Monday, August 13, 2018

In Which FT Alphaville Pokes At One Of The Most Profound Questions In Finance

Expected future returns—and getting your fair share, or better yet, more than your fair share—is pretty much the raison d'ĂȘtre for all the words and pixels and neuronal sparks on this blog and anywhere else the topic is business/finance/investment, and, as the rabbinic sage Hillel said in a very different context, "All the rest is commentary".

Here is the problem, last seen in 2015's "Mutual Funds In the Venture Capital Business: 'Eye-Popping Valuations'":
Maximizing expected future returns.
One of our favorite topics, along with agricultural commodities and production, materials science, really, really fast computers, advanced manufacturing technology, energy and Dogbert's schemes for world domination. 

One of the most profound facts of investing is that the growth is in the new companies.*
Not small companies, new ones.
So the question is: How to capture that growth?
And while you're at it, maybe mitigate some of the risk inherent in new ventures?...
We'll come back to that asterisk but first, FT Alphaville.
And just a heads up: our concern here is not buybacks but getting companies public while there is still some growth left in the things. For buybacks,  the answer is pretty straightforward, go back to the pre-1982 rules on share repurchases:
...II. Overview of Current Rule 10b-18
A. Rule 10b-18 as a "Safe Harbor"
In 1982, the Commission adopted Rule 10b-18,4 which provides that an issuer will not be deemed to have violated Sections 9(a)(2) and 10(b) of the Exchange Act, and Rule 10b-5 under the Exchange Act, solely by reason of the manner, timing, price, or volume of its repurchases, if the issuer repurchases its common stock in the market in accordance with the safe harbor conditions.5 Rule 10b-18's safe harbor conditions are designed to minimize the market impact of the issuer's repurchases, thereby allowing the market to establish a security's price based on independent market forces without undue influence by the issuer....
Here Alphaville looks at both topics, the changing characteristics of the IPO biz and the astonishing metrics of the repurchase racket:

The slow death of public markets
Last Wednesday Bernstein dedicated its Global Quantitative Strategy note to buybacks. Tucked in the note's final paragraph is, you know, no big deal, just a hint of concern about the future of capitalism:
Also, is there a society-level worry here if these incentives and the scale of buybacks are distorting the allocation of capital? There is probably something in this, we do worry about how management incentives are set. We will leave that topic for future research.
We are tired of hearing that there is nothing inherently wrong with buybacks. There's also nothing inherently wrong with tequila, but take too much of it at the wrong time, and you're probably making bad life choices.

In the last week both Bernstein and Goldman Sachs have predicted that buybacks in the US will either reach or exceed $1t in 2018. Investors have been eager to explain that this capital is not disappearing. It is merely rotating out of equities and into other assets. But this is just an accurate restatement of the problem: public markets are shrinking.

The pace at which companies are buying back stock from their shareholders this year does make our eyes water a bit. Since January, US corporations have authorised 80 per cent more buybacks than the year prior, totalling $754bn so far.

US companies are flush with cash, thanks both to blockbuster earnings growth and new tax incentives to repatriate capital from abroad. Traditionally, a buyback is a sign that a company's executives have greater confidence in future growth than its shareholders. According to Bernstein, companies that repurchase stock usually outperform by 3.4 per cent, but in 2018 they're underperforming by 2.7 per cent. All that tequila this year seems to be more a sign of despair than good cheer. Companies don't seem to have enough good ideas or confidence for all the cash they have on hand.

But this is a bigger story than what's happened in 2018. For years, companies have been both skimming the supply of shares off the top through repurchases, and restraining it at the bottom by issuing fewer shares altogether. Bernstein looks at a metric it calls “net issuance”: equity issuance — buybacks. The gap is largest in the United States, where net issuance currently sits at the lowest level since April 2009:...
...But Bernstein also finds that net issuance is unprecedentedly negative — buybacks exceed issuance — in Europe, the United Kingdom and Japan:
The stock of listed equities in the world has never shrunk at such a rate... We have not seen anything like this in 25 years.
We're seeing the move away from public-market equity capital in new companies, too. In June WilmerHale, a law firm in the US, published its annual IPO Report. Both the annual number of IPOs and their total dollar volume, the report shows, have never reached the heights of the late 1990s — and that's not for lack of available capital in the world. The median offering size hasn't really changed since 2000; companies tend to raise about $100m when they go public.

But: companies are now waiting about twice as long to go public. And they're raising about twice as much money in private capital markets before they do:
When Spotify listed on the NYSE earlier this year Daniel Ek, the CEO, published a letter that basically said “Meh.” He wasn't ringing any bells or doing interviews, he explained, he was just going to keep doing his thing, because Spotify was not raising capital. We're not calling Mr Ek out on this. He was just saying something in plain English that's been true for years.... 

That 2015 asterisk goes to some additional comments on getting at the growth:
...For portfolio investors the situation is even worse than for the overall economy.
You miss all the growth of private companies.

On the one hand private companies are often fine businesses which the owners have no desire to share and on the other hand the universe of private companies is where you find the younger, smaller, more dynamic and thus faster growing entities.

These two attributes are what private equity and venture capital, each in its own way, attempt to capture. ...
See also the intro to 2014's:

Barron's Cover: Tech Stocks--The Bubble Is In the Private Market
There are two things that have changed over the last couple decades in valuing soon-to-be-public companies:
1) Long gestations to accrue every bit of hyper-growth from successful business to the private owners.
2) Late round valuation bumpers, a tactic we first saw in Kleiner, Perkins deals, note below....