A high-tech version of the Cold War
March 23, 1998
"How high's the water, mama??Well, it?s five feet high and rising." -- Johnny Cash, "Five Feet High and Rising"
As a venture capitalist who was once a Wall Street analyst, I am continually asked about my views on the high-flying U.S. equity markets and how this affects my job as an investor in private companies. Historically, I have shied away from commenting on macro-economic trends, as the large number of relevant variables and the inherent complexities of global financial markets make predicting such things more of a theoretical discussion than an absolute analysis. However, I do believe there are some very interesting interrelationships between the state of the current market and the opportunities that have arisen as a result of the Internet. Hopefully, my position as a former insider-turned-outsider will offer an insightful perspective.
It is certainly no secret that the U.S. equity markets are enjoying one of the most prosperous bull-runs in our nation's history. The Dow Jones Industrial Average has been up 12 out of the last 13 years and has enjoyed an average return of 15 percent over the past five years. Despite this upside, there is no sign of a diminishing appetite for stocks, and every dip or correction is interpreted as a major buying opportunity. While 1998 was a little shaky coming out of the gates, this year is legging into a full sprint. The DJIA, for example, is up 8.8 percent* in only 72 days. If the market continues at this pace, we could be looking at a quite respectable annual figure of 52 percent. The tech-heavy Nasdaq, for its part, also has shown a remarkable amount of resiliency, with a five-year annual return of roughly 17 percent* and a strong 12.8 percent start in 1998. Lastly, by almost any valuation metric, U.S. markets are trading at near all-time highs, reflecting an unbridled optimism about the future.
So what are the factors that have led us to this enviable position? The most obvious and most cited factor is the strength of the U.S. economy. Growth is strong, yet there are no signs of inflation. This implies that interest rates will stay low, which helps equities in two ways: Many analysts value public companies by discounting future expected cash flows, and with rates low, future cash flows are more valuable. Also, low rates hurt the relative attractiveness of U.S. fixed income investments, the equity market's chief competitor for capital. The other frequent explanation is the establishment of the "New Economy." While the specific details of the New Economy are somewhat sketchy, the main pitch goes something like this: The rise in productivity related to our increased use of information technology allows us to economically fly at a higher level than in the past. In other words, it's different this time.
While these theories are unquestionably plausible, I would like to offer two more that deal with consumer education and the fund manager's reaction to this education. Over the past 20 to 30 years, financial advisers have sung the praises of equity markets as a great long-term instrument for capital appreciation. Over the long run, as the saying goes, stocks always have had a higher rate of return. As recently as the early '70s, most Americans were skeptical of this viewpoint. They had seen firsthand the high risk associated with stocks, and they preferred to play it simple and safe. However, the fantastic stock market returns of the '80s and '90s have confirmed the financial advisers' original premise. As a result, the average American is much more comfortable participating in the equity markets and has confirmed this by voting with his or her pocket book. Record amounts of capital continue to flow into the equity markets, and it would be hard to ignore this phenomenon as a potential contributor to the bull market.
Investors also have become more educated in how they invest in stocks. Once again, financial advisers have pointed out that investors can do just as well, if not better, investing in equity indexes (such as the S&P 500), as opposed individual funds. What?s more, index funds have lower fees and lower turnover, which equate to higher after-tax returns for the investor. Over time, individual investors have become more enamored with index funds, and as such, money flows into these funds and has continued to do so at record rates for several years. One could argue that the money flowing into these indexes drives up the demand for these stocks (such as the S&P 500), which creates a bit of a self-fulfilling prophecy. However, I think the fund manager's response to the index craze is a much more interesting phenomenon.
A high-tech version of the Cold War
I believe that the single most important driver of the market's continued success is a fundamental shift in the attitude and optimization function of the average fund manager. Once again, financial advisers have educated us that asset allocation should be a separate task from equity selection. They argue that fund managers should be judged relative to risk, and therefore relative to their particular asset classes--the idea being to let the individual decide on the split between stocks and bonds and cash, while letting the fund manager focus on equity selection and performance. The success of indexes has contributed to this sentiment. If a fund manager can't beat the index, why invest in his fund? I would argue that this slow education process has led us from a world in which fund managers cared 100 percent about absolute performance to one in which they care primarily about relative performance.
So why is the shift from absolute performance to relative performance important? Fund managers that care about relative performance equate "not investing" with not doing their job. Therefore, despite the fact that valuations are at historical highs, they insist on being "fully invested." Whereas some fund managers used to hold cash during periods of concern, today's fund manager cannot afford to hold cash, as it hurts his or her ability to compete against the indexes. As a result, mutual fund cash levels are at all-time lows. This is a subtle but important shift. The "fully invested" mutual fund manager sees the world through a different lens. No stock is expensive on an absolute basis, only as it compares with other stocks. This unfortunately leaves the burden of determining when equities are "expensive" on an absolute basis to the individual making asset allocation decisions. As mentioned before, however, we just spent the past 30 years convincing this same individual that he or she always wants to be invested in stocks.
This elongated bull-market run coincidentally overlaps with the rise of the Internet, and the abundance of equity capital has played a critical role in the Internet's growth. A plethora of Internet-related companies have relied on the U.S. capital markets as an efficient source of funds, and they subsequently have used these funds to grab market real estate. As the saying goes, "Internet real estate will never be cheaper, so grab while the grabbing's good." To date, this philosophy has proven remarkably successful, and those firms that have dived in with both feet typically have crowded out those with a more conservative execution plan.
Indeed, the public markets appear to agree with this philosophy, immediately rewarding companies that enter into expensive long-term marketing arrangements. This seemingly irrational behavior of rewarding those who spend more by increasing their valuation is based on the theory that those who spend will survive and those who don't will fail to gain a presence in the future. This is the high-tech version of the Cold War.
This environment presents an interesting dilemma for young private companies. On one hand, there is huge temptation to prime the pump--to raise a ton of money and spend your way to success. After all, these gates only come open every so often. However, there are risks to this strategy for both the company and the investor. First of all, a full frontal assault typically results in a huge increase in the cash burn of the company. As cash is the lifeblood of a company, climbing on this treadmill is a bit like musical chairs: If you begin to execute on this strategy and the equity markets decide they are through participating, the music stops--and it's a long way down. Of course, there are equal risks for the conservative executive. If you sit back and watch as your competitor raises capital, doubles its staff, and attacks the market, you may have sealed your own fate. To spend or not to spend, that is the question.
This leaves an interesting dichotomy of choice for young Internet companies, and the key determinant of operating strategy may be predicting just how long the U.S. equity markets can continue to soar. Unfortunately, as author and former manager of Fidelity Magellan Peter Lynch noted, this is not an easy task. "Nobody can predict interest rates, the future direction of the economy, or the stock market," he said. "Dismiss all such forecasts and concentrate on what's actually happening in the companies in which you invested." Warren Buffet has been known to utter similar phrases. However, today's young companies are forced to act and may not have the liberty of deciding not to choose.
Times are good, but this is obviously reflected in the market. Equity returns have outpaced earnings growth for many of the past few years, which implicitly means that valuations are increasing. To keep this game going, we will need to see either continued multiple expansion for the overall market or a very strong earnings environment. With the market valuations already at record levels, betting on further valuation expansion seems unsound. However, counting on further earnings gains may be equally optimistic. Earnings growth has been aided by operating-margin expansion, but this becomes increasingly more difficult as we move forward, particularly in light of potential pricing pressure from foreign goods.
Equity markets historically have placed bets on small companies, but small companies may be increasingly betting on the market.
J. William Gurley 1997-8. All rights reserved. The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice. The author is a general partner of Hummer Winblad Venture Partners (HWVP). HWVP and its affiliated companies and/or individuals may, from time to time, have positions in the securities discussed herein. Above the Crowd is a service mark of J. William Gurley.