Monday, June 6, 2016

Investing in Death

Companies die all the time. Until recently, it’s been a quiet process. One recent example is the grocery chain A&P, originally known as the Great Atlantic and Pacific Tea Company.  Growing up in the 1960s in NJ, my family frequented A&P as our everyday grocery store. Back in the day, A&P was “Walmart before Walmart.” In 1930, it had 16,000 stores around the country and, at $2.9 billion in revenue, was the largest grocery retailer in the country. Decades later, high costs, sub-scale stores and lagging innovation led the company down a long, slow path of decline. When it filed for bankruptcy protection in 2015 and closed the last of its supermarkets, no one heard a pin drop.

The quite deaths of companies like A&P have so long gone unnoticed that investment advisors effectively urge you to ignore the phenomenon of death itself. The conventional narrative goes like this. In the “circle of life,” the inevitable process of “creative destruction” clearly favors investing in “disruptive innovators” as they take their rightful place at the top of the league tables. The best way for an investor to manage the gloomy reality of corporate demographics is to focus on growth and dividends via long positions, ignore (for the purposes of investing at least) the inevitability of death (or senescence) and cross your fingers that some portion of the long portfolio will hit it big. Like the quarterback in a street football game who has never heard of the West Coast offense, the favored route is always the deep pass: “you go long.”

“Going long” is the default strategy of any investor looking for returns above the T-bill rate. Even if some of those long positions don’t pan out, the thinking goes, the winning positions, especially returns from the big winners, should outweigh the losers in the long run. Jeff Bezos makes the standard argument for long investing this way: “Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a ten percent chance of a 100 times payoff, you should take that bet every time.” Sitting in Bezos’ shoes, that’s an easy thing to say. After all, he counts himself among one of a handful of entrepreneurs who lived that dream, faring much better than even that 100 times payoff.

Still, making bets on just that 10% leaves a lot of money on the table, not to mention the higher risk of premature death in the high flying segment.  And further, what about the other 90%? While some might generate a modest return, many of those long positions will generate flat or negative returns for a long time. More to the point, for both investment types, why should investors accept long positions as the only option? Why not make returns on the downside as well?

Why not invest in death?

How would you do it? First, you need to abandon the almost universal default in portfolio management to long positions (whether via individually held securities or managed and index funds) and recognize the massive and largely untapped opportunity to build portfolios that include short positions in parallel. Investors routinely seek portfolio diversification, so why not seek to diversify one of the most basic forms of risk, the long form?

Such portfolio strategies would make sense even if short opportunities were a niche asset class, but what if they’re not? For a long time, there’s been an implicit assumption that the “circle of life” for companies is some kind of biological constant. But what if death investing opportunity is growing? As it turns out, the ratio of company deaths to births has been rising rapidly as a number of imbalances in the global economy are creating a fundamental shift in the circle of life for companies.

These shifts include:

General investment forces
  • Low interest rates globally. Zero and negative interest rate policies are forcing investors out of fixed income investments with long equity investment as the dominant alternative, forcing individual company valuations ever higher in aggregate.
  • Peak equity market values. With equity markets rising to historic peaks, peaks reached in only a handful or previous bubbles, there is little room for widespread new sources of alpha within those positions. Even the most promising investment candidates are fully priced.

Technology investment forces
  • Renewed boom in venture capital. As part of the general move to equity, the search for that “100 times payoff” has sparked a new boom in the venture capital cycle, with equity oriented investors looking to push money into technology investments that historically have offered the best odds of that kind of return.
  • Rushing start-ups to market. With money flooding into startups, strange things are happening to their governance.  Technology companies--which need to strike a delicate balance between the need to grow quickly and the need to avoid chaos--are facing increasing pressure do stupid things. This race for return has an inevitable consequence in the venture board room: more demands for pre-emptive strategic behavior, a well-known recipe for disaster in emerging companies.
  • More binary outcomes, especially on the downside. Part of the argument for pre-emptive strategies comes from a reasonable place. Many technology industries increasingly face a winner take all dynamic. For the winners in such races, the binary nature of the competition raises the reward. At the same time, there is another side to the “winner takes all” coin:  “loser loses all.” As competition becomes more binary, the likelihood of death rises along with it.
  • Less organic growth. The dynamics in emerging technology companies spill over into larger players. Large companies, which manage high-speed dynamics poorly, are simply choosing not to compete in the traditional way and aren’t investing less in the R&D required for organic growth. Instead, in a search for sure things, they acquire fledgling businesses, effectively buying the most promising R&D projects. For venture investors, strategic acquisition by large players in lieu of organic growth investments offers an exit path for capital that simply transfers the death risk inside the larger organization.
  • The rise of the unicorn. As venture capital has flooded into the market and startups have been pushed too quickly to scale, the world of startup valuations has seen its own microbubble: the unicorn. By definition, a unicorn is a pre-IPO venture-backed company with a theoretical value that exceeds a billion dollars. In an older world, one in which the discipline of public markets was part of the rite of passage for successful startups, such lofty valuations were vanishingly rare. Yet in just the last two years, over a hundred unicorns have been spawned.

Financing industry forces
  • Jumping ahead of the queue. Instead of watching all the fun from the end of the funnel, powerful equity investors, long restricted to public market investments, have been finding ways to move upstream in the investment process. In the last couple of years, we have seen a sharp rise of late stage venture rounds, with mutual fund titans like Fidelity and Wellington jumping the queue ahead of the IPO stage and becoming new entrants into the venture investing game. 
  • Limited short-side opportunities. Despite the obvious presence of technology overvaluation, most investors continue fill their portfolios with long positions, in large part because they have few practical alternatives. It’s one thing to be right when “everyone knows it’s a bubble,” it’s quite another thing to miss the party and far easier to go along for the ride as long as you have confidence, however, misplaced, to call the peak. This is especially tempting when the alternative is so hard to execute. Short investing involves substantial trading complexity, a willingness to say negative things about public companies and has produced relatively few viable managers. So even those who want to invest in death have relatively few good options.

If the quiet death of A&P exemplifies the old pattern, consider a more recent example of a company we believe is dying: GoPro, the wearable camera company. Founded in 2002, GoPro went public in 2014 at a valuation of $3 billion, quickly saw its stock price triple. But as sales growth slowed, profit margins have tanked and the stock has collapsed, now trading at over 85% off its peak value in a strong market. GoPro represent the leading edge of the unicorn phenomenon; post-IPO, it has also been one of the first to falter.

But even as individual companies lose their luster, the broader bubble remains in place. The powerful appeal underlying the unicorn hype is well stated, again by Jeff Bezos: “In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it's important to be bold. Big winners pay for so many experiments.”

Perhaps. But if even a normal market produces far more big losers than winners, why not place short bets alongside the long ones? And if market forces are creating an abundance of microbubbles that are increasingly ready to burst, why not find a way to invest in their negative inevitability? Take the short side as much as, if not more than, the long side. Get away from the bubble economy and the unicorns.

Invest in death.


Post a Comment

Note: Only a member of this blog may post a comment.