Tag Archives: IPOs

Beware Of Those Selling “Technology”

“3. And they said to one another, ‘Come, let us make bricks, and burn them thoroughly.’ And they had brick for stone, and bitumen for mortar. 4. Then they said, ‘Come, let us build ourselves a city, and a tower with its top in the heavens, and let us make a name for ourselves; otherwise we shall be scattered abroad upon the face of the whole earth.’” Genesis 11:3-4 (NRSV)

Technology

Technology can be thought of as the development of new tools. New tools enhance productivity and profits, and productivity improvements afford a rising standard of living for the people of a nation. Put to proper uses, technological advancement is a good thing; indeed, it is a necessary thing. Like the invention of bricks and mortar as documented in the book of Genesis, the term technology has historically been applied to advancements in tangible instruments and machinery like those used in manufacturing. Additional examples include the printing press, the cotton gin, and the internal combustion engine. These were truly remarkable technological achievements that changed the world.

Although the identity of a technology company began to emerge in the late 1930s as IBM developed tabulation equipment capable of processing large amounts of data, the modern-day distinction did not take shape until 1956 when IBM developed the first example of artificial intelligence and machine learning. At that time, a computer was programmed to play checkers and learn from its experience. About one year later, IBM developed the FORTRAN computer programming language. Until the early 1980s, IBM was the dominant tech company in the world and largely stood as the singular representative of the burgeoning technology investment sector.

The springboard for the modern tech era came in 1980 when the U.S. Congress expanded the definition list of copyright law to include the term “computer program.” With that change, software developers and companies like IBM involved in programming computers (mostly mainframes at that time) had a legal means of preventing unauthorized copying of their software. This development led to the proliferation of software licensing.

As further described by Ben Thompson of stratechery.com –

This highlighted another critical factor that makes tech companies unique: the zero marginal cost nature of software. To be sure, this wasn’t a new concept: Silicon Valley received its name because silicon-based chips have similar characteristics; there are massive up-front costs to develop and build a working chip, but once built additional chips can be manufactured for basically nothing. It was this economic reality that gave rise to venture capital, which is about providing money ahead of a viable product for the chance at effectively infinite returns should the product and associated company be successful.

To summarize: venture capitalists fund tech companies, which are characterized by a zero marginal cost component that allows for uncapped returns on investment.

Everybody is a Tech Company

Today, every company employs some form of software to run their organization, but that does not make every company a tech company. As such, it is important to differentiate real tech companies from those that wish to pose as one. If a publicly traded company can convince the investing public that they are a legitimate tech company with scalability at zero marginal cost, it could be worth a large increase in their price-to-earnings multiple. Investors should be discerning in evaluating this claim. Getting caught with a pretender almost certainly means you will have bought high and will be forced to sell low.

Pretenders in Detail

Ride share company Uber (Tkr: UBER) went public in May 2019 at a market capitalization of over $75 billion. Their formal name is Uber Technologies, but in reality, they are a cab company with a useful app and a business producing negative income.

Arlo Technologies (Tkr: ARLO) develops high-tech home security cameras and uses a cloud-based platform to “provide software solutions.” ARLO IPO’ed at $16 per share in August 2018. After trading as high as $23 per share within a couple of weeks of the initial offering, they currently trade at less than $4. Although the Arlo app is available to anyone, use of it requires an investment in the Arlo security equipment. Unlike a pure tech company, that is not a zero marginal cost platform.

Peloton (Tkr: PTON) makes exercise bikes with an interactive computer screen affording the rider the ability to tap in to live sessions with professional exercise instructors and exercise groups from around the world. Like Arlo, the Peloton app is available to anyone, but the experience requires an investment of over $2,000 for the stationary bike. PTON went public in September 2019 at the IPO price of $29 per share. It currently trades at roughly $23.

Recent Universe

From 2010 to the end of the third quarter of 2019, there have been 1,192 initial public offerings or IPOs. Of those, 19% or 226 have been labeled technology companies. Over the past two years, many of the companies brought to the IPO market have, for reasons discussed above, desperately tried to label themselves as a tech company. Using analysis from Michael Cembalest, Chief Strategist for JP Morgan Asset Management, we considered 32 “tech” stocks that have gone public over the past two years under that guise. We decided to look at how they have performed.

In an effort to capture the reality that most investors are not able to get in on an IPO before they are priced, the assumption for return calculations is that a normal investor may buy on the day after the IPO. We acknowledge that the one-day change radically alters the total return data, but we stand by it as an accurate reflection of reality for most non-institutional investors.

As shown in the table below, 23 of the 32 IPOs we analyzed, or 72%, have produced a negative total return through October 31, 2019. Additionally, those stocks as a group underperformed the S&P 500 from the day after their IPO date through October 31, 2019 by an average of over 35%.

Data Courtesy Bloomberg

Summary

Over the past several years, we have seen an unprecedented move among companies to characterize themselves as technology companies. The reason is that the “tech” label carries with it a hefty premium in valuation on a presumption of a steeper growth trajectory and the zero marginal cost benefit. A standard consumer lending company may employ technology to convince investors they are actually a new-age lender on a sophisticated and proprietary technology platform. If done convincingly, this serves to garner a large price-to-earnings multiple boost thereby significantly (and artificially) increasing the value of the company.

A new automaker that can convince investors they are more of a technology company than other automobile companies’ trades at many multiples above that of the traditional yet profitable car companies. Still, the core of the business is making cars and trying to sell them to a populace that already has three in the driveway.

Using the technology label falsely is a deceptive scheme. Those who fall for the artificial marketing jargon are doomed to sacrifice hard-earned wealth as has been the case with Lyft and Fiverr among many others. For those who are not discerning, the lessons learned will ultimately be harsh as were those described in the story of the tower of Babel.

It is not in the long-term best interest of the economic system or its stewards to chase high-flying pseudo-technology stocks. Frequently they are old school companies using software like every other company. Enron and Theranos offer stark lessons. Those were total loss outcomes, yet the allure of jumping aboard a speculative circus is as irresistible as ever, especially with interest rates at near-record lows. The investing herd continues to follow the celebrity of popular “momentum” investing, thereby they ignore the analytical rigor aimed at discovering what is reasonable and what allows one to, as Warren Buffett says, “avoid big mistakes.”

Throwing Money Into Tech Startups Will End In Tears

The tech startup boom has been one of the most important and visible economic “growth engines” of the past half-decade. The boom was spurred, in large part, by the success and excitement over Facebook, Uber, Airbnb, and similar companies, which led to a widespread search for the “Next Facebook” or billion dollar “unicorn” company. Unfortunately, the tech startup boom has devolved into a dangerous bubble as a result of record low interest rates and the trillions of dollars worth of liquidity that is sloshing around the globe as a result of central bank quantitative easing (QE) programs.

As an Austrian economist, I believe that central bank manipulation of borrowing costs (typically by holding interest rates too low) creates false signals or “fool’s gold” business and economic booms that trick investors into jumping into “hot” trends, only to lose their shirts when borrowing costs are inevitably increased again. These bad investments are called malinvestments, and occur largely as a result of central bank market distortions rather than organic market forces. I believe that a very high proportion of today’s tech startups will prove to be malinvestments when the current boom turns into a bust.

A recent Wall Street Journal article describes the latest phase of the startup bubble quite well –

SoftBank’s Billions Spur Global Race to Pour Money Into Startups

Silicon Valley Venture Capital Chart

The Silicon Valley money machine is once again in high gear, thanks largely to SoftBank. The conglomerate is injecting billions of dollars into tech, in turn causing deep-pocketed global investors—and some U.S. venture firms—to arm up in response. A record level of late-stage money is flooding in, threatening to keep some startups out of the public markets even longer while heightening concerns that the sector is overvalued.

In recent months, hotly contested companies like ride-hailing service Lyft Inc. and dog-walking app Wag Labs Inc. have received hundreds of millions of dollars more than they sought. Bidding wars are re-emerging, and some once-staid foreign investors are expanding U.S. offices and ditching their ties and suits to court talented entrepreneurs.

“The top companies have as much heat around them as ever and continue to get bid up,” said John Locke, who runs late-stage investing for venture-capital firm Accel Partners.

Also:

The big-check bug has spread to U.S. venture-capital firm Sequoia Capital, which is in the process of raising up to $13 billion, including an $8 billion fund for late-stage companies, the largest ever for a U.S. venture-capital firm.

Sequoia was previously content with smaller sums; its largest fund to date is $2 billion. But it made the decision last year to go bigger, seeing an opening to keep investing in companies as they stay private longer and grow larger.

This flood of private investment has heightened concerns it will create a shaky foundation for startups. When money rushes into Silicon Valley, startups historically have overspent by advancing into expensive new markets or battling with competitors in price wars.

“We’re encouraging the excessive use of capital,” Bill Gurley, a partner at Benchmark, said of venture capitalists at a February tech conference. “We’re all doing it because it’s the game on the field.”

Softbank, a Japanese conglomerate, announced in October that it was planning to invest as much as $880 billion into tech startups. At the time of that announcement, I recoiled in horror at the idea of companies “throwing” money into tech startups just because it was a hot, heavily hyped sector:

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Sound, long-term business decisions are not made by picking an arbitrary dollar or yen figure and throwing it into a hot sector. This behavior is the hallmark of a liquidity bubble in which there is too much cash clamoring into unprofitable investments. Throwing ever-increasing amounts of cash at unprofitable startups won’t make them profitable – it’s just “throwing good money after bad.” While this is common sense, many business leaders aren’t seeing the obvious because they’re completely drunk on the startup bubble euphoria. I have no doubt that Japan’s Abenomics stimulus plan (in which over $4 trillion worth of new Japanese yen was printed) has played an important role in encouraging Softbank to jump headlong into the tech startup bubble with gobs of cash.

Thanks to the tech sector hype and high tech stock valuations, VCs are looking to cash in on their tech startup investments by going public, just like during the late-1990s Dot-com bubble –

Silicon Valley Venture Capitalists Prepare for an I.P.O. Wave

 Investors, bankers and analysts said they expected a wave of initial public offerings to bring some of the most highly valued and recognizable start-ups to the public market over the next 18 to 24 months — and billions of dollars in returns to their executives and investors. The potential bonanza would follow years of waiting as a few dozen companies amassed valuations without precedent in the private market.

Already, 2018 has gotten off to a fast start. Two of the biggest start-ups still sitting on the sidelines — Dropbox, an online file storage company, and Spotify, the streaming music service based in Sweden — successfully went public over the past month. Tech I.P.O.s have already raised more than $7 billion this year — more than all of 2015 and 2016, and more than half the $13 billion they raised last year, according to the market-data firm Dealogic.

While the mainstream financial world sees the current tech startup boom as a legitimate technology revolution, I see it as a gigantic, liquidity-fueled malinvestment bubble. As the Fed and other central banks remove liquidity as the economic cycle matures, the stock market bubble will burst, which will spill over into tech startups. When the tech startup bubble pops in earnest, I expect thousands, if not tens of thousands, of startups to fold. While the world should have learned from the Dot-com bubble, today’s tech startup bubble proves that we didn’t, so we are doomed to repeat the lesson.

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