The Great Divide
tl;dr: Software markets are much larger than expected. Investors bet on optionality for $100B companies. Individual stocks are mispriced, but portfolios can be priced correctly. Value investors are getting priced out of the market.
The valuations of technology stocks are through the roof. They will bring a new way of investing to public markets.
In the last few years, revenue multiples have kept going up. They run from the "standard” 10x revenue of established SaaS businesses like Salesforce to the lofty 50x (or more) of Zoom, Shopify and others. I hear every value investor in the world cringe - even Howard Marks has published a memo somewhat reconsidering his theories. Many claim these valuations are outright nonsense. The question is there: Have people really gone mad?
I believe a fundamental change is happening in the way people evaluate stocks. We are moving from portfolios of rightly priced assets to rightly priced portfolios of wrongly priced assets. Price has always been considered the cornerstone of investing: "buy low, sell high". But today, I believe price is just another risk factor at the portfolio level since you can hedge yourself with other high price / high variance stocks.
Venture Capital thrives on wrongly priced assets
A typical early stage fund buys ~15% of ~15 assets. Each of those assets has an entry price of ~$10M, yet general partners know most of these assets are not worth $10M. After all, nobody would actually acquire the company at that price on the day the fundraising round closes. And so each asset they hold is wrongly priced, and thus each reveals itself to be overpriced or underpriced over the long term. The winners cover the losses and the VCs’ portfolios thrive, with top funds like USV returning 30%+ IRR cash on cash on every fund.
Companies are reaching unprecedented scale
Software markets are much, much larger than anyone expected. Some companies do $40B in revenue per quarter (with impressive gross margins) and maintain double digit growth rates. You can be a growth stock with a $100B valuation today and still potentially provide new investors with ~10x outcomes. Tesla did it in a year (when it would probably have been "reasonable" in five), others will follow.
What does it all mean? In 2021, it’s now possible to apply the venture capital model to high market cap public stocks.
When does the music stop?
As I mentioned above, it seems to most people that the crowd has gone completely mad. Yet if we look at price / growth rate correlation, we see that as soon as growth slows (meaning companies slide away from their potential 10X outcomes), their multiples get smashed. They become unfit in a portfolio of "overpriced" assets and return to normal stock prices. Maybe there is a rationale in investor behavior after all. The mega tech stocks (FB, GOOG, AMZN, MSFT) aren’t valued at those high multiples either, simply because they cannot be included in those 'portfolios of potential 10x outcomes'.
Price is just another risk factor.
Hedge funds (and really every sophisticated investor) have long measured portfolio level attributes like volatility, variance, Sharpe ratios, etc. They use diversification, derivatives and more to hedge themselves and maximize risk-adjusted returns.
But the 'efficient market theory' states that the price of a stock is 'the right price'. I believe that for growth companies, price can be calculated at the portfolio level, too (and it may well be better calculated there).
The best way to hedge yourself against an 'overpriced' asset is to buy other 'overpriced' assets with high variance.
A fantasy portfolio
Shopify, Zoom, Snowflake, Doordash, Airbnb, Stripe, Uber, Square, Twilio, Okta are all considered overpriced, but could a portfolio with these 10 stocks perhaps be rightly priced? I would bet that in the next 10 years, one of these names becomes a $1T company, one becomes a $500B company, 2 become $300B and a few might stall around or below their current valuation.
The great divide
Rightly priced portfolios increase the price of each of the assets in the portfolio. Indeed, you can cover the losses on some stocks because of the large gains on other ones. As a result, you can't buy one of these stocks without owning (all) the other ones, it makes little sense in terms of a portfolio risk profile. Value investors are getting priced out of these growth companies.
Just like assets have different risk profiles depending on your portfolio, price doesn't mean the same thing to everyone anymore.
Have investors noticed?
Venture Capital and Private Equity funds have been increasing in size rapidly these last few years, propelling private companies to $100B valuations. Sequoia, a16z, Silver Lake, and SoftBank are powering the billion-dollar power law outcomes.
Retail investors have intuitively understood too, supercharged by Robinhood and their Tesla shares. Since they were long only until very recently, they had no other choice than to hedge themselves with other stocks. They became venture capitalists.
Time for a change?
The distortion induced by these portfolios of public stocks will impact private markets too. They contribute to ever-rising private valuations and will introduce more opposite incentives between individual stockholders (employees & founders) and portfolio holders.
Maybe it will be time for a new generation of stock exchanges like the LTSE built by Eric Ries, where investors hold their positions over a long period of time. In that case, such a model would be better suited towards companies that are still rapidly growing since prices will reflect long term expectations.
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