Bubble, Bubble, Where Is the Tech Bubble?
I don’t like writing about investment bubbles. It’s a pastime better left to French economists and buy-side analysts. That said, along with the reality show “Shark Tank” it’s the work topic my family asks me the most about: “Do you think we are in a bubble?” So let’s start with some foundational opinions.
First, we are unquestionably in a bubble for residential real estate in San Francisco:
- There are many buyers with a lot of money looking to invest [in a home].
- There is limited housing inventory because San Francisco is a 49 square mile peninsula [along with some other reasons].
This will and did drive the expected value of my house in the Mission neighborhood of San Francisco up 60% in 2013. That’s a bubble. Where it levels off, who knows? But the acceleration in prices is unlikely to be maintained indefinitely. Speculator home buyers will invest into that acceleration, paying higher and higher prices for homes. At some point, a speculating home buyer will pay more for a house than they can sell it for, and will lose money. When a home buyer loses money, they are embarrassed. Their spouse may question their investment choices and how much risk they should have with their savings; they think maybe they should just go back to putting money in the 401K. They get nervous and won’t pay as much for the next house, or maybe, they’ll even get out of the house owning business entirely.
When this happens to a lot of home buyers around the same time, nervousness spreads and the growth in homes values decreases. If the difference from the new, non-accelerating value [the actual or underlying value of the house, if you will] and its peak value is big, that’s a big loss. If there are a lot of big losses, it’s a big deal.
Where to Watch for a Bubble
The big question, then, is: are technology companies like San Francisco real estate?
- There are many investors with a lot of money looking to invest [to get a return greater than the S&P].
- There is a limited inventory of high potential companies in which to invest.
There are a few areas where you can observe pricing for technology companies, for example public markets, private markets (purchasing secondary or primary shares), and early-stage investment.
What drives the acceleration in pricing is where the volume of money is the greatest and the inventory most restricted. Late-stage private market investments are where the most money is rushing after the most limited inventory. (Public markets and early-stage investing both have an ample inventory of companies in which to invest- with their respective risks.)
Late-stage growth companies come in two forms. The first type encompasses companies with an established trajectory and (hopefully) a revenue model, like Uber or AirBnB. The second type are those that have an asset that maps to an existing company’s successful model (like SnapChat to Facebook).
Late-stage growth companies historically have gone public, making their financials available to all investors and making a percentage of their company available for anyone to own. Going public is a funding event for a company; it’s a way to raise capital to run and expand the company. These growth companies are now staying private for longer period of time, for a couple of reasons (which Marc Andreessen captured correctly in a recent interview).
The simplified motivations for keeping a company private instead of going public may be as follows:
- As a private company, the leadership team can invest without having to be beholden to shareholders looking at quarterly results.
- They can. That is, there is money available for the company to keep either running at a loss and money available to give liquidity to their existing shareholders (which is good for employee morale and earlier investors).
The first point has been true since Warren Buffett started investing. As an easy case in point, Jeff Bezos and the team at Amazon has never really wanted to have to answer questions about profitability.
The latter point is a significant change in the investing world. People who manage large, truly large pools of money begun to invest more money and more often in growth companies. Why?
It’s the result of a cyclical pattern starting with some amazing companies. Facebook went public with a $104B public market valuation. Google went public at a $23B dollar valuation. The money managers that were able to buy at the initial public offerings of these two companies had different experiences. Both positive, but the Facebook stock had dramatically less growth in value after being public because it went public at a much higher valuation.
We could see it as an outlier, except Facebook is illustrative of an emerging pattern of late-stage companies which are getting money from investors which historically would invest in public companies, possibly at the IPO. This includes emerging consumer brands like Square and AirBnB, and marquee enterprise companies like Palantir.
[Side note: There is an additional growth in available capital coming from hedge funds which aren’t constrained to traditional asset management rules. I’m not yet confident in how the dynamics with hedge funds will play out over time for a number of reasons.]
You could ask whether investing in a private company is the same as invested at the IPO. The answer is: yes and no.
Yes. Some companies will continue to grow after investment, possibly going public at a high value like Facebook. Investors in those companies will be heroes and will outshine their investors peers who didn’t invest.
No, and here is the momentum for the bubble. The problem for investors is that there is only a small number of growth companies whose revenue model or user monetization strategy is clear. These companies quickly attract investors and there are more investors, more money than these “good” growth companies absorb. This creates a bubble and acceleration in pricing as more investors :
- Pay more for the marquee companies which they identify as good growth businesses with risks they understand.
- Be optimistic about the risks and consider more businesses as growth companies.
Given there are many interested investors and a small number of great companies in which to invest, over a relatively short person of time, there will be an acceleration of pricing and this will create a bubble as values rapidly expand. It’s only a matter of time: days, weeks, or months.
There is near-unlimited capital looking to be invested. This will create pressure for investors to be optimistic — and to augment and encourage that desire to look past uncertainties in a company and treat it as a growth businesses.
What happens when a bubbles bursts?
The history of San Francisco houses, especially in certain areas, is that gap between a house priced in an accelerating price market and it’s true value isn’t that large. When accelerating prices subside, the underlying house is still worth a lot because people still keep moving to San Francisco. As a result of the 2008 housing value bubble, we have evidence that to-date, the value of the peak price and the actual price of a house in Detroit, Gainesville, suburbs of Dallas, suburbs of Vegas (but not downtown Vegas) have all been quite large. So if you bought a home in San Francisco you are probably doing OK. If you bought a home in Detroit. You aren’t.
So are we in a bubble?
We aren’t in a bubble yet, but we’re seeing the conditions in which on could easily form.