had 500 million accounts even before Facebook reached that milestone. But Apple could never create network effects around these (remember doomed ping?). Microsoft bought Skype but could not create the magic. These companies failed to create network effects because of their model of extracting value before it was created. I still wonder why Apple had not realized that charging for iCloud storage (above 5GB) is forcing die-hard iphone users like me to use Google and Prime photos for backup!

So which companies are next value creators by leveraging "network effects". Here are some  predictions: Uber, Slack, Venmo/Paypal and of course Amazon, Facebook and Google!

Next week should be another interesting week with GOP releasing details of their tax cut plans, Trump potentially nominating Powell as next Fed chairman and blowout earnings by Apple and Facebook. With GDP started growing again at 3%, its all clear now till new year for markets to continue doing what it has been doing for this year!

Have a great and safe Halloween!

Four Horsemen of the Markets: Fed, Taxes, Earnings and Trump!

The Four Horsemen of the Apocalypse is a metaphor depicting the end of times in the New Testament. They describe conquest, war, hunger, and death respectively. While this analogy may not exactly map to economy and markets, it's one way to look at how good times could end.
Markets are on a roll with indexes hitting all-time highs every week (DOW has reached this milestone 53 tines in 2017). At current pace, my predictions for indexes by end of year are: DOW: 24K, S&P: 2625 and Nasdaq: 6800 (about 2-3% upside from current levels). No one would have predicted that we would see these levels 12 months back. So with this backdrop, let's look at analogy of Four Horsemen which could propel or end the good times!
Federal Reserve (FED): For world economy and markets, this institution is most powerful in world (even powerful than US Government itself). FED came to rescue during 2008 financial crisis and still helping the economy with its policy of gradual interest rate hikes. Many believe that lack of action by FED was one of the major reason for 1929 Great Depression and Bernanke avoided similar fate during 2008 by opening the vaults and very un-coventional policy gimmicks. Who would be next FED chair-person would decide how policy would evolve. Current favorite (Powell) should reassure markets that Yellen's policy would continue. New chair-person would also have to decide on pace of interest rate hikes as well as un-winding of FED balance-sheet to reasonable level. 
Taxes: Last week some good news came out on this front with Senate passing budget with 51-49 (along party lines) which paves way for increasing deficits by $1.5 trillion over next decade. This means now congress can work out tax-reform details and pass it with simple majority. Despite major differences in who should get how much and hectic lobbying which is bound to happen, there is momentum building up to pass tax-reforms in next few months. I won't be surprised if congress pushes it in next few weeks and call it as "Christmas/New Year Gift" to American People. Any indications that this would fall similar to health care would be a major blow to GOP. With mid-term elections in 2018, GOP has every incentive to get it done (just for sake of self-preservation).
Earnings: Initial earnings season has been good with 75% earnings reports giving positive surprises. Next week we should expect more of these with more than 200 S&P companies reporting (AMZN, MSFT, BA, CAT and many more). Companies are reporting both top-line growth as well as expansion of margins. This should help justify high P/E ratios. There are few laggards like GE but these are exceptions. Even previous laggard IBM is showing some momentum. Next 2 months, laggards would take leadership role and help propel the market. Companies are also planning for how to use windfall coming due to repatriation at one time low-tax rate (below 10%) and reduced corporate tax rate as part of tax reforms. Both of these factors should be good for earnings in 2018.
Trump: And finally President Trump! During first 11 months of his presidency, every day has been different and full of new excitement (mostly caused due to his controversial comments/tweets).  It's difficult to understand why Trump does what he does. He could have handled condolences to fallen stars, NFL national anthem controversy, Puerto Rico hurricane and many such incidents to bring America together. Instead he wasted these opportunities to change the narrative. At this time markets don't care what Trump says and does not say. However this unpredictable and divisive nature could become dangerous especially if there is major international crisis caused due to North Korea, Iran or Russia. We need President Trump to be President to all Americans and re-establish himself as respected world leader!
These four horsemen could decide if good times would continue or not!

Economics: Science of Equations or Emotions?

During my MBA at Haas School of Business, UC Berkeley, my most favourite subjects were economics (macro, micro) and finance. I really enjoyed topics on how policy impacts countries' economic growth, currencies, interest rates as well as formation and success of businesses. Around that time I also developed interest in "behavior finance". Since then I have always wondered - Is Economics a science of pure math (Equations) or human behavior (Emotions) or mix of both?
In most of the academic history of Economics, it is considered a mathematically precise discipline. There have been few exceptions along the way when in 30's Maynard Keynes suggested that we should also consider Animal Spirits which was taken up as book topic by Yale professor and Nobel Laureate Richard Shiller. This years Economics Nobel was awarded to another practitioner of human side of economics - Dr. Richard Thaler (his book Nudge is my reading list).
In my opinion, Economics as science is best understood when we balance it with:

• Mathematics: Rigorous mathematical foundation
• Psychology: Human behaviors 
• History: Geo-political and stock markets

Upcoming week also happens to be 30 year anniversary of Black Monday (Oct 19, 1987). On that day DOW crashed by 22.6% (equivalent of more than 5000 point drop in today's numbers). This was largest fall on any single day. There has been extensive study done on causes of crash and many articles/books have been written. No one can precisely point out reason(s) why it happened. Few factors which have led to this largest crash were:

• Markets were at peak after nearly 7 year expansion
• Computers had started taking over large amounts of automated trading
• Republican president was in white house
• Month on Calendar was October (somehow crashes of 1929, 1987, 2008 happened in Oct)

Well - all four factors are applicable today. Does that mean we are heading for something similar and one should convert all of their holdings into cash?

Answer lies into "Psychology" aspect of Economics/Finance. Most of the recent indicators (consumer confidence, unemployment, inflation, interest rates) have been very good. While there is lot of noise in political spectrum, there is general indication that President Trump is going to reduce regulations and taxes which are generally good for growth (unfortunately its not good for environment). Fed is slow and steady in raising interest rates and most likely Trump would nominate market friendly FED president (re-appoint Yellen or nominate Kohn or Powell). Given all these factors, economy would keep on chugging with growth between 1.5 to 3% and that should keep markets at elevated levels for next 6 months. In fact there is fear of missing out which would push people to start investing. When all of these factors converge (similar to what happened in 2000 and 2007), that's time when we would have really reached peak. So the merry-go-round would continue for another six months. If Trump and congress are not able to pass tax reforms by Spring 2018, it may be completely different narrative. We will revisit that in Spring 2018.

Till then enjoy the the holidays. Happy Diwali to all my readers!

Bet on "BET = Biotech, Energy and Technology"?

My family and friends know that I like to take small bets almost on any topic. They also know that I win most of them. I did lose  big one with one of my colleague on Hillary vs Trump (no one would have imagined Trump would win except may be few folks like my colleague Arun). I ended up buying lunch for my colleagues for losing the bet. Investing is somewhat like betting. Depending on analysis and confidence, one is really making bets on companies doing well (or not) and investing (aka making bets) on stock prices going up (or down). Markets being at all time high, one must be wondering: Are there any sectors which are still worth making bets? Based on my analysis there are still opportunities in three of my favorite sectors - Biotech, Energy and Technology. In today's world of acronyms like FANG, I decided to call these as "BET". Let's look at why these three sectors?
Biotech: Two years back our family went thru experience on cancer. Since then, I have been doing quite a bit of reading on biotech field. I am reading The Emperor of All Maladies as well as follow various trials and FDA submissions. This field is really on cusp on major break thru for treatments for many fatal and rare diseases as well a finally some kind of cure for cancer. Last week Barrons even had cover-story on Gene Therapy With phase 3 trails for CAR-T, Gene Editing, Personalized medicines, world of cure is going to significantly change in 10 years. And biotech companies are leading the way. On investing side, this field is really brimming with activities with startups, big biotech companies as well pharma companies trying to transform into biotech companies (e.g Gilead buying Kite for $12B). Trial results and FDA decisions being "binary" event, one needs to be really brave, knowledgeable and lucky to make investing decisions. With this backdrop, here are my picks. Biotech ETF (IBB $330), Biogen (BIIB $320), Zogenix (ZGNX $38), Newline (NLNK $10), Regenxbio (RGNX $32). Most of these are extremely risky so best way to get exposure to biotech would be thru ETF (IBB)
Energy: With oil finally settling up above $50, I still stand behind my hypothesis that Energy stocks would have repeat of 2H of 2016 as I covered in my previous blog "It's time to get some Energy" So to avoid repeating myself, just check out my previous blog.
Technology: Outside of FANG, there is vast world of technology. So while FANG stocks are up significantly, there are still opportunities to grab. Personally I like small to mid-cap tech companies which are on upswing. With tax reforms almost here, tech companies are going to significantly benefit from worldwide economic growth as well as favorable repatriation rates. With trillions coming back to US, big tech companies would be on acquisition spree in next 2 years. Whom they are going to acquire? small to mid-cap companies to close portfolio gaps. Here are some picks: Nutanix (NTNX $22), AMD (AMD $13), Blackberry (BB from Oct 16, $10-11), FireEye (FEYE $17), Cloudera (CLDR $16), ServiceNow (NOW $100). With semiconductors back in action, SMH ($90) could be worth a look.
October is always tricky month - there are always surprises in Oct like political, economical as well as investing world. So to avoid getting caught in these surprises, I would recommend let the third quarter earnings season play out. It would give good indication on how companies in all three sectors have performed in Q3 and confidence level their CEOs are projecting, Then decide to do your own analysis and invest. Just don't "bet" based on my analysis!
It's also time to celebrate Holidays - starting with Diwali all the way to New Year! So enjoy the holidays with your family and friends!

Micron: New Nvidia?

Nvidia has been hottest tech company (and stock) for last 3 years with his stock more than triple in just 18 months. Most of the excitement is justified due to Nvidia's unique position in cloud players (Amazon, Google etc) as well as emergence of Artificial Intelligence in self-driving cars (Tesla and so on). So while Nvidia stock may not repeat last 3 years feat, there are other companies which could offer similar excitement. Micron (MU) has been on similar trend with its stock already tripling from under 12 to 39 in 18 months. Last week Micron announced record quarter with revenues growing at 91% compared to last year. Let's look at factors which are causing "commodity" players like Micron shine.

• Micron makes DRAM and NAND memories. In technology world, ASP (average selling prices) go down every year. Due to demand and supply imbalance, ASP for DRAM and NAND   have gone UP by 6-8%. That's rare!
• On demand side:
• Memory markets used to be driven mainly by PC industry. It's no more true since memory is being used across so many devices like mobiles, automobiles, robots, VR, watches, IOT devices and so on
• Average use of memory everywhere is going up (blame it on SW engineers)
• Applications are becoming memory intensive even if some of the compute intensive tasks can be handled by customized ASICs/GPU/TPUs
• On supply side:
• There are really only 3-4 players in this market - Samsung, Hynix, Micron and Toshiba
• It takes major capital investments and close to 3 years to bring on new supply
• Due to obvious benefits of quadropoly, none of the suppliers want to rock the boat by over-supplying the market

So in all, supply-demand would remain in favor of demand and hence ASP of memory would remain high or steady for some more time. 

With Sanjay Mehrotra as CEO, Micron got a seasoned CEO (and he is from Cal, Go Bears!) with excellent background in technology and business. So Micron company is in very good position. What does it mean to stock given it has already gone up so much. It is worth the investment? After results, it has already gone up by over 11% in one week. It has potential to go $60 in next 18 months giving potential return of over 50%. (MU management rejected Chinese offer 3 years back to acquire it at $33 which was right decision). I recommended it at $22 at start of year and would still stand behind my recommendation of MU at $38-$39. Given that Oct is here (worst month for stock markets), you may want to wait to see how it plays out over next 3-4 weeks and take small positions if stock goes down.

PS: Usual caveat of doing your own research before investing remains!