Charlie / NYC / Tech, Finance, & Policy

May 5, 2016

Bubble, bubble, toil & trouble?

A brief overview of the current market environment for tech

Note: For a review of terminology, see the bottom of this article.

Evidence of a correction

When considering the current market environment, it is important to reflect on just how far we’ve come since the Great Recession. Despite the rhetoric (on both the right and left), the US has actually led the world in its recovery. Overall employment growth has been exceptional (and yes, even labor force participation has begun to trend in the right direction); households have massively de-levered; GDP growth, while tepid, has been consistent; corporate profit margins are at an all-time high (though for mixed reasons, namely a lack of capex); the S&P is up by nearly 200%; and everything from vehicle sales to consumer spending has been broadly and consistently strong for the past several years (thx Obama). While there remain some glaring weak points, namely the lack of wage growth, low productivity growth, and muted business investment outside of the energy sector, this is nothing less than incredible given the context of 2008/2009.

However, in recent months, there seems to have been some shift in outlook: Q1 2016 saw only tepid GDP expansion at 0.5% (initial estimate). Most analysis has pointed to: continued weakness in emerging economies (particularly the BRICS), some employment headwinds in the US (as domestic energy production has slowed in response to ongoing low prices), mixed consumer sentiment and outlook (perhaps somewhat exacerbated by the political environment), and still-weak inflation figures (Janet Yellen noted that the recent uptick seemed only transitive).

Against this somewhat grey backdrop, the outlook for the technology sector saw some sharp revisions during Q1. Analysts have slashed their Q2 earnings forecasts for listed tech stocks by 9.4% since the start of April, compared to a 1.8% reduction for the S&P 500 as a whole. A number of headlines have called the market top, pointing to indicators both traditional and questionable…

Looking at the recent share prices of some of the largest players to emerge and benefit from the current tech era, it would seem that perhaps there has been a peak indeed…

1 year share price movements for Apple (-28%), LinkedIn (-40%), Yelp (-46%) and Twitter (-63%) as of May 5, 2016

Then again, it depends who you look at:

1 year share price movements for Netflix (+12%), Google (+30%), Facebook (+49%), and Amazon (+56%) as of May 5, 2016

There have been no shortage of eternal-bears calling the market top since the recovery began in 2010:

Clearly the outlook for the technology sector, like the wider economy, is more nuanced.

Public market tech valuations

The obvious question becomes, how does today’s environment compare to the last cycle? This is an open debate and a topic which warrants a much deeper inspection, but two charts can provide some insight:

The Case Shiller Cyclically Adjusted Price/Earnings (CAPE) ratio is based on average inflation-adjusted earnings from the previous 10 years, and arguably provides a better measure of overall valuation than a simple price/earnings average. Admittedly, there is some noise in the current figures given the impact of 2008, but nonetheless, relative to 2000 (and 1929), we’re in fully-full— but not irrationally exuberant — territory, yet.

Further, I would argue that today’s tech sector is on far more solid footing than during the last cycle. The impact of ubiquitous connectivity and mobile computing — combined with 16 additional years of globalization and a hardening of the “knowledge economy” as a central leg of global growth — has made technology not only important, but central to most businesses today. No longer are we counting “clicks on page” or other dubious 2000’s-era metrics as hard inputs for valuation (though perhaps there is a strong argument to be made that it has simply been replaced by “followers” and “likes”…). Nonetheless, the nature, quantity, and quality (stickiness) of not only revenues, but earnings, at most major technology players is substantial today, certainly more so than what the relatively nascent sector demonstrated in the late 90’s.

Perhaps the biggest factor which gives me pause is the recent dearth of technology IPOs:

Certainly, the downward trend in both volume and value from 2014 is concerning. During Q1 2016 there were no tech IPOs whatsoever. The only other periods where this has happened (since Dealogic began tracking in 1995) was Q3 2002, Q1 2003, and Q1 2009, all following recessions. Overall, the first quarter was one of the slowest quarters for IPOs (of any kind) on record: companies raised only $1.2b in the quarter, the smallest amount since Q1 2009 (with $830m).

While I certainly can’t claim to have any great insights into tech IPO markets, some thoughts come to mind. First, it may be the case that the “low hanging fruit” had its moment of maturity in 2013–2014. Companies (such as Facebook, Tesla, etc) — which had been battle tested during the recession and came out ahead with deep talent pools, mature technology, and secular tailwinds — were simply ready to IPO, and the current crop of startups has yet to reach that point. There are certainly IPO-ready companies (UBER!!!!, maybe Dropbox) which have delayed floating given relatively cheap equity available in the private markets, but there seem to be fewer clear market leaders in the more-recent batch of startups.

This is admittedly a somewhat weak argument given the sheer number of “unicorns” with hyper-valuations, and probably actually one of the stronger arguments in favor of declaring a bubble. However, other considerations include: a general “pause” in market sentiment given incredibly high valuations and asset prices across the board, and equally, a pause in 2015 driven by expectations of the first rate hike since 2006.

Nonetheless, the recent freeze in the IPO market is certainly concerning and will definitely cause heartburn for the investors with major exposure to the current crop of “unicorns”. Speaking of which…

Private tech valuations

Unicorns. They’re magical, they’re sexy, they’re misunderstood. They are also, by far, the biggest indicator of inflated valuations and strongest argument in favor of a bubble.

For the most part, the public markets agree:

But what has changed this time? Why did unicorns seemingly magically appear? Have venture capitalists simply had too much kool aid and built too few DCFs? Perhaps, but the biggest structure change in the market (relative to 2000) is the entrance of mutual funds as major sources of capital in the private funding markets for technology.

Mutual funds have turned to private tech investments as a way to boost returns in a relatively low-growth environment. While this is somewhat shocking given the historically low returns of venture investing as a whole, it is tempting fruit for asset managers with enormous piles of cash and relatively few good options. Tech companies are one of the few asset types that feature potential for extremely high growth, low capex requirements, and somewhat flexible cost structures which can be dialed up or down. Nevertheless, mutual funds are unproven players entering into a new space, and historically, particularly for private equity investors, this is THE recipe for disaster.

Some mutual funds have not gotten the message however:

More than anything, I view a pullback by mutual funds as one of the key risks for the sector, and one that is likely to be permanent (at least for private companies) once they realize the folly of trying to build costly venture teams for what may ultimately be mediocre (at best) returns.

Fundraising environment

Looking at more-traditional institutional investors, there is a similar dynamic affecting the rise (and potential fall) of unicorns, but a slightly more hopeful outlook for early-stage tech investing as a whole.

Venture capital firms have continued to raise an incredible sum of money across a huge number of funds, with 2015 being the largest year for commitments since 2006. This is despite both sky-high asset prices in VC target sectors as well as their historically, ahem, lacking returns (~5% on average, no better than the S&P). By all measures — total volume, time to close, net flows — VC appears to be a core strategy for asset managers (even if small relative to overall allocation targets).

While, again, this is a topic for deeper inspection, I would argue that it is simply another manifestation of asset-price frothiness driven by continued quantitative easing. In my former job, I actually had the opportunity to ask former Fed Chairman Ben Bernanke his views on the matter (I asked if he viewed it as a “manifestation of inflation” driven by Fed policy). He responded that inflation refers specifically to consumer prices (lol), but that no, in his view it is a rational market-response to a low return environment: investors are willing to pay more now for higher relative growth, and therefore asset prices as a whole get pushed up. Frothy? Yes. Outright bubble? Probably not in the same vein as 2000 or 2008. Snark? Definitely. (He was actually really funny).

Forward outlook

So, with all of this, is the picture any clearer? Not really. I will however offer my views for different time horizons:

Short term

“Pause” for a falling knife: Investors tapped the brakes in Q1, and despite the market rally in Q2, there is clearly some tension in the market. Expect less chat apps and other me-too’s to get funded, with some pullback in overall valuations. However I doubt an outright freeze at the lower end (angels/seed/series A), particularly given the few options available to growth-oriented investors today. Watch out for dead unicorns and the ripples this creates at the higher end though.

Medium term

There continue to be a multitude of drivers of fundamental long term growth. Namely, the need to find new drivers of productivity growth (at a macro level), the move towards cloud computing (at a tactile level), and increasing levels of connectivity (globally and domestically) will continue to drive both new entrants and overall innovation.

The biggest governor (constraint) on medium-term tech sector growth in the US is a relative skills shortage (go Flatiron School!) and capacity bottlenecks in underlying infrastructure (broadband speeds, maybe the end of Moore’s law, and a lack of overall business investment). For innovators (both individuals and companies), these also offer opportunities.

Longer term

VC returns suck (historically). Unless the current environment persists, and investors take advantage of the opportunity to actually return cash, this is likely to be the last mega-golden era for VC for some time. The VC asset class cannot continue to marginally outperform the S&P while offering none of the benefits of public market liquidity, and still expect to raise multiple billions (much less maintain a 2/20 fee/carry structure on such poor risk adjusted returns). This assessment is somewhat harsh as it’s so colored by the last boom/crash, but the picture will become clearer as we get closer to 2018–2020, when the current crop of funds will be well into their duration limits and we’ll hopefully have more clarity on the asset class, tech sector, macroeconomic outlook, and Presidential rationality.

If anyone actually reads this and would like to contribute thoughts or challenge my views, I would welcome it. Until next time!

— Charlie Tafoya

Quick review of terminology

Venture capital (VC) investors provide capital (money) to startups and growth-stage companies to fund expansion and help them rapidly scale. Because of the relatively small dollars required, VCs aim for “homerun” outcomes, aka extremely high returns. There are usually only a few (hopefully highly-) successful investments in any given VC portfolio, with the majority being failures.

VC is a subcategory of private equity (PE). Broadly speaking, any investment in a private company (one which does not freely trade as a listed stock on an exchange and/or is not required to publicly file and disclose information) is considered PE.

Institutional PE investors (general partners, aka “GPs”) raise pooled money (funds) from limited partners (LPs) — typically pension plans, endowments, foundations, insurance companies, wealthy individuals, and other entities with high return requirements but which lack the infrastructure or institutional capacity for direct investing.

In order to realize a return on a private investment, an investor must be able to exit their position (sell their equity/security and ultimately receive cash). For most companies who survive and grow, the eventual goal is an initial public offering (IPO), or listing on an exchange (though in reality the vast majority end up selling to a strategic acquirer [competitor] or to other institutional investors). For those companies who do successfully IPO, the securities (“stock”) of listed companies can then be traded freely, providing liquidity for investors.

At all stages of the investment lifecycle, the key metric is a company’s valuation. Valuations are an “art and a science”, and are often driven by wider considerations such as market sentiment, sector focus, business model, macroeconomic perceptions, and a host of other factors. For a startup, the higher the valuation, the less equity one has to sell to raise an equivalent amount of cash. (Ex, if a company is trying to raise $1m and is valued at $5m, then the cost in equity is 20%. At a $10m valuation for the same amount of cash, the cost in equity is only 10%). On a basic level, valuations for private companies are established only during fundraising periods, and thus are less transparent. For public companies, the value is set by the wider market through a company’s share price.