The Compound and Friends - Big Tech Has Til Year-End…or Else.

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Starting point is 00:00:47 Click the link and the show notes for more. All right. Guys, welcome to an all-new edition of what did we learn. On today's show, we are going to attempt to answer one of the biggest questions facing the stock market today. How much more time will investors give the hypers before they turn negative on all of this KAP-X spending? I'm here with my friends Nick Colis and Jessica Rabe, co-founders of Datatrek research and the authors of Data Trek's morning briefing newsletter, which goes out daily to over 1,500 institutional and retail clients.

Starting point is 00:01:28 Nick and Jessica also have their own YouTube channel, which you can find a link to in the description below. Welcome back, guys. Good to see you. Thank you. Thank you for having us back. Oh, it's my pleasure. And I missed you guys. I know it's my pleasure. And I missed you guys. I know it's been a whirlwind start to the year, but we're back into our thing. And what a great topic because, Nick, you're making a pretty big pronouncement here. Big Tech has 12 months to show that AI is worth it. Do you really think that's it?

Starting point is 00:01:59 The clock is ticking. They have to prove it by the end of this year. The clock's been ticking for a while, I think. If you look at the charts on these stocks, they're kind of flat for just, not just year-to-date, but for the last couple of months in the end of last year. So the clock actually started probably October, maybe even September of 25. And so I think I'm being a little bit generous, actually, about the year timeframe. Okay.

Starting point is 00:02:22 And what just so we can frame why this matters so much before we get into the details, why is this so important? Is this going to be, will we see the referendum show up in the stock prices? Yeah, it's the only referendum that matters, right? I mean, we'll ultimately decide. We all know the numbers. The big tech, the top 10 names are 35 plus percent of the S&P. Jessica will go through this math. The three names we'll talk about today. Alphabet, Amazon, meta, or 11 percent of the S&P, these companies, these stocks kind of define large cap returns. So it's super important. Okay. So you say big tech's business model has changed dramatically in a short period. Why don't you walk us through what you're telling clients about what's happening here? Sure. The way I approach this was the way I looked at auto stocks back in the 1990s, which may sound weird, but auto stocks, auto companies are hugely capital intensive. And so the same kind of analysis you use on them, you can use on big tech now, which didn't used to be the case. So let's just start by looking at a couple of tables. The first one we've got is asset efficiency.

Starting point is 00:03:27 Asset efficiency is revenues divided by property plant and equipment. It's an item on the income statement, revenues and an item on the balance sheet, property plant and equipment. And it shows you how efficient a company is with its physical capital. And the big tech companies used to be very efficient. So on average, Alphabet, Amazon, and META ran a ratio of 2.2 times back in 2023, meaning for every dollar of capital they had, they generated over $2 in revenues, which is a great ratio. But because they've been investing so heavily and will continue to invest so heavily this year, their asset efficiency is going to be down 42% from 2023 in,

Starting point is 00:04:06 2026. And a company like Alphabet will literally be half as efficient as it was just back in 2023. Other ones are 30 or 40% less efficient. So over the last three years, these companies have gone from being very capital efficient, kind of low cap X for every dollar of revenue to not being very efficient. And I'll give you sort of one kind of scary soundbite. Ford's revenue to P.P.E ratio is 5x, way higher than any of these companies. And Ford is a very capital-intensive business. But tech has become even more capital intensive. That didn't used to be the case even three, four years ago. It is absolutely the case now. And the direction is very troubling. Nobody would, nobody would have been able to guess what you just said, that Ford is now more

Starting point is 00:04:52 efficient in that, what is it, their revenue versus their, their capital expenditures. But their capital on their balance sheet, yeah. Yeah, I don't, I don't think anybody would guess that that's the case. Can we go back to that chart so I can ask you about once in particular. Sure. I know the one. Meta is cheating. Meta is, okay.

Starting point is 00:05:13 So meta is committing to these long-term operating leases in exchange for someone else being willing to stand up these data centers, which is rational. And I think shareholder friendly, I don't think anyone invests in meta hoping to own piles of servers. I get it. But are we measuring them using the right yardstick given that they're doing so much of this not only building but financing off balance sheet? Yeah. And you've raised a great point. And I'm glad you did because the numbers that we looked at on that table do not include capitalized leases.

Starting point is 00:05:51 This is just the PPNE that META actually owns. So if you layer on that additional level of complexity, which I agree with you is smart financing but also worrisome financing because it's ultimately debt, then you end up with an even more capital intensive picture. Okay. Do people ask you specifically about that one? And was that the one that you thought I would ask you about? I thought you'd ask about it because meta is the only one at less than one. So literally meta has less in revenues than it has cap X, which again, crazy. Yeah. So how do they prove it? What would happen would the 2027 estimates start to trend back in the right direction, meaning the revenue is not? now catching up to all the spending that they've been doing? Or what would a successful test look like? That's a great question. Let's go to the next slide, which is profitability. So this is operating cash flow divided by revenues, how many dollars of cash flow they make for every dollar

Starting point is 00:06:53 of revenue. And these companies, as we all know, very profitable. So running 34, 36, 39 percent average operating profit margins over the last three years, going to decline this year on average to 34%. So for every dollar of revenue, $34 cents of operating cash flow. That is down five points from last year. The margin compression is across the board. And the way you prove any investment is worth it is to show incremental margins, to show better margins. So the bottom line is we've got to see profitability begin to increase in 27 because of these investments. It's not just going to be revenue growth. It's going to be revenue growth that is profitable. And that's really the core of the And again, I think we all know this, but it bears repeating, markets do not like it when margins compress.

Starting point is 00:07:42 They worry about committed advantage. They worry about profitability. They worry about those cap X budgets. So seeing margins come down this year, not a great sign, which is just one more layer on the story of these cap X numbers being scary in and of themselves, but also worrisome because profitability is declining. Now, presumably, the people making these spending decisions at these companies, they see the same numbers that you see. They may be looking at them differently or thinking about them differently, but the dollar amounts are the dollar amounts. They're doing this for a reason. And I think what they would say is it's not like we have a choice.

Starting point is 00:08:23 It's some people have called it a suicide pact. I wouldn't go that far. But you can't be in this group of companies that, and I guess we could throw Microsoft in here too, where you're going to spend materially less than your peers and be able to maintain your market share as all of these workloads move from traditional data centers to GPU stacks and AI data centers. So I think that's like the really important caveat that almost all of them have this like, plausible way of looking back and saying, well, what choice did we have? Do you see it the same way? It's a very fair point. And let me just make one answer and then go to the last slide because I think it addresses a piece of your question. And I wrote this last night for clients. There is kind of a subtle agency problem going on between the management of these companies and the shareholders.

Starting point is 00:09:18 Because the shareholders can own a diversified portfolio of stocks and they don't actually care which company wins. What they want is the companies to allocate capital intelligently. The companies have a more existential problem, as you pointed out, because they can't be so far behind. They can't underinvest. And this is the wrap on Apple right now, right? They're not investing enough in AI. Fine. They might just be saying, we don't know who the winners are and they'll have to run through our platform anyway, so who cares? We're not going to spend that kind of money. But the rest of them kind of do. And let me go to the third slide that we have, because I think it addresses one question. I think a lot of people were asking, which is how did these companies come up with the numbers

Starting point is 00:09:57 that they are announcing as CAP-X budgets for the year. And the simple answer is they figured out their operating cash flow for the year, and they said, we're doing all of it. And that is different from the last three years. So, for example, back in 2023, these companies spent about 44% of their operating cash flow on CAP-X. Then it became 50, then it became 70 last year. And this year, Alpha is going to be 103%, met as 106%, and Amazon's spending way more than its operating cash flow,

Starting point is 00:10:27 133 percent. So these companies basically said, okay, what's the maximum we can spend on this project? And so they went to their budget department and said, hey, we're going to make in cash flow this year. Okay, we're going to make $200 billion. Okay, cool, we're spending all of it. That's the answer. That's how they got to these numbers. So you say these companies don't really have a choice. They have to do it. Falling behind is not an option. In these sort of tech, platform shifts, the companies that fall behind never come back. Yep.

Starting point is 00:11:01 It is existential. But investors have a choice. And this is you. They don't have to wait around and see who wins the science fair. They can reallocate capital elsewhere. And I know we're going to get to that with Jessica now. But that's really the key thing is that investors could say, okay, maybe they're allocating wisely, maybe they're not.

Starting point is 00:11:21 It's too soon to tell. Yep. I'm going to put this in the too hard pile and allocate somewhere. else while the world figures the answer to that question out. You're probably hearing that more and more from investors as the stock's flatline. Somebody is selling. Yeah. Yeah. No, I think that's, it's very well put. And look, I mean, I want to make one final point and then hand over to Jessica because she's got a ton of good data on how this rotation is happening. But the bottom line is that investors are a little bit complicit in this bet because they're still awarding these

Starting point is 00:11:52 companies huge valuations. And those valuations come from the assumption that they will find the next big thing and make a ton of money off of it. So it's not like these companies are trading at 10, 12, 15 times earnings because their cap expot process is broken. They're trading it 25 and 30 times because the market's giving them a vote of confidence. So management can tell investors, you're paying us to do this. This is what our stock price implies. We have to do it. There's no not doing it. Yeah. Okay. That's a really good point. Jessica, you say equity investors, have a stark choice right now, either stick with big tech as they shift their business model into this hyperinvestment mode or go elsewhere.

Starting point is 00:12:31 When I look at the stock market on a daily basis, it looks like more and more people are choosing the go elsewhere option. But why don't you tell me what it looks like from your standpoint? Sure, yeah. Just building off what you're saying, the stark choice is really, they can stick with big tech as it goes through this huge shift in their business models, which is taking all their cash flows to execute and hitting margins, or they can be good risk managers and park their capital elsewhere as this story plays out. And really, the macro backdrop is so good that they can justify

Starting point is 00:13:08 taking incremental risk. And that's proven by the fact that last year's global trade shock didn't cause a global recession. So I have three points on this topic. and they're all anchored in the same index-based framework. And that's that there's over 2,200 stocks in the MSCI All-C-C-World Index. So, of course, that's just too many to evaluate individually. So investors sync in terms of bucket. So you have the S&P 500, and then you have rest of the world, which is the MSCI-All-country XUS Index, or the ETF symbol is ACWX.

Starting point is 00:13:44 And my first point is that the SMP and ACWX's sector weightings are super different. And we have my first chart, if you could please pull it up. The SMP 500 overweights relative to ACWX are on the top and the underweights are on the bottom. So the takeaway here is that the S&P has a 17 percentage point overweight to tech, which is almost exactly equal to its combined underweights and financials and industrials. and it's also meaningfully underweight materials. So the S&P is structurally skewed towards growth and innovation, whereas the MSCIL country XUS Index has a much stronger value and cyclical bias.

Starting point is 00:14:28 The SMP and ACWX also differ in that the S&P is much more concentrated in its top 10 holdings, which we have in our next table. If you could please bring that up, thank you. This is where the S&P and ACWX really diverge. because, as you can see, over a third of the SMP is in its top 10 holdings. And in ACWX, that's just 14%. Let's pause on this. This is incredible.

Starting point is 00:14:55 So for those listening, not watching, the largest holding in the All-Country World Index, X-U-S, is 4.1%. And that's Taiwan semi, which you might have guessed. The next largest holding is Samsung, which is already down to 1.6%. percent. Then you have ASML 1.6, and then they get smaller from there. Tencent is the last one above one percent. Every other international holding is less than one percent of that index. Contrast that with the S&P where Nvidia is eight. Apple is almost seven, alphabet five and a half, Microsoft five, Amazon three and a half, Broadcom two seven, meta two and a half. So that obviously,

Starting point is 00:15:38 you're talking about a lot more stocks in that all-country world index universe, of course, because it's what did you say, 2,200 versus 500? But that is a massive skew away from concentration. Right. So, and that's a great point, Josh, because U.S. mega-cap tech alone accounts for about 35% of the S&P versus only about 10% for comparable names in the rest of World Index. Okay.

Starting point is 00:16:06 So I thought now we could move on to my second point, and that's just how dramatic the recent move in non-U.S. And this next chart shows the trailing 100-day relative price returns between the S&P 500 and rest of world stocks from 2010 to the present. And since 2010, the S&P has beaten rest of world stocks by about three and a half percentage points over a typical 100-day holding period. And as you can see in this chart, this relationship is asymmetric. And that's largely because of the S&P structural outperformance. When rest of world stocks catch up, the rotation tends to happen quickly and violently. So the recent 11 percentage point move in favor of rest of world over U.S. large-cap stocks is between two and three standard deviations.

Starting point is 00:16:58 So it's extremely unusual. But per usual, this outperformance came right after a period when U.S. stocks were exceptionally strong up 10 points or more than one standard deviation in September of 2025. And this next table shows what every investor knows, and that's namely that the S&P has outperformed rest of worlds over the longer term. So the three, five and 10 year annual compounded returns have beaten the SMP by four to six and a half percentage points. So this really gets back at what Nick was talking about. In order for the S&P to keep its long run edge, U.S. big tech companies need to prove that their AI investments are worthwhile really over the next 12 to 24 months and

Starting point is 00:17:41 frankly, the sooner the better. Because if the three-year data starts showing rest of world outperformance, investors may start questioning whether big techs AI investments have not fundamentally changed the story around U.S. stocks for the worse. And that brings me to my third and last point. And that's that U.S. stocks have outperformed rest of world over the long term because U.S. companies leverage disruptive innovation at scale and are laser focused on growth and profitability. And the U.S. also dominates the global venture capital market. So public markets have a stronger and deeper pipeline of disruptive companies focused on monetizing gen AI because at the end of the day, it's disruptive innovation that drives longer on equity returns. And the U.S. markets have a strong

Starting point is 00:18:28 bench currently with SpaceX, open AI, and anthropic planning. to go public this year or next. And we'd rather lean on believing in the track record of American capitalism and big text history of executing on its goals than assuming, you know, suddenly that's come to an end. I meet with a lot of wholesalers, or at least I used to, a lot of wholesalers of equity funds, different themes, different strategies styles. And whenever you met with the people selling international, invariably, they would say when international outperforms the U.S., it's typically not a one-year phenomenon.

Starting point is 00:19:07 It's usually part of a multi-year cycle, and if you miss it, you're going to be in big trouble with your clients. When you had that second chart up showing how it oscillates back and forth, I mean, I guess the thing to say here is, yes, it looks like there are some extended stretches in 100-day traveling returns, but like, could you speak to the multi-year opportunity for the person that says, let me get this straight, all country world just outperformed by, what was it, 30% or just went up 30% of the last year? Why do I want to buy it now? Why do I want to allocate there now? What's the historical data-driven answer to that question? Well, that's a really good point

Starting point is 00:19:55 because I think it gets back at the crux of the issue with big tech. And that's that they really need to prove that their AI investments are worthwhile, like I was saying within the next year or two, because if not, there's such a large part of the S&P that they won't be able to mathematically outperform rest of world. So the cornerstone of the American exceptionalism trade is that U.S. stocks outperform over three-year cycles. If non-U.S. stocks outperform another year, it only gives U.S. stocks one year to make up for those two bad years. And the market has so far, like Nick was saying, given U.S. stocks a long long, leash. And if AI does pay off, then the American exceptionalism trade will continue through the

Starting point is 00:20:36 end of this decade. But if not, there would be such a large paradigm shift that non-U.S. stocks would likely outperform through the decade because, and this kind of answers your question, gets to what you're asking, Josh's money has to go somewhere. So if AI doesn't look like it's going to pan out, people are going to look elsewhere and they're going to go to non-U.S. equities because of big techs, has such an outsized large weighting in the S&P 500. Yeah, and I would add to that, Josh. I mean, I know that argument extremely well. I remember working with wholesalers in the 1980s who made exactly that pitch.

Starting point is 00:21:13 It's different. The question is, how similar are the 2010s to now versus the 80s, the 90s, the 2000s? And I think you have to make the argument that it's extremely different because you now have technology really running the ability to surprise investors to the upside. And that's been the case now for 15 years and most tech is domiciled in the U.S. If you look at, you know, the top, those, you know, the top 10 waitings of MSCI Europe versus the U.S., do you want to own Nestle and Roche or do you want to own Amazon and meta? That's the key question. Japan's had a great run. It depends on if there's an ROI on all the tech spend, I guess.

Starting point is 00:21:52 That would be the answer. That is the right forward-looking answer for sure. But in terms of like, if you had to lock your money away, let's put it this way, you lock your money, away for five years and you cannot touch it. Where do you want to be, honestly? Do you want to be? I mean, I see Europe or U.S.? It's so funny. If I'm talking about the entirety of those two markets,

Starting point is 00:22:13 I think I would obviously answer U.S. Like 99 out of 100 people I know would probably also say U.S., but maybe the value investor, if there were any left, they would still just say, I want cheaper assets and like for a five-year hold, I'm willing to believe that ultimately somebody will care that this is selling at a discount, and they might focus less on why the discount exists.

Starting point is 00:22:42 Yeah. No, I get that, but typically... Not me. Not me. You know what happens? When that trade works is because you're losing less money than you would be in growth, which is a purec victory at best.

Starting point is 00:22:54 Look, we've just kind of talked about this like ad nauseum for the last couple of weeks, just trying to suss this out. there is one argument for Europe, and that is that the social safety nets are so strong there that you're not going to get the same labor market disruption with AI that you might in the States. Now, that blows out the budgets, and that increases yields, and so that's a touchy way to think about it, but that's kind of like our best argument for Europe right now.

Starting point is 00:23:20 Another argument for Europe is that they are going to look at the example of Japan and actually push through with the sort of massive corporate reforms. that triggered a wave of domestic buying enthusiasm for their own stocks. Combining that with the threat that Russia poses to Western Europe, Eastern and Western Europe, and all of these fiscal programs and all of these programs around defense spending. And I'm not saying that explains the re-rate for European stocks last year, but earnings growth definitely doesn't because it wasn't any.

Starting point is 00:23:59 No, no. I mean, the re-rating is, the re-rating was, well, we have to be careful about this because a big part of the quote, re-rating was currency. So the euro was up, call it 10% last year, pound, I think might have been up a little bit more. So a good, call it, third to 40% of the gains that we saw in European stocks as American investors was currency, not underlying fundamentals. The balance of it was probably some re-rating because of all the things Jessica talked about. Okay, money's got to go somewhere. So, you know, we got to wait out this whole tech thing. Europe is cheap and fine. You know, they're good companies. Let's go there. The question is forward-looking. Look, I mean, the dollar could weaken another 5% this year. No problem.

Starting point is 00:24:40 And European stocks on dollar terms would do fine. But that's not really the fundamental issue that we're talking about. And the last point I'd make is Japan went through the wilderness for 20 years. I mean, I remember studying the Japanese stock market in Chicago and B-school in 1990 is this miracle of high valuations and cross-shunders. shareholders, and it was all wrong. And the thing went through 40 years of nothing and then finally started coming back. So I think we have to be careful in the comparison because European stocks in Europe didn't go through that. It's a really great point.

Starting point is 00:25:13 I would also just make the point that in thinking about rest of world stocks, yes, momentum is a super powerful factor in capital markets, but just realize like if you want to get in now, you are getting in when rest of world stocks have outperformed by two. to three standard deviations over the S&P 500. That's extremely statistically significant. So just realize you're getting in at extreme levels. Okay. So to sum up, this is the big bet that you have to make.

Starting point is 00:25:43 If you're going to be long in the U.S. or overweight the U.S. relative to the rest of the world, you are de facto betting. These KAPX investments are going to start paying off. And in order for them to matter to the stock prices, that has to happen between now and the end of this year, shareholders are not going to give these companies a leash into 27, 28 in order to be able to prove why this makes sense. Is that where we're landing?

Starting point is 00:26:09 Perfect. All right. Guys, this has been so much fun as always. And I want to let people know if you guys enjoy learning from Nick and Jessica as much as I do, make sure you're following Datatrek on their YouTube channel. And, of course, datatrek research.com. where you can subscribe and get their daily note. And that's literally daily.

Starting point is 00:26:33 They're putting out research every day. And lots of really bright, successful people on Wall Street, rely on Nick and Jessica's insights. And maybe you will too. So by all means, check that out for yourselves. Guys, we'll talk soon. Thanks so much.

The Compound and Friends - Big Tech Has Til Year-End…or Else.

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