HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

June 11, 2023

Price & Value – Bubbles & Butts

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Investing involves making an outlay today, hoping for a favourable future return. But the future is shrouded in uncertainty, and the outcome is path dependent and unknowable. Successful investors aren’t better at predicting the future but at assessing its risks.

Avoid Strikes

Superior returns derive from the probabilistic estimation of future outcomes in the context of prevailing opinion. Contrary to the mainstream narrative focusing on the big winners, success for most of us is more about avoiding strikeouts than hitting home runs. It is generally better to avoid outcomes in the left tail than try and always end up in the right tail.

Emotional Outcomes

The determination of asset prices results from human action and, thus, from our emotions and behavioural biases. Understanding where we are in the hope and fear cycle for any asset class or investment type is critical to the potential return we might expect. An effective rule of thumb is that the future is rarely as bad as we often fear, nor usually as good as we sometimes might hope. Superior returns derive from buying from fearful sellers and selling to greedy buyers.

Subjective Value

When Buffet says that price is what we pay and value is what we get, it is a pithy synopsis of Carl Menger’s subjective theory of value. The value of anything is what we think it is and is revealed by what we are prepared to give up for it. The market price is a construction derived via a process with multiple independent parties. Price and value are fundamentally different, but successful investing requires an intimate understanding of their relationship.

Liquidity & Efficiency

The effectiveness of a market process (its structure) determines the speed and accuracy with which a price reflects the collective opinion of its participants. When markets are deep and liquid, they tend to be efficient voting machines. However, prices that are only periodically “tested for value” in illiquid inefficient markets can remain mispriced in either direction for extended periods.

Private Markets

We typically view the investment universe as partitioned into private and public markets. In private markets, sophisticated investors interact, cutting ad-hoc bilateral deals, the terms of which are often more important than the price. Such private markets are the preserve of accredited investors, participants whose income, net worth, or experience exceed defined thresholds. Private market regulatory oversight is light, and the opportunity for outsized returns is significant, but transactions are sporadic and tethered to counterparty and liquidity risk.

Public Markets

In contrast, public markets involve trading standardised contracts (regulated securities) between willing investors, sophisticated or otherwise. The regulatory regime to ensure investor protection builds confidence. As a result, public markets offer superior execution and liquidity and virtually no counterparty risk. While private investors may envy the liquidity of public markets, moving from the former to the latter comes at a significant cost.

AI Picks & Shovels

Nvidia was a public company for nearly a quarter of a century before recently becoming an overnight success. Its $1tn value makes it the world’s fifth most valuable company. It bestows upon its chief architect and CEO, Jen-Hsun Huang, celebrity status and a very low cost of capital through a market process reflecting the collective view of many investors. This view is that generative AI, as popularised by Chat-GPT, will be a transformational technology along the lines of the PC, the internet and the smartphone. Specifically, investors see Nvidia’s GPUs as the picks and shovels required to enable the AI revolution.

Internet Picks & Shovels

For a period at the turn of the millennium, Cisco became the world’s most valuable company, and the market values of fibre optic cable providers Global Crossing and Alcatel also increased rapidly. Investors had yet to determine if Pets.com or Amazon.com would survive but collectively agreed that the internet’s success meant much more network infrastructure for carrying all the data. Whoever won the race would need Cisco routers and thousands of miles of fibre optic cable. Cisco was a no-brainer investment.

We Are All Going to Die

It is impossible to know if public market emotion will carry Nvidia to a $2tn valuation in this current cycle. Most media commentators, policymakers and technologists warn that AI will destroy humanity and requires regulation, including some suggestions that governments should be prepared to bomb data centres to protect their citizens from our impending dystopian future.

But We Will All Be Rich

But when markets want a bubble, they don’t hold back, and year to date, they remain optimistic that we are on the cusp of a radical technological leap forward every bit as transformative as the internet and maybe the most consequential since we learnt to make fire.

Or Will We?

Last week’s post from Marc Andreessen typifies the techno-utopian view. And just as Andreessen’s 2011 post, Why Software is Eating the World, explained why (Cisco) hardware was much less necessary than we thought a decade earlier, it also illustrates why Nvidia is unlikely to be the preeminent AI success story of the 2030s.

Bubbles to Butts

If Nvidia represents an emergent bubble, then small and micro-cap UK equities represent the dregs the market has left behind in capital’s hasty exit from post-Brexit Britain. Warren Buffet described his investing experience in 1950s America, buying the ugly and leftover relics from the WW2-era economy as cigar butt investing. Buffet said in his 2014 shareholder letter that my cigar-butt strategy worked very well while managing small sums. Indeed, the dozens of free puffs I obtained in the 1950s made the decade the best of my life for relative and absolute performance. 

Hidden Gems

Today there are hidden gems among the cigar butts of the UK small-cap space valued on multiples of revenue and earnings a tenth of those of Nvidia. Although none of these companies may become globally significant, they can all attract higher valuations over the next three to five years as investors reassess the prospects for the UK market. Cigar butt companies are assumed to be ugly or even broken, and while value traps exist, many are good businesses that investors have ignored for systemic rather than idiosyncratic reasons.

When is Warren Coming?

At the turn of the year, there were two stand-out under-valued developed equity markets: Japan and the UK. Japanese equities have risen 30% in the last six months without any apparent fundamental revaluation catalysts. (Warren Buffet’s purchase of Japanese international trading house shares being the most proximate). Meanwhile, the UK market has fallen further amid fears of embedded inflation, higher interest rates, and the inevitable declinism of London as a financial centre and equity listing venue. The clear message remains that staying private is better than putting your company’s value under the auspices of the UK’s economic and financial backwater.

Maybe the UK Isn't Closed

But last week, two substantial companies and an interesting new US-based, distressed-debt fund announced plans to list on the London market. The CEO of WE Soda, the Turkish-based soda ash producer likely to become an FTSE100 constituent, said:  London is an important global financial hub, able to attract the biggest and best investors worldwide. It is underpinned by a robust regulatory framework focused on governance, stability and transparency, and it has a rich heritage and reputation for nurturing successful global companies. We have already seen evidence of this since we announced our potential offering, with more than 400 investors engaged in discussions about our IPO from all over the world, half of whom are from outside the UK. WE Soda might not have the allure of ARM Holdings, let alone Nvidia, but re-evaluating a market’s potential starts with a few small steps. British players might not be able to win Wimbledon, but we can still put on a world-class tennis event.

On Planet PE

Also, last week, news from the world of privately held companies might make one consider that the grass is not necessarily greener on the other side of the fence, especially at a time of rising interest rates. The FT analysed the moves by the TDR Capital financed Issa brothers to use newly acquired Asda to borrow some £750m from Apollo Capital at 11% to acquire (save) the UK assets of their own petrol forecourt business. The FT believes that the brothers have turned £100m into £7.5bn by using private equity and a lot of debt. While a PE supporter might back the focused attention and returns that such debt structures and incentives produce, with that risk profile, there is no likelihood such valuations would pass muster on public markets.

Debt Hangover

In a surprisingly candid interview, Matt Nord, the co-head of PE at Apollo, described the private equity market as waking up with a hangover now the 30-year low-interest rate party is over. In a fascinating discussion, he revealed that PE’s fixation on technology and healthcare (historically c50% of all deals) would loosen to include businesses with more immediate payback profiles. But more revealing was the admission that debt financing is harder to obtain and the five-minute-long financial risk warning legalese to ensure they didn’t attract the wrong type of investor.

Turning the Screw

In other private company news, we heard that the Barlclay brothers’ media empire is breaking up under its debt strains and complex holding structures. The quote from one party involved was that the Daily Telegraph and Spectator magazine are “good businesses, just with the wrong balance sheets.” Unfortunately, it was a balance sheet that Lloyds Bank determined was not serviceable from the underlying asset structures.

Uncertain Uncertainty

How should we value the vehicles where the rubber of private equity meets the road of public markets? Listed PE vehicles occupy the financial market’s no man’s land. Its promoters claim such vehicles give private and smaller investors access to privately owned assets that are the usual preserve of sophisticated professionals. But the combination of interest rate uncertainty and illiquidity means that listed PE is clouded under layers of uncertainty over realisable value.

Listed PE Valuations

The broker Jefferies covers 22 listed Sterling-denominated PE and VC funds. Excluding 3i, which has effectively become a German discount retailer, the simple average discount to underlying NAV of the 13 PE funds (with an aggregate value of £10bn) is 31%, ranging from a 57% discount to a 3.5% premium. The average for the nine VC & growth capital funds is 47%, ranging from a 20% to a 60% discount. Underlying PE assets are often opaque, and leverage and fee levels are often hard to establish, but at these valuations, as ever, there will be steals on offer among the train wrecks to avoid.

Jeremy

Not investment advice, DYOR.

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