The 60's Conglomerate Boom and Today's Growth Companies

The Conglomerate Boom of the 60's, like all bubbles, sounds ridiculous in hindsight. From 1965 through 1969, the market was obsessed with rising earnings and investors didn't seem to care if the earnings came from new business or from buying other business. As long as earnings growth was up the company would keep its high valuation multiple.

The basic formula was that a fast growing company valued favorably by the market would use their stock to purchase low growth companies - and the earnings of the combined company would have the same multiple as the fast growing company. 

Investors didn't seem to realize that the low growth company's earnings wouldn't magically start growing just because it was bought by a company with a high multiple. The total valuation of the combined company would be higher than the prior valuation of the separate companies. The market's irrational behavior created incentives for unnecessary mergers. This lasted as long as the credit financing mergers was cheap (Conglomerates didn't have to properly account for convertible debt until 1969) and the market was willing to give high valuations to companies that produced earnings growth through the acquisition of other companies.

We might be seeing the start of similar incentives in today's private early growth stage companies. Most of the new start up companies are seen as competitors with the potential to disrupt whole industries. They are judged more on revenue than on earnings since the logic is that revenue will be more easily turned into earnings after the competition is decimated. Winning is what matters.

Whenever there are successful companies attracting capital and getting high valuations, there are less successful companies who will only succeed in mimicking the visible traits of successful companies. This creates some perverse incentives. The valuation given to successful growth companies is anywhere from five to ten times revenue - or higher. Meanwhile, the average company in the S&P 500 is trading at 1.7 times sales and the smaller companies in the Russell 2000 are trading around 1.2 times sales. Right now, it should be very tempting for a variety of early growth companies with high valuation multiples to go out and use their stock to buy companies with old economy valuations, point to total revenue growth, and hope that investors don't significantly change their valuation multiples.

Lending Club's $140 million cash and stock acquisition of Springstone Financial LLC looks like a good example of the conglomerate boom dynamic resurfacing in the current market. Lending Club is currently valued at 40 times its 2013 revenue, which appears to be significantly more than Spingstone Financial was valued. If the market mistakes the additional revenue from Springstone as indistinguishable from growth in Lending Club's core business then the acquisition will push up the market value of Lending Club's future IPO. This could happen regardless of whether or not the move into financing private education and elective medical procedures works out for the company in the long run.

For those looking to make long term investments in growth stage companies, it's important to make sure that the revenue these companies are valued against is the type of revenue that can scale and not revenue gained from the acquisition of businesses. Nostalgia for the 60's should have its limits.

Assorted Current Events

1. The DOJ is finally putting pressure on the Chinese government hackers that have been attacking multinational corporations for the past decade.  

It seems like the main difference between the Chinese and the Russian hackers is that Russian hackers are more often working purely for ways to immediately enrich themselves via theft/fraud, while the Chinese hackers have also mounted operations to support their state-owned enterprises. 

I wonder if the calculation of real return on equity for state-owned companies in China included these services as part of their hidden subsidies. 

2. The seemingly increasing closed mindedness of the political youth is an interesting phenomena. Between these graduation speaker protests and requests for trigger warnings on class material, it's hard to tell if the college students have gotten crazier or if the rest of society has gotten used to taking crazy people more seriously. 

3. Twitch TV, online game streaming platform, is rumored to be in talks to sell themselves to Youtube. This would make sense for Twitch for numerous reasons. Most obviously, tech valuations are relatively high but have been unstable recently so it makes sense to look to sell while values are still high. (Whether or not one billion dollars is a high price for Twitch is unclear, in 1999 was able to sell themselves to Yahoo for $5.7 billion)

Beyond the volatility around technology valuations, a further risk to Twitch is that a very significant portion of their viewers come from a single game - League of Legends (LoL). Many of the popular LoL streamers are paid directly by Riot, the owner of LoL. If Riot decided to make their gamers stream on a platform of their own creation then Twitch could lose a lot of eyeballs/advertising revenue. 

If Riot does this successfully, it shows that those who own the games can choose to monetize their streamers directly unless Twitch works to keep them on board. This could lead to a situation where the economics of Twitch resemble music streaming services more than Youtube channels. If viewers left to watch their games on other services, this would also show that Twitch viewers aren't necessarily as sticky as Twitch would like buyers to think*. 

*Whether or not users will stick around in the long run seems to be one of the big questions when it comes to the valuation of many current tech companies. 

Pay more attention to the newer guys at the Ira Sohn Conference

The Ira Sohn Conference is going on today. This is a charity event where top fund managers pitch trade ideas to attendees who spend (donate) thousands of dollars for the right to attend. Looking at the performance of last year's picks gives some clues to the incentives the presenters have. 

The big names, people like Bill Ackman, David Einhorn, Jeffrey Gundlach, Kyle Bass* and Jim Chaos, can push their largest positions or trades that have been doing well recently. They can impress investors just by the media and market reaction to their views. The common stock of Fannie Mae and Freddie Mac, two companies whose stock might go to zero without extensive lobbying efforts, shot up today after Bill Ackman talked about them. And given that these managers are already well known, the marginal value of additional positive press is relatively small.

It's the smaller investors who need to make their name. The exposure from the conference gives many of these managers more media exposure than most of them have had in the past. A big win that was widely publicized ahead of time can help their funds gain a lot of exposure and make it much easier to raise assets. We know that the best ideas of fund managers are often be good ideas - so when lesser known managers are pitching their best ideas it makes sense to take a closer look.

*Apparently his fund makes money for investors, but every time his views are expressed in the news (Japan hasn't gone bankrupt yet!) it seems like following those views would lose a lot of money so I'm genuinely curious as to how that happens.

A little bit of help

My friend Ben (via his awesome tumblr) pointed me towards an article in National Geographic that highlights an empirical study on the impact of privilege and luck.

In order to study this topic, they looked at four different ways of giving out small levels of success - small amounts of funding on Kickstarter, positive ratings on Epinions, signatures on petitions, and awards to Wikipedia editors.

(van de Rijt et al, 2014.)

Those who were randomly given a random initial boost went on to do significantly better than those in the control group. Whether this is because the success attracted notice by others or more because the success made those granted positive feedback try harder isn't clear (except in the case of ratings, where additional effort would be less likely to impact a comment that is already made).  

But whichever effect dominates, the implication for what to do when you have friends embarking on projects is clear. Helping them a little bit can have a large impact on their eventual success. 

The study also found that large amounts of help were only marginally better than small amounts of help. This implies that helping four friends a little bit is probably going to have a higher return than spending four times as much effort helping just one person.  

This also explains why networking properly - helping lots of people you meet in little ways - can have a large impact in the long run.

Assorted Links: Politics, Google, politics and antiobiotics

1. South Korean politics are strange. I could pretend that my model of scapegoats could somehow have predicted this, but the fact that a prime minister would have to resign after a (very tragic) regional accident really surprised me.

2. An interesting article on Larry Page and Google.  Investors should take note of the following:

"Page recognized that Google’s search-advertising business, with its insane profit margins and sustained growth, was exactly the kind of cash-generating machine that his hero, Nikola Tesla, would have used to fund his wildest dreams. "

A portfolio allocation towards Google seems less about betting on them creating shareholder value in the short or medium term, and more about making sure that if this company takes over large sections of the economy then at least they are hedged. A third scenario is that Google is more like the Xerox of our day. They might be the first to invent and implement a product that becomes as common as a computer mouse (Wow, this example might be a bit dated), but they might not be the company that fully benefits from their advancements. This is a risk as long as the cost of computing keeps falling, since what only a big company can do today might be cheap enough for college students to do from their dorm rooms five years from now.

3. The US Treasury is cracking down on financial insiders trading on material nonpublic government information.  Perhaps "cracking down" is the wrong set of words, "facilitating" seems to be a better word choice.  They are warning privileged investors about additional Russian sanctions before the rest of the market finds out.

Unfortunately this is nothing new - many financial players will attend events like the World Economic Forum because policy makers will often tell market participants what they are thinking before it is more widely known - Trichet in particular told attendees at a meeting a few years before the financial crisis that the ECB's monetary policy was going to be tighter than expected because of petrodollar flows. 

And it should be mentioned that the ones who go there to learn about policy ahead of time are the less harmful ones - those who use access to help shape policy in their interest, leading to regulatory capture, are the ones that do the most damage.

4. New Delhi metallo is an enzyme that can be produced by some bacteria that turns them into antibiotic superbugs. There were 6 cases in the UK in 2008 and 143 in 2013. Scientists are only sure about one treatment working, and expect that treatment to eventually stop working. 

Antibiotic resistance is one of the more interesting (and troubling) collective action problems of our day. Our medical system currently doesn't incentivize research into novel antibiotics enough since novel antibiotics are saved as a last line of defense against resistant bacteria. Part of the solution to this problem involves X-prize type bounties that incentivize researchers and companies to discover novel forms of antibiotics the can be used against bacteria with these new defenses. This is much more important than developing a tricorder, but perhaps it is too backwards looking for those who might otherwise want to be affiliated with the project.

Why haven't prosecutors gone after Silicon Valley yet?

One of the patterns of modern day politics is that prosecutors can move on to higher political offices by taking down a big name or two. Rudy Giuliani famously took down Michael Milken by threatening him and his company with the RICO act, a law that was designed to only apply to Mafia style organized crime organizations. That victory gave him the name recognition that helped him become the mayor of NYC.

Eliot Spitzer publicly went after many people on Wall Street, which raised his profile enough to become governor or New York State. He was eventually caught with a prostitute, but his story still adds another data point to the idea that all a prosecutor needs to do to achieve higher office is win high profile cases against big names. 

It doesn't matter to the prosecutor's career if the company or person getting prosecuted is acting significantly worse than their peers. All that matters is that the prosector gets positive press for fighting a big name (That they help the press demonize) and that the prosecutor finds some way to win. 

Today, inequality is a growing political issue. Many people see technology, and Silicon Valley as its proxy, as one of the driving factors of inequality. That leads to the obvious question: Why haven't prosecutors gone after any big Silicon Valley targets? 

It isn't because they don't have anyone to go after. Carl Icahn's attack against Marc Andreessen gives an overview of plenty of grey areas where it looks like a prosecutor could make his career.  The quote, "No conflict, no interest" is frequently attributed to John Doerr.  He sits on numerous public company boards while making VC investments in companies while benefiting from internal information gained at these board meetings. While there are many ways to break federal law, breaches of fiduciary duties are generally regarded as civil actions. So regardless of whether or not a determined investigation would find wrongdoing, this might not be as fertile an area for prosecutors as the headlines make it appear.

There are still other places prosecutors can look. Despite what many people seem to think, insider trading in private companies is illegal. And there are likely to be a few big names out there involved with situations where employees, the most sympathetic of the investors allowed to own shares in private companies, are found to have been ripped off by insiders who traded with them while misrepresenting relevant information about the company.

Michael Milken was largely thought to be a target of Giuliani because of how unpopular he was among certain groups of people. His work in high yield bonds took business from banks (if it weren't for the "junk bond" market, companies would have to get much higher cost loans from banks) and facilitated leveraged buy outs which were unpopular with both existing management and with workers at the companies that might get laid off after a takeover.  Eliot Spitzer only became the Sheriff of Wall Street after the stock market crash.

This presents two ways that Silicon Valley can be dragged into the bullseye of prosectors.

1. A financial crash centered around tech stocks. If investors start losing lots of money in tech stocks, a scapegoat will be required. This is the Spitzer scenario. In this case those behind the most inflated valuations will be most at risk.

2. The continued success of Silicon Valley as entrepreneurs focus on more traditional industries. If software continues to eat the world, those incumbents who find themselves being pushed to the sidelines will fight back. They might do more than fight to protect their rents, they might use their political connections to get prosecutors to punish those who they see as responsible for their business's growing irrelevance.

Either way, those in Silicon Valley should remember to be careful in their electronic communication. I'm sure that many of them are ahead of the curve when it comes to this issue, maybe that is why all of those secret sharing applications are getting funding.

Simple Truths about High Frequency Trading

The interest in High Frequency Trading, of HFT for short, comes from how it combines finance, technology and secrecy. The press around the subject has increased dramatically as Michael Lewis has been promoting his new book on the topic, Flash Boys.  A chapter appeared in the NYTimes that is well worth the read. Discussions around the issue made CNBC's daytime market coverage look very similar to Fox News (because of the yelling and screaming, not because of any right wing agenda).  In the midst of this uproar, the high frequency trading firm Virtu has delayed their IPO.

Michael Lewis is a good author, but he likes to tell narrative stories with good guys and bad guys. And as Tyler Cowen once said, "As a simple rule of thumb, just imagine every time you’re telling a good vs. evil story, you’re basically lowering your IQ by ten points or more."  So without getting into some of the more esoteric details, what's really going on?

1. The market has always needed intermediaries, the people who help connect buyers and sellers when they don't want to buy and sell at exactly the same time. These intermediaries need to make money. Without some money being paid to liquidity providers there will be no liquidity.

2. As floor traders have been replaced by computers running algorithms, spreads have narrowed. Investors spend significantly less money getting into and out of positions compared to 10 or 15 years ago.

3. HFT firms attempt to front run large traders. Any market intermediary needs to try to get out of the way of big buyers after the shares they have offered to buy or sell have been taken because if they didn't they would go out of business very quickly. But HFT set ups allow them to pretend there is are more shares available to be bought or sold in the market than there actually is which can be quite frustrating for those trying to execute large trades.

4. Googling "backing away" shows that intermediaries have been causing issues well before they consisted of the population labelled as "high frequency traders".

5. The ones losing the most money from high frequency traders are those attempting to trade large amounts of stock on the market. These are institutions such as mutual funds, pension funds and hedge funds.

6. While the situation remains annoying to institutions, HFT volumes and profits have actually been falling over the past few years. 

Wall Street rips people off all the time, but there seems to be more of an outrage when the people making money are outsiders and the people losing money are closer to being insiders. 

HFT firms have been the best customers of many of the exchanges - they pay high fees to get their servers situated next to the exchange and provide large amounts of volume to the exchange. In an effort to increase their profits from HFT traders many of the exchanges have implemented some trading rules that benefit HFTs at the expense of other traders on the exchange. Michael Lewis's story explains how some large institutional traders have figured out how they are being taken advantage of and are turning to people such as the IEX Group (The "good guys" in his book) in order to trade without having to worry about people gaming the system. 

Exchanges are going to have to reevaluate their own systems and make them more favorable to institutions that engage in relatively simplistic trading if they want to be profitable in the long run. (Part of this also involves setting up incentives for market makers which reduce the probability of future flash crashes, but that's a much more complicated subject).

If you are a retail investor, the hubbub over HFT shouldn't matter that much to you. You are getting better execution than you ever did under a system managed by human market makers. HFT traders are small parasites that have outcompeted bigger parasites. Overall they've been a net benefit to the ecosystem.  

And it is worth keeping in mind that the impact of HFT firms is small compared to other financial players. The only surprising thing about revelations that many large banks have been manipulating numbers they trade in both the interest rate and foreign exchange markets is that they finally got caught. And the additional 0.1% market impact that HFT firms might cause on large trades is very small when compared to the 5.1% average commission that Real Estate brokers take in on every transaction they make.  The HFT story is smaller than it looks. 

Thoughts on Current Events

Facebook continues shopping with its overvalued stock: 

Facebook most recently bought Oculus Rift. The key here is that the purchase of both WhatsApp and Oculus Rift only make sense if Facebook plans on eventually ignoring the wishes of the founders. WhatsApp founders don't want ads and Oculus Rift founders don't want Facebook integration. It doesn't have to happen now, but if Facebook doesn't decide to spin out those companies then in three to five years there is no way that Facebook integration and ads aren't on both of those products.  Facebook is an important stock to watch, as any long term underperformance would be a strong signal that investors are falling out of love with tech.

Corrupt US Politicians:

 Leland Yee, the Californian State Senator who was in the running to be California's next Secretary of State, is really corrupt. The surprising part about the corruption is the small scale nature of it. Campaign debt of less than $75,000 was apparently enough to get him to participate in a gun running scheme. This might have been the tip of the iceberg and he could have been making a lot more money, but if corruption occurs for such low amounts of money then this is one of the best arguments for libertarianism I've seen in a long time. Corrupt politicians do less damage when they have less power.

Putin and Crimea:

The interesting thing about Russia's takeover of Crimea is that given Crimea's history and large russian population, Russia could have taken it back without force if they wanted to. One way to interpret this situation is that when their puppet, Viktor Yanukovych, got overthrown Putin wanted to make a statement. Others say that Putin is creating an "us versus them" situation to distract from the corruption that is being revealed about the set up for the Sochi Olympics. However, given that both Russia and the rest of the world would face short term pain if the situation escalated further it is unlikely to do so in the near term.

Too Good to Question

The Federal Reserver Bank of New York posted about their study that confirms many people's biases about moral hazard and large financial institutions. The question is "Do “Too-Big-to-Fail” Banks Take On More Risk?" and the answer is yes.  The basic idea is that higher government support leads to riskier loan portfolios, which indicates to many people that Too Big To Fail (TBTF) banks were abusing their positions by loading up on risk.

I'm sure TBTF banks have taken on more risk - I believe moral hazard exists in the financial system. But I am not sure this study should give anyone more confidence on this issue.

After controlling for many variables, the study found that on average eight months after an increase in the perceived government support as measured by Fitch's "Support Rating Floor" the bank would have more impaired loans around eight months later (and vice versa). 

This is using data from March 2007 through August 2013, so the time period covered both the financial crisis and the european sovereign debt crisis. Given that, which explanation is more likely?

1. The average bank goes out and makes riskier loans after getting government support.

2. A negative economic shock created a scenario where government indicated support rating floors are needed. Banks who more obviously needed help got it first. Because problems in banks balance sheets show up slowly, it took a while for the banks that got support to admit that more of their loans were impaired. Support goes away when it isn't needed and slowly the loans are found to be performing better.

3. Only after a bank is assured that it is getting more government support (this happens only after the support has been promised for some time) do the banks feel comfortable marking down part of their loan portfolio. 

4. Banks that take over ailing financial institutions become TBTF and get boosts in support levels. After taking over troubled institutions, they find that many of those loans end up impaired.

The analysis controlled for quarter year fixed effects among other things, so the simplistic "Oh they were just pricing in the timeline of the crisis" argument doesn't quite work.  But even so points 2, 3 and 4 seem far more likely than the first scenario. In their paper the NY Fed researchers claim that because tier 1 capital ratios didn't decrease then their interpretation of moral hazard is more likely to be correct, but this doesn't account for the capital raising that occurred during the crisis.

Thinking of it from another perspective, it's likely that the age of the impaired assets are greater than eight months - the banks didn't rush out to make or buy bad loans just because they got some more perceived support. The relationship between changes in the support floor an subsequent changes in the bank's portfolio are both related to the bank being in trouble and this isn't adequately captured by the other variables. It is far from certain that the story played out as neatly as people would like it to play out.

There is moral hazard and many banks have abused their positions a TBTF, but studies that confirm everyone's biases should be examined even more closely than usual. 

10,000 Hours of Non-Deliberate Practice

Deliberate practice is a very important.  When learning a skill, breaking down ideas into small pieces and mastering those segments can lead to competency and expertise if the process is repeated properly over a long enough period of time. 

Many people will put in the hours but will not actively engage in practice. This phenomena is everywhere, but it is most easily found in video games.  One account of players actively not learning can be found in a blog about StarCraft 2 on TeamLiquid.  In this account, the author (a player who was ranked among the top 85% percentile of all players) plays a strategy that has a counter so simple an absolutely new player could easily be coached to beat it via simple instructions. Most people he starts out playing it against do beat him, so he soon ends up playing in a league with the bottom 35% of players. Soon he starts winning about 50% of his matches with a strategy that is very simple to beat.

The mindset of the players who have been playing for a long time and are still really bad at an activity is interesting. Some of them have played for many years, and perhaps if you include their original StarCraft experience they might soon be candidates for the 10,000 hours needed to develop true expertise. And yet this is a group of people who have put in tons of time but have remained generally incompetent. It doesn't make them stupid, but they are definitely suffering from some forms of cognitive bias. Besides the relative immaturity of the players involved (both the author and his opponents), a few things stand out:

1. The losing player blames the game, claiming imbalance where none exists.
2. They declare that the player was not playing fairly. In Starcraft, "cheese" is what other games call cheap.  In both cases, the player tries to add extra rules to the game that their opponent isn't necessarily going to follow. This is a little reminiscent of investors creating structured products and claiming that they never expected housing markets to be correlated on a national level during the 2008 financial crisis.
3. They don't look up how to beat the specific strategy and apply the technique. Even more surprising is that some of the players who lost to the author had actually read his blog in which he describes quite clearly how to defeat the strategy.
4. Perhaps the most important factor is that most of the players who have been stuck at their level for a long don't conceive their actions in clear and defined plans. They act on feelings and find it hard to explain why they did what they did when thinking about the game they just played.

The importance of a plan is learned in many ways, but I was first exposed to it through chess.  Middle game rule #1 of the Thirty Rules of Chess* is probably the most broadly applicable rules of the thirty rules.

M1. Have all your moves fit into definite plans.

Rules of Planning:
a) A plan must be suggested by some feature in the position.
b) A plan must be based on sound strategic principles.
c) A plan must be flexible,
d) Concrete and,
e) Short.

Evaluating a Position:
a) Material
b) Pawn structure
c) Piece mobility
d) King safety
e) Enemy threats

Without a clear reason behind actions, in a chess game, a video game or in any activity requiring strategy, there is little room for significant improvement. Playing without a plan or a way to determine whether you are doing well or not is just as bad. 

So if you want to avoid 10,000 hours of non-deliberate practice, making sure that actions are formulated around plans with ways to determine whether or not the plan worked is a necessary start. 

*Reuben Fine's 30 rules of chess aren't really rules - they are more like suggestions that should be followed about 80% of the time by the average club level player.