The recent rally in technology stocks is a kind of mania. We think this mania has inﬂated many equities in the sector with little intrinsic value; companies that simply won’t exist in a few years time.
We are looking to short the weak companies, with valuations that have gone stratospheric but are burning cash to carve out a niche.
We are bullish on Microsoft, so it is natural to look for shorts in the adjacent markets they will swallow, and we have identiﬁed a number of single-function software companies that look vulnerable.
Slack’s user growth is slowing amid tighter budgets and a slowdown in IT spend. Meanwhile, Microsoft has included Teams as a free feature to the 258 million monthly users of Ofﬁce 365 and adoption is accelerating.
Dropbox’s core cloud storage offering has been commoditized by Microsoft and other tech giants, and management has failed to meaningfully differentiate the product. User growth has continued to decline and we expect cash ﬂow to drop next.
The core investment philosophy driving our stock selection is the belief that in the long run quality will outperform. The assumption of perfect competition, that returns on capital will eventually fall to the cost of capital as new participants enter a market, is ﬂawed.
Microsoft has been one of our biggest positions for years. We own Microsoft shares in client portfolios, in our funds and in our structured certiﬁcates. It is a highly cash generative company with deep economic moats, a massive installed base, huge scale, and a monopoly-like position. When assessing quality, these attributes are foundational. They suggest sustainably high returns on capital employed.
The recent rally in technology stocks is a kind of mania. We think this mania has inﬂated many equities in the sector with little intrinsic value; companies that simply won’t exist in a few years time. We are looking at these weaker technology companies, companies that are burning cash to carve out a niche but whose valuations are stratospheric, as shorts. We know Microsoft well, so it is only natural that when we are looking for shorts, we analyze Microsoft’s competition. If the run in technology stocks is slowing, we want our clients to beneﬁt from our ability to pick losers as well as winners.
We have identiﬁed a number of single function software companies that look vulnerable. It is helpful that these stocks have entered public consciousness through the Covid-19 pandemic. This has only extended their valuations, increasing the opportunity.
It is also helpful that many of these companies highlight their ability to integrate the Microsoft suite of applications. This integration is essential to drive adoption and is part of the sales campaign. But this is not a symbiosis. It is more like a sheep lying down with a vast, ravenous wolf.
Microsoft’s offer cannot be jettisoned. The Ofﬁce 365 package has essential applications and ubiquitous ﬁle formats. And for business and household customers, Microsoft is a one stop shop covering word processing, e-mail, presentations, and spreadsheets.
When users require more functionality and smaller companies innovate to offer it, that stirs the wolf. With the sudden change in the workplace this year, someone is in his territory. He is wide awake now. The Ofﬁce 365 package has 258 million monthly active users (as of May 2020). Adoption and user growth are accelerating.
We want to highlight Dropbox and Slack, two companies that we think are struggling. Both companies enjoyed explosive growth from early adopters of their free plans and wooed investors with the lure of their large user base.
Work from home mandates due to the coronavirus lifted the awareness of these companies, but paid user growth has disappointed and the proﬁtability of their business models has come into question. As the competition, not least Microsoft, reacts to customer demand, their myopic focus and lack of differentiation could spell doom.
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