Doubling Down on VC in a Post-dot Com, Post-recession Era
Our world is changing faster than ever before. We are making strides in computing, artificial intelligence, machine learning and health care at a pace never before seen in human history. Much of this innovation has come from smaller companies, not corporate behemoths. Yet typical investors — those using traditional financial advisors — have less than a 1 percent allocation to alternative asset classes, such as venture capital, which fuels these tiny outfits ushering in massive technological breakthroughs.
Ultra high net worth individuals and institutional investors on the other hand? On average, they invest roughly 42 percent of their allocations to alternatives. We believe this discrepancy should be rectified.
The answers lies in analysis of the history of the markets — particularly, two distinct time periods: The dot com bust of 1999 and 2000, and the financial crisis of 2008. The economic transformations caused by these historical periods, collectively, have made investments in the venture capital space essential.
Market conditions in the months leading up to the dot com bust bear significant resemblance to those of today. In 1999, almost any company with a .com after its name was christened as the Next Big Thing (remember Pets.com?). There was talk of internet companies vying to become the first trillion-dollar market cap company (CSCO) and the old rules of valuation and earnings did not apply (Sun Micro, Qualcomm, etc). The world was awash in day traders and stock gurus, and we were told the ride would last forever. Until it didn’t.
These dot-com “new rules” stocks suffered losses of more than 90 percent by 2000. The U.S. was facing an economic recession, and the federal government was forced to step in and lower rates to spur the economy.
Fast forward to 2008, and another market meltdown had materialized. This time, the meltdown was a global financial crisis, caused by various factors with far-reaching effects.
In the years leading up to the Great Recession of 2008, money was cheap and credit standards were lax. As a result, the American company was awash in poor investments, by both companies and individuals.
Normal people became real estate “experts,” and, seemingly overnight, millionaires, and media outlets gleefully shared these stories of prosperity. There were zero-money down loans, NINJA loans, and Wall Street dove in, headfirst.
The banks packaged loans into investment instruments that few understood. Some of these loans were packaged to create AA and AAA bonds. The underlying paper, however, was risky.
The crisis became so widespread that it bankrupted countless individuals and caused widespread carnage on Wall Street. Lehman Brothers and Bear Stearns went belly up. Countrywide and Merrill Lynch were bought in a fire sale by Bank of America. Regular people lost their savings, and the economy here, and abroad, spiraled into recession.
In response to the economic downturn, two major changes occurred, and directly contributed to the present state of the market.
The first policy involved the Fed’s decision to lower interest rates to effectively zero, and keep them there for almost a decade. This quantitative easing has flooded the market with free money and liquidity. It has rewarded speculators and punished savers.
The other major change was the way corporations would be run.
When confronted by crisis and a drop in stock price, management is forced to cut costs.
During the financial crisis, R&D budgets were slashed and some companies cut the departments altogether — not uncommon due to the high costs of running these divisions. Earnings, therefore, have not been driven by growth of top-line revenues; rather, the majority of earnings and stock appreciation has come from cutting costs and running lean.
The combination of quantitative easing and corporate cost cutting has lead to an amazing bull run in the equity markets. We have been on a mostly unencumbered ride straight up from the doldrums of 2008 to today. We are again hearing about crops of trillion-dollar companies and that “this time is different.” We believe this to be untrue.
Today‘s markets are under pressure from a number of factors:
- Rising rates on record levels of U.S. and global debts
- Quantitative Tapering
- Escalating trade wars with many of our major trade partners
- Climbing inflation
- Strengthening dollar (which hurts S&P company results)
Rate hikes by the Fed have occurred gradually. In fact, it has been the Fed’s slowest rate-hiking campaign in history, although the U.S. economy is in its ninth year of recovery. But with inflation currently rising at its fastest pace in six years, the Fed is forced to act, or lose credibility.
Along with slowly rising rates, the Fed’s quantitative tapering has gradually picked up steam. To reduce the balance sheet accumulated during the crisis, the Fed has been selling securities in the open market. They started with $10 billion a month in the 4th quarter of last year, moved to $20 billion a month in Q1; $20 billion in Q2, $40 billion a month in Q3; and, currently, are selling off $50 billion a month in Q4.
In Europe, the European Central Bank (ECB) is also withdrawing liquidity from the European markets. It has reduced its QE program to about $35 billion a month and kept interest rates negative to further stimulate the European economy. However, for the first time in almost 10 years, there will be no outside government stimulus in the markets. In fact, with the U.S. selling off $50 billion and the ECB buying only $35 billion, the overall effect will be negative.
The massive money printing efforts by Central Banks around the world has led to massive inflation of asset prices. However, they are no longer flooding the system with cheap money, causing a slow erosion of global stock markets and economies.
At the end of June, we noted the Dow Jones Industrials, Utilities and Transports were all down between 1 percent and 2 percent. The DJIA was down over 2,300 points from its high, a little over 9 percent. However, the S&P and Nasdaq were both still positive at 2 percent and 9.6 percent, respectively.
Wall Street pointed to these gains and told us there is no cause for concern. Meanwhile, large parts of the broad U.S. markets reversed course and are sharply lower for the year. Sectors such as homebuilders, industrials, healthcare, financials and telecommunications services are all slumping. The gains year-to-date in the tech stocks, most notably, the FAANGs — Facebook, Apple, Amazon, Netflix and Google — were disguising the overall weakness of the markets.
In October, stocks fell around the globe. This fall was caused by a combination of higher rates, quantitative tightening and possible investor exhaustion. Even the invincible FAANGs were not immune. The Dow lost 6.4 percent, the S&P lost 7.3 percent and the NASDAQ lost 9 percent. The Nasdaq breakdown was lead by a breakdown in the FAANGs. This 9 percent loss was the largest monthly decline since October 2008. While tech has been largely immune to corrections over the past five years, October saw a reversal.
Another major index we follow is also pointing to tough times ahead: the SOX. The SOX is the Philadelphia Stock Exchange capitalization-weighted index, composed of companies primarily involved in the design, distribution, manufacture and sale of semiconductors. It has a tendency to act as the canary in the coal mine for the general market. In the past two bear markets — 2000–2002 and 2008–2009 — the SOX showed weakness well before the general averages.
In 2008, the SOX was foreshadowing the trouble to come in the markets. It peaked in 2006, and sold off the rest of the year. In 2007, it rallied within 2 percent of the 2006 high in July, it then sold off again. When the S&P peaked at 1576 in October 2007, the SOX rallied too, but only up to 508 this was a full 7 percent off the high. The SOX peaked a full three months before the general market. This was a sign of trouble to come. By the time the S&P finally bottomed in March 2009, the S&P had lost 58 percent from its peak and investors portfolios were devastated during the bear market. Investors failed to heed the warning of the SOX, and paid a heavy financial price. Today the S&P sits down 7 percent, while the SOX is down 18 percent. (It was down as much as 24 percent, but had a dead cat bounce recently.)
If we examine the SOX during the 2000 to 2002 bear market the numbers are eerie similar to this year. The Sox peaked in March of 2000, while the S&P topped in September. A full six months of warning for bulls to consider. The S&P would lose over 48 percent, while the Nasdaq lost 75 percent and the Sox was demolished with a loss of 81 percent. Our belief is the public markets are headed for a major re-pricing.
We feel the combination of high valuations and the removal of Central Bank stimulus places the stock market in a very fragile position.
Wealth accumulated in the prior two bubbles was washed away in a sea of red ink and bad investments from free money. Innovative public companies are trading at sky high valuations which we believe are unsustainable. We believe it is time to adopt the institutional model and move some of your accumulated wealth into alternative investments.
Why VC, and Why Now?
We are often asked, if the market is currently overvalued, why should I invest in venture capital?
The answer: An allocation to VC is equivalent to an educated guess on the future of the market and corporate America.
As stated, corporations have driven growth through cost-cutting measures and cheap leverage on their balance sheets. However, as the cost of money rises and the Fed withdraws liquidity from the market (by raising rates and reduction of their balance sheet), corporations will again be forced to innovate to drive growth. Unfortunately, due to cost cutting and bottom line optimization, many of these corporations have no R&D. What they do have, however, is record amounts of cash on their balance sheets.
This cash position has been further enhanced by the tax policies of the Trump Administration, which allowed companies to repatriate cash from overseas. Corporations have funneled this capital to acquisitions, buying disruptive technologies and incorporating them into their businesses before they can truly disrupt the existing companies. Examples include: Apple’s acquisition of Beats by Dre; Facebook’s acquisition of Instagram; and Google’s acquisition of YouTube.
Money has poured into the venture capital space for almost a decade, with valuations in all sectors swelling to unforeseen levels.
In 2010, the average Series A round was $6.5 million. By 2016, the average A round rose to $21 million. Other rounds have seen similar inflation. It is Rokk3r Fuel’s belief that the real value in this assets class exists in the early stages of a company’s life cycle, especially pre-Series A.
The reason this value exists is based on investors’ risk aversion. Many of the family offices and advisors we speak to prefer to invest in C and D rounds. They feel investing later in the process gives them a better guess as to the eventual success of the company (the traditional failure rate of early stage companies is 90+ percent).
Yet great companies and brilliant founders still need early-stage funding, and one person’s aversion to risk is another person’s opportunity.
This post was authored by Rokk3r Fuel ExO partner Shawn Bromley. A former trader and portfolio manager, Shawn combines his knowledge of trading, investment theory and decision-making science to help shape Rokk3r Fuel’s investment thesis.