Stocks were mixed yesterday ahead of today’s FOMC meeting. Saudi Arabia suggested that it will recover from the weekend missile attack fully by the end of September. As a result, oil prices fell sharply, although they still remain above last week’s levels. While there is near unanimity that Iran supplied the missiles, there isn’t complete consensus as to who fired the rockets. Whatever the ultimate conclusion, there seems to be consensus to try and avoid escalating political tensions further. Markets took that positively.
Today’s FOMC meeting is almost certain to deliver a 25-basis point cut in the Fed Funds rate. What is less certain are the post-meeting comments Fed Chair Jerome Powell will make at his press conference. The doves want him to lean in the direction of multiple further rate cuts possible down the road to insure an upward sloping yield curve. They believe that until core inflation is sustained at well over 2%, the Fed should remain accommodative and pursue a policy of progressively lower rates. The other side doesn’t see the need for any further cuts given very solid economic data, including year-over-year increases in the Consumer Price Index (CPI) of over 2% and wage gains now approaching 4% annualized. They argue persistent rate cuts are tools used to combat economic weakness or recession. They have no place in an economy doing just fine with no clear signs of slowing down. In fact, recent data not only shows a robust consumer, but also indicates that industrial production may be bottoming and set to rebound as excess inventories that existed at the start of the year are worked off.
While I understand the dovish argument, and it fits more neatly into the world picture where rates are negative in so many geographies, one hazard of very cheap money is that it encourages bad investment.
One only need look at the private equity market which has exploded both in size and valuations over the past decade. By most calculations, there are about 150-200 private companies today dubbed “unicorns” meaning they are valued, based on the latest funding round, at $1 billion or more. In fact, conservative estimates, again based on most recent funding rounds, are that these companies have a collective worth today of over $600 billion. Yet collectively these unicorns barely make any money. In fact, based on some recent public offerings, it is quite possible that collectively they might be losing money.
The bull market of 2019 has been accompanied by a very robust IPO market. Most deals have quickly risen above their offering prices subsequent to going public. A few, however, have not including several high-profile names like Uber and Lyft. With numbers now on the table, investors are beginning to scrutinize future expectations more closely. The phrase “path to profitability” is now spoken everywhere. At the moment, momentum is on the side of the bulls. Talking about Uber and Lyft, for instance, you hear investors say they see a path to profitability at Lyft but the path at Uber, due to its worldwide investments in so many new ventures, is less certain. I might argue that (1) the path to profitability at Lyft is based on a lot of optimistic assumptions, especially for a service that is highly commoditized. It is very hard to differentiate a trip on Uber or Lyft or any other ride sharing vehicle. The optimistic path forward assumes less competitive pricing (why, I don’t know) and well controlled costs.
We have all come to love being able to hail a ride from anywhere using our cellphones. Peloton bike owners absolutely love them. Casper mattresses have become very popular. And cheap! And what start-up doesn’t appreciate cheap, cool office space from We Works? But while all these companies have found ways to attract consumers, none has yet to demonstrate they have an economic model that works now or ever. The reason they have all gotten as far as they have is because money is so plentiful and cheap. Investors, who don’t believe they can get historic returns from traditional investments in a world of low interest rates have raced into a world of alternatives, including private equity. The net results have been an explosion of valuations and a virtually unlimited supply of money to chase future deals.
But in the world of private investing, you never know your returns until the end. Managers of private equity funds, real estate funds, and venture capital provide investors periodic valuations (usually quarterly) based on a composite of realized and unrealized transactions. But just how accurate are those valuations? Let’s take the example of We Works or simply We now that the company has changed its name. Based on its last funding round, the company was valued at $47 billion. That doesn’t mean every investor accepted that valuation given the illiquidity of a private investment but most valued it at $20 billion or higher. We has tried to come public, but public investors had no appetite to buy in at that price. In fact, for a lot of reasons including bad corporate governance and an uncertain economic model, it appears the company couldn’t even get a valuation of $15 billion. So, what is We worth today? $15 billion? Probably not since public investors appear to have snubbed buying shares at that price. $10 billion? Based on losses to date and future projections, that might be optimistic as well. The points to be made are:
1. Market euphoria that occurs so often at the end of a bull market cycle may be infecting the private market more than the public market.
2. Too much money chasing too few opportunities leads to negative unforeseen consequences.
3. The negative real cost of money only exacerbates the problem.
4. To the extent pension funds and other tax-free money is chasing private equity to boost returns, they may be very disappointed when all the deals are done and the money received is compared to the money invested. These partnerships have finite lives. Eventually, the books are closed. Only then can one determine the true return on investment. Almost always the peak internal rate of return (IRR) is not the ending IRR.
There have been lots of successful IPOs this year and many private unicorns will end up as big winners. But We doesn’t sit in a vacuum. Others, like Theranos, can go from Fortune cover story to worthless. It is no different than public markets. It’s just that the stakes are higher. And because there is so much money chasing limited good opportunities, both the risks and rewards are elevated. So, while I get the idea that low rates are always the best friend of investors, in the long run they aren’t the best friend if they create massive distortions of allocated capital. We live in an oversupplied world. Certainly, there is a need for creative ideas, but creative businesses ultimately have to earn money. Many unicorns simply won’t. If capital were rationed, the best deals would always attract capital. It’s the tertiary companies that would lose.
In the end, markets shake themselves out. Public investors will now price Lyft and Uber. Other unicorns will come public. Some will be big winners but others will disappear over time. History says that 90% of new public offerings subsequently trade below their offering price. Some will be bought out. Others might simply die. Bubbles need air to expand. In the financial world, money is the air. There are few signs to date that negative interest rates do any good at all. Lower rates could be a short term elixir and help to propel stock prices to record highs. But if easy money is the only propellant for higher prices, watch out. Fortunately, it appears that our economy is doing just fine. Earnings are a better driver of higher equity values than interest rates that promote misguided capital allocation.
Today, Lance Armstrong is 48. Dr. Ben Carson is 68.
James M. Meyer, CFA 610-260-2220