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Tech Giants Play the Game of Thrones

Serial entrepreneur and NYU marketing professor Scott Galloway talks about the dominance of Alphabet, Apple, Facebook, and Amazon.

Chimps, babies, Taylor Swift—these are common subjects of viral YouTube videos. Marketing professors, not so much. Yet New York University’s Scott Galloway has racked up millions of views talking about brands, big tech, and who’s disrupting whom. Part of the appeal is his deadpan delivery of peppery one-liners. Google Glass, the head-mounted display shaped like eyeglasses, isn’t a wearable, he once told a conference: “It’s a prophylactic, ensuring you will not conceive a child, as no one will get near you.” But the former Morgan Stanley bond analyst and serial entrepreneur, who runs a business-intelligence firm called L2 when he isn’t teaching, also has a reputation for prescience. “I can’t imagine why they wouldn’t buy Whole Foods Market,” he said of Amazon.com (ticker: AMZN) in a June interview. Five days later, Amazon announced the deal.

Barron’s recently sat down with Galloway to discuss the rising power of America’s tech giants, which he writes about in a new book, The Four: The Hidden DNA of Amazon, Apple, Facebook, and Google. Our talk has been edited for space and clarity. Videos of the full conversation are available at Barrons.com.

Barron’s: Let’s start with “Amazon the Destroyer,” as you call it. You say Amazon’s core competency is storytelling. What do you mean by that?

Galloway: Despite the fact that this company hasn’t always been profitable, and has hit certain bumps in the road, whether it’s their phone or attempts at auctions, the market keeps bidding the stock up. As a result, Amazon plays by a different set of rules. It has replaced profits with vision and growth. Typically, tomorrow at some point has to become today in terms of investors’ patience, but we’ve never seen a company with access to capital this cheap in the history of modern business. Amazon can now borrow at a lower rate than China.

I believe that every time Amazon makes a mistake and becomes profitable one quarter, Chief Executive Jeff Bezos calls his management team into a room and says, “You screwed up. Greenlight everything.” That’s because they’ve changed the compact with the markets through storytelling. They have never got the markets used to the crack cocaine of profits, because once you go profitable, you take that crack cocaine back away from the addict and he or she—the market—gets very irritable. Amazon never fell into that trap, with amazing storytelling.

What’s next for Amazon that we’re not watching?

Going right after Netflix [NFLX]. There is talk of their acquiring some television networks to get scale and content quickly and fill in some niches, because those assets have been beaten down from a valuation standpoint and Amazon has the ability to monetize them. Not just with advertising, because if they create more intensity across their Prime relationships, which are now 60% of U.S. households, then they can sell more stuff to them.

There are about 1.3 billion self-identified Catholics. There are 1.4 billion Chinese. If you look at the number of people who adhere to some form of capitalism, it doesn’t get near the two billion people who have a meaningful relationship with Facebook. It is bigger than communism, capitalism, the Kardashians. It is the most successful thing in the history of mankind if you look at the intensity of the relationship across Facebook and Facebook-owned properties.

That was all of the Kardashians together?

All of them, yeah.

If it’s that big, where does it go from here? Where does it find growth?

Facebook has pulled off this incredible hat trick with what is arguably the best acquisition in technology in the past 20 years, and that’s Instagram. At the time, people were saying that the child-CEO has really screwed up here and paid $1 billion for a company with only 19 people. By most standards, if you try to value Instagram now, it’s probably worth somewhere between $60 billion and $150 billion. So it has put an afterburner effect on the company, as has likely WhatsApp. They keep finding growth.

Where do you come down on the issue of Facebook, fake news, and the presidential election?

This could be, if they handle it poorly, the moment Facebook goes into structural decline. I don’t think they are owning up to the fact that they are a media company. You produce content. You run advertising against it. You have large influence over society. Boom, congratulations. You’re a media company. The fourth estate has extraordinary influence and, with that, some responsibilities. Facebook seems to be comfortable with the former, not the latter.

It looks as if Facebook has been co-opted rather cheaply by Russians. And the notion that they can’t put in place safeguards to check this, such as when an advertising account is paid in rubles? I mean, that is literally a red flag. So they need to get out in front of this issue. Martha Stewart wasn’t put in prison for insider trading. She was put in prison for denying the issue.

Now, Google. You talk about it in religious terms.

I believe Google is a modern man’s god. Our species throughout time has needed a superbeing to fill in gaps around huge questions we are unable to answer. However, as a society becomes more affluent and educated, church attendance goes down. So we have this void. Google has filled that void. If we were to look at everything you have ever put in that search query box, we would probably come to the conclusion that you trust Google more than any priest, rabbi, boss, mentor, coach, professor. If something goes wrong with your kid, your whole world stops. You start praying and you look for some sort of divine intervention that sees everything and then sends you back an answer. Will my kid be all right? So you type “symptoms and treatment of croup” into Google. We trust Google more than any other entity. It is our god.

Google’s parent, Alphabet, also owns YouTube. Now Facebook wants to do more video. How does this competition shake out, and what does it mean for television?

Facebook, by virtue of its huge audience, is immediately a player overnight. These two can peacefully co-exist. The bleeding carcass of traditional broadcast advertising is so big. TV advertising in the U.S. is $60 billion. There is enough baffled prey for both of them to go after. It is bad news for broadcast media. I believe we are experiencing the death of the advertising-industrial complex. The last firewall of broadcast TV was sports, and when you look at how sports viewership is aging—you are soon going to see the deeper-pocketed Amazon, Apple, Facebook, or Google go after and get the World Cup or the Super Bowl—it is just bad news for any ad-supported media.

Let’s talk about Apple [AAPL]. You have a slide that you show where you have various body parts. Google is the brain, because that’s where people go to ask things. Facebook is the heart, because people keep their relationships there. Amazon is the stomach because it’s all about consumption. Apple is the private parts. What’s the connection?

Apple draws on the second most powerful instinct behind survival—procreation. The luxury industry has created more wealth in the past 20 years than any other industry with the exception, I think, of finance, and this taps into our need to procreate, our need to feel more attractive to the other sex. The watch you are wearing isn’t a timepiece. It’s an attempt to signal to people that, if they mate with you, their kids are more likely to survive than if they mate with someone who’s wearing a Swatch.

Apple is the new signal of wealth, of creativity, and that you’re part of the innovation class, and that you have better genes. The price premium is irrational, but we’re willing to pay a lot of money to seem more attractive to other people. So, it’s kind of the opposite of having ad-supported Pandora or paying with a Discover card, which I think says to potential mates you have bad genes. I think this is the way you say mate with me. If you have an iPhone, it means you come from a wealthier household and will pay a $1,000 for a phone you can get for $200 elsewhere.

You have a part in the book where you talk about what Apple should do with its cash. You say start a college.

The way you identify an industry ripe for disruption is you look at whether the price increases are greater than inflation and justified with underlying innovation. The one industry that is most ripe for disruption is education. I think Apple’s roots in education give it unbelievable license to go into that business. I mean, my class generates $160,000 in tuition for each night I teach. They don’t pay me that much. My agent, NYU, takes a 97% commission on that. But when you think about that, it’s ridiculous, and it has some very negative outcomes for our society in the form of debt on young people. So what could Apple do to really change their role and to think different? Start the largest creatively driven low-cost university in the world.

Let’s play Game of Thrones. These are four impressive companies, but they can’t all be the best in everything they do, and increasingly, they are starting to compete against one another. Who’s going to come out on top?

So, who ascends to the Iron Throne, if you will? Right now, the good money is on Amazon. Where the others are bumping up against Amazon, they are losing. In search, you think of Google. That’s their domain. But in terms of product searches, Amazon’s share went up from 44% in 2015 to 55% in 2016. Some people would argue that Amazon is becoming a search engine with a warehouse attached to it. In hardware, Apple has given up a lead in voice with Siri, which is now getting the crap kicked out of it by the buttery voice of Alexa. The most innovative hardware product of 2015 and 2016 wasn’t the Apple Watch. It was Amazon’s Echo.

If you look at trying to garner digital marketing dollars from the corporate world, Amazon’s media group is now growing faster than Facebook or Google. A billion and a half dollars in revenue last year—triple the size of Snapchat, creeping up on Twitter. The most profitable, fastest-growing business in tech is the cloud. Who is No. 1? Amazon. The infrastructure, the moats, the momentum. It was No. 7 in video streaming in 2015, and now it’s No. 3, going after Apple iTunes and Netflix. This company is just going everywhere and swallowing industries whole.

Does Amazon become so powerful at some point that government has to step in and break it up?

I believe it will, unless Amazon spins off its web-services business first. One of the four—or all of them—is going to have regulatory intervention because the worm has turned on big tech. The left doesn’t like them because of job destruction and because it looks as if elections were circumvented. The right doesn’t like them because they don’t feel like they have a seat at the table of this new kind of political leadership. So you are going to see one of these companies come under attack, and it could be any of the four.

Margrethe Vestager, the commissioner on competition in the European Union, seems to be the only regulator in the world who is levying real fines against these people. You are going to see the first $10 billion-plus fine against one of these four companies in the next 12 months, and it is going to come out of Europe. The real estate isn’t going up in Hamburg. It’s going up in Palo Alto. America gets a lot of the benefits of these four companies, with some of the downside. Europe gets all of the downside and not much upside. The war is going to start, as it has throughout history, on the continent of Europe.

Thanks, Scott.

5 Reasons to Doubt the Rally

Skeptics warn investors that developing markets still hold dangers.

Nothing succeeds like success, especially on Wall Street. A 27% surge this year in the major emerging markets index has brought out a flock of analysts to explain why the developing world is back to stay as an outperformer. Not everyone agrees, though. Before you jump on the bandwagon, it might be wise to consider these five die-hard emerging market bear arguments.

There Is No China Reform. As President Xi Jinping nears the end of his first five-year term, his promised structural changes have proved a nothing burger, says J.P. Smith, a former Deutsche Bank and Pictet emerging markets analyst who now runs Ecstrat, a political and global markets consultant in London. State-owned enterprises and the financial system that feeds them are as bloated and opaque as ever. “We’ve seen bailout after bailout, and the underlying debt system is very fragile,” says Smith.

Xi goosed China’s gross-domestic-product growth a bit with new government stimulus that is turning to tightening, adds David Donabedian, Baltimore-based chief investment officer at CIBC Atlantic Trust, which manages $40 billion in private wealth. China accounts for 29% of the global emerging markets index itself, and drags along smaller economies that sell it commodities. So a downturn there would rock the whole asset class.

The Dollar Has Hit Bottom. Impotence in Washington has driven the greenback’s trade-weighted value down more than 8% this year, creating a bonanza for ex-U.S. investments. But it may steady or rebound from here. The Federal Reserve had a muscular Sept. 20 meeting, reiterating tightening pledges and committing at last to balance-sheet reduction. The euro’s short-lived luster meanwhile faded, thanks to Angela Merkel’s underperformance in German elections. “[Emmanuel] Macron’s victory in France revived talk of a more cohesive euro zone, but that isn’t going to happen after Germany,” Smith says. The dollar gains by default as a global safe-harbor currency.

Low Valuations Are an Illusion. The average trailing price/earnings ratio for the MSCI Emerging Markets Index is still less than 16, compared with 25 for the Standard & Poor’s 500 index of U.S. stocks. But for many of the state-owned whales that dominate emerging markets—think Chinese banks or Russian oil companies—“there is no reason to believe the E,” Donabedian says. More-transparent private-sector companies that are firmly linked to the great middle-class growth story already trade at P/Es above 20, he notes.

Governance Still Stinks. Emerging market governments have made impressive strides on macro fiscal and monetary policy—arguably more impressive than their highly developed brethren. But corporate governance often remains a black hole down which investors throw their money and hope for the best. “Everybody likes to talk about high-quality emerging market companies, but there may be, like, two of them,” says Richard Bernstein, who runs his own investment advisory and made a prescient bear call in Barron’s in 2011. Bernstein is tactically overweight on emerging markets “as a cyclical beta play on global profit acceleration.” But he rejects arguments that they’ve improved structurally.

India Can’t Do It Alone. Even bears are more hopeful for Narendra Modi’s India than for its fellow BRICs (Brazil, Russia, and China). But Indian equities make up less than 9% of the global emerging markets index, not enough to bolster the asset class against a broad sentiment shift. And Mumbai markets are already “priced for perfection,” Donabedian says, a term that seems out of place in a chaotic nation of 1.2 billion.

Hedge Funds Ain’t Dead Yet

With an improved environment for stock picking, the average hedge fund is up an average 5.4% through August

Written off less than a year ago as overpriced and underperforming, hedge funds are pulling off an unexpected two-step this year: Making money and taking in new cash.

The average hedge fund is up 5.4% through the end of August, while stock-focused hedge funds have gained 8.31%, according to researcher HFR. Over the same period, the Standard & Poor’s 500 rose 11.9% including dividends, while the traditional 60-40 split of stocks and bonds would have earned 8.9%.

That makes this year the industry’s best relative performance in a rising market since 2010. Investors, particularly in Asia and the Middle East, have begun sending new money hedge funds’ way, attracted by the better returns and a broad lowering of the industry’s famously hefty fees.

For now, at least, the gloom that had beset hedge funds is lifting and even giving way to outright optimism.

“It just feels better,” said Alper Ince, partner at hedge-fund investor Pacific Alternative Asset Management Co. Mr. Ince credited an improved environment for stock picking that has fallen in hedge funds’ favor, with popular stocks like Amazon.com Inc. outperforming, and bets against retailers also paying off.

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A year ago, things looked ugly for the industry.

Longtime managers like Richard Perry were shutting down, and many who remained were forced to negotiate their fees to sate disappointed backers. The pressure was compounded by a decade of nearly uninterrupted gains for the S&P 500, contributing to dramatic outperformance for low-cost, passive investment products.

Sticking around seemed even less attractive as managers had to dip into their pockets to pay out ever rising salaries to dissuade staff from leaving for flush technological companies dangling seven-figure packages.

Earlier this year, for instance, billionaire Kenneth Griffin was so frustrated with investment performance at his $27 billion hedge fund, Citadel LLC, that he sent the staff a stinging mass letter that read in part, “I am disappointed that after years of leading our industry we failed to deliver,” people familiar with the matter said. Citadel separately announced that compensation for some staff would be slashed.

This year, Citadel’s flagship fund is up more than 9% through mid-September, already eclipsing last year’s total 5% gain. Last year was the fund’s weakest mark in nearly a decade, the people familiar with the matter said.

Hedge funds at large pulled in $39 billion of new money this year, a reversal of $112 billion in outflows last year, researcher eVestment says. Industry executives expect the inflows to continue with several banner fund launches in the months ahead, including the return of fallen star Steven A. Cohen and a multibillion-dollar China-focused fund from Ray Dalio’s Bridgewater Associates, the world’s largest hedge-fund firm.

Few managers expect a return to the heyday of a decade ago, when every young trader with a pulse dreamed of a hedge fund of their own. Privately, many industry executives fret that the industry, which bets on and against markets world-wide, has been tagged with a permanently undesirable patina.

Fall is typically the season of hedge-fund shutdowns and this year is no exception. The well-known so-called value investor Whitney Tilson said last week he would shut his hedge-fund firm, Kase Capital Management LLC, which had dwindled to $50 million under management and lost 8% so far this year.

Among hedge funds girding for a continued bumpy road ahead is GoldenTree Asset Management, a $25 billion firm.

This month, GoldenTree warned investors in a private note reviewed by The Wall Street Journal that credit markets were “providing mid cycle pricing for late cycle risk.” GoldenTree’s main fund is up 5% this year, the note indicates.

Within hedge funds, macroeconomic-focused managers, who try to get ahead of political and other broader trends, have mostly whiffed in predicting this year’s major moves, particularly the weakening in the U.S. dollar, investors say. The average macro fund is roughly flat this year, according to HFR.

For now, the industry’s gains are shared by managers large and small, including many who came into the year with something to prove.

One of the biggest rebounds is under way at Brahman Capital Corp., a New York hedge-fund firm that flew under the radar for more than three decades.

At its apex around two years ago, Brahman managed more than $5 billion, as principals Mitchell Kuflik and Robert Sobel bet big on hedge-fund favorite Valeant Pharmaceuticals International Inc. When Valeant’s stock plummeted from $257 to $14 a share, Brahman fell in turn, as the firm reported losses and investors pulled their money.

Brahman sold Valeant stock last year and with what is now $3.8 billion of remaining cash pivoted to new ideas like a stake in travel company Expedia , people close to the firm said. This year, Brahman’s main fund is up 17%, the people said.