Large cap stocks like Apple Inc. (AAPL), Facebook Inc (FB), and Alphabet Inc (GOOGL) enjoy one of the weirdest periods in the history of the stock market. Historically, small-cap stocks outperformed large-cap stocks by an average of about five percentage points per year. In fact, “size effect” was the first major anomaly that was identified and incorporated asset pricing models.
Over the last two years, technology stocks have been defying this conventional wisdom. Investors believed bigger is better and pushed the prices of large-cap technology companies like Apple, Facebook, and Alphabet to record highs. At one point Carl Icahn predicted that Apple, a hardware company, would reach a market valuation of $1.5 trillion.
Today, Alphabet practically has the same valuation as Apple. Facebook and Alphabet, both advertising companies, have a combined valuation approaching $1 trillion. William Randolph Hearst must be turning in his grave.
I am at one of the biggest hedge fund conferences in the world: Skybridge Alternatives (SALT) Conference. Hedge funds have failed to outperform the market since 2008 and the alpha generated by the industry as a whole has been declining. Yet, hedge funds collectively manage 50% more money compared to 2008. Traditional investors like Warren Buffett, who used to invest in media and newspaper stocks don’t understand the tech industry. Warren Buffett also doesn’t understand the growth and sustainability of the hedge fund industry.
Hedge funds and Apple, Alphabet, and Facebook have something in common: market capacity.
Let me start with Apple and explain what I mean.
Last July I was invited to CNBC Asia as a guest to talk about my bearish stance on Apple. The stock was trading above $130 when they contacted me. Let me be clear. They didn’t contact me because I am this tech guru with a crystal ball who can foresee the future. They contacted me because there weren’t a lot of investors who were bearish on the stock. Apple was flying high and most market prognosticators were taking the “safe” route and predicting that Apple will keep growing for the foreseeable future.
My thesis was simple. Apple is mainly a single product company that is very likely to face increasing price competition. Consumers pay a premium for iPhones because of their superior quality and exclusivity. Competitors caught up in terms of the quality gap. Consumers are slow to learn and react. I thought it would take a recession to bring consumers and Apple shares back to the reality. Financial turmoil in China seems to have done the job.
Apple’s market is global but it isn’t infinite in size. Only a small percentage of people can afford to buy iPhones and only a certain percentage of those people will buy iPhones. Apple’s marketing prowess has played a crucial role in securing a large share of the market together with high margins but this moat isn’t insurmountable. I don’t know of any industries where market leader maintained large market share as well as large margins when the barriers to entry are so low. Sooner or later Apple will have to slash its price and profit margins to protect its market share.
That’s why Apple shares lost more than 25% of their value since I appeared on CNBC last year.
Alphabet and Facebook haven’t felt the effects of limited market size yet because search and digital display ad markets are still growing at a healthy clip and will keep growing at least until we hit a recession. Even in the case of declining sales, Alphabet and Facebook may be able to grow their advertising market share, so the threat of limited market size doesn’t have any effect on their share prices.
The problem with these two stocks is their earnings multiples. Alphabet’s trailing price-to-earnings ratio is more than 30 whereas Facebook’s P/E is more than 90. This means the market is already counting on a large increase in their earnings over the next few years. I wouldn’t short these stocks at this point, but I definitely don’t think they are “sure bets”. Buyer beware. Sooner or later, these companies will reach the boundaries of the advertising market and their multiples will shrink dramatically.
Hedge funds as a group face the same market limitation. Every year there are some winning stocks and some losing stocks. Some of the investors will invest the majority of their assets in winning stocks, some of the investors will unfortunately invest the majority of their assets in losing stocks, and passive investors will invest pretty much equally in both winning and losing stocks. Historically, retail investors, most of whom are naive part-time investors, used to invest the majority of their assets in losing stocks and hedge funds were able to capture a large chunk of alpha by picking winning stocks.
The problem with this picture is that sooner or later, the patsies at the poker table recognize their shortcomings as the pile of chips in front of them shrinks and start doing two things. First, hand their money to hedge funds that have shown skill in picking winners. Second, they may not able to afford hedge funds and invest their money in passive index funds like the ones that are offered by Vanguard and Fidelity.
And that’s exactly what has been happening in recent years. Index funds are growing rapidly, hedge funds are growing rapidly, and the share of the stocks that are owned by retail investors and actively managed has been shrinking. By the way some academic studies estimate that retail investors underperform the market by about 8 percentage points annually.
When these investors stop actively picking stocks, there is less alpha to be picked up by hedge funds. So, in recent years, the size of the alpha available for hedge funds has been shrinking and the number and the size of hedge funds trying to capture this have been increasing at a rapid pace.
As a result, the average alpha generated per hedge fund has been declining rapidly. We may be at the point where the total fees charged by hedge funds are greater than the total alpha generated by hedge funds. Hedge funds aren’t in trouble because they are underperforming a bull market. Any investor with half a brain knows that hedge funds which are usually at least partially hedged will outperform in bear markets and underperform in bull markets (yea, most members of the media either don’t have half a brain or just pretend that they don’t understand this simple fact). Hedge funds are in trouble because their alpha is becoming smaller than their fees.
You can fool some of the people some of the time but you can’t fool all investors all the time. These days hedge funds are trading against each other because dumb retail investors are leaving the market. Some hedge funds are good at investing and marketing, and the remaining hedge funds are good at marketing.
I will listen to the presentations of these hedge fund managers today and tomorrow at the SALT Conference. Some of them are truly brilliant investors and they know their limits. These people generally close their hedge funds to new investors. I am pretty certain that these hedge funds will continue to pick winning stocks at the expense of remaining retail investors in the market as well as other hedge funds that are very good at marketing but not investing.
You will keep reading stories in the media about these high profile hedge funds blowing up. At the end of the day remember that markets aren’t infinite in size. Apple, Facebook, Alphabet, and hedge funds as a group can’t keep growing forever.
More From InvestorPlace