Beyond The Headlines
The Other Unicorns
A unicorn might be the famous mythical creature with a spiraling horn projecting from its forehead, but in the investing vocabulary, a unicorn is a privately held startup priced at over $1 billion. The unicorn as a term with its Latin and Ancient Greek roots signifies something desirable but hard to find. CB Insights lists 495 unicorn companies in the world. There are 500 companies in the S&P 500, the US stock index that includes the 500 largest companies. If there are almost 500 unicorn companies, are they still that rare and hard to find? This revelation made me think of the other unicorns. Not the highly-priced new exciting companies that have yet to prove their business models, but the older, more established companies that trade at low valuations (less than ten times their annual earnings, for example). There aren’t many of them to be found.
The terms value and price are often confused in the investing world. We agree with the legendary investor Warren Buffett’s definition: “Price is what you pay; value is what you get.” In that case, tech unicorns are priced at $1 billion or more, but we are yet to see what we are really buying and what the value might prove to be. Some of those companies will prosper; some of them will fail. That’s the nature of all early-stage companies. They are still in the process of developing their product or service, finding their customers, and finally establishing their business model – a path to profitability. Any company with no plan or intention to reach a profit has no business, in our opinion. It resembles more a non-profit with private shareholders providing financial support for the time being. When those shareholders realize that there are no profits, we expect/believe/have seen they wake up and run. If they are still holding on to their shares with hopes of gains, they possibly subscribe to the Greater Fool Theory. That’s the idea of selling shares at a higher price to someone else — the greater fool.
Most recently, WeWork has been a prime example of such a company, a tech unicorn who rose quickly, focusing on growth at any cost. We had our experience meeting with many WeWork reps as we were looking for our New York office space over four years ago. It seemed to be a very aggressive sales machine taking over buildings and floors from major companies as they were shrinking their Manhattan footprint. One of those locations was a prime Park Avenue location that I remember visiting a few years earlier. It held the offices of one of our portfolio holdings that’s been in the process of reviewing their office space needs. That was long before the 2020 work from the home shift caused by the Covid pandemic.
After years of eye-popping growth, WeWork attempted to go public and offer its shares to new investors. It was supposed to be priced at $47 billion. That would buy you one and a half of Walgreens, one of two major chains of pharmacies in the U.S., together with its international presence. WeWork reported a $1.3 billion operating loss in the first six months of 2019 alone (Source: company filings, S-1) while recording $1.5 billion in revenue. That’s not that much different than giving away $100 bills for $50. How quickly can you find takers for $100 bills if you charge $50 for them? There is no real limit to such growth, but it’s not growth that leads to profitability. As a comparison, Walgreens earns around $4 billion of profits on over $130 billion in revenue annually.
WeWork knew it well and didn’t hide it. They actually openly disclosed in their IPO filings: “We have a history of losses and, especially if we continue to grow at an accelerated rate, we may be unable to achieve profitability at a company level (as determined in accordance with GAAP) for the foreseeable future.”
A long-term investor (as opposed to a trader or speculator looking for a greater fool) would only buy a business for its current or expected profits (earnings). How would we value a company that doesn’t expect any profits in “the foreseeable future.” That might be beyond the limits of any reasonable investment horizon.
It was quite refreshing to see the market reject the IPO, and WeWork is still trying to find its bearings a year later. The Covid pandemic and work from the home model have only made it more challenging to turn it around. WeWork might have been priced at $47 billion at some point, but we are yet to see what its actual value proves to be.
Looking for the other unicorns, I came across an article. This summer, Barron’s made a list of ten S&P 500 stocks with a market capitalization above $5 billion, and the lowest price to earnings, in other words, ten cheapest stocks. A shortlist of ten included some insurance, health care, old tech companies, among others—familiar brands and businesses, with mostly steady earnings but no excitement or growth. What caught my attention was the length of the list – 10! Not 495. What rare finds these stocks have become, especially compared to startup unicorns.
I remember recommending stocks as a junior analyst some 15 years ago now. We would sit around a big long conference room table and present investment ideas to fellow portfolio managers. Some of my more senior colleagues with vivid memories of the 1980s markets occasionally asked me if the stock was trading below ten times earnings (meaning, we pay less than ten dollars for each dollar of our annual earnings of the company). I would often say no, and explain why it deserves a higher multiple. It had a unique market position, growth potential, brand, etc. I was always curious about those mythical times when the markets were apparently full of companies trading at sub-10x earnings. In my early days, I still could find cheap stocks that met this stringent criterion. Some of them even qualified as decent investment ideas. More recently, though, I see that this group has dwindled to the point that I could almost count them on the fingers of my two hands. What happened?
As a student of history, I asked, investigated, and read to understand better where those other unicorns have gone. Those mythical creatures that used to roam the markets freely and could be bought at low multiples, and even offer generous dividends are nowhere to be seen. Today, the unicorn label has been claimed by the exciting startups, who have become anything but rare.
I believe the most significant phenomenon that occurred since 1980, which coincides with the year when I was born, has been a gradual decline in interest rates and a continuous increase in debt worldwide and in the US. The 10-year US treasury yield peaked at close to 16% in 1981 and has fallen to 0.8% as of November 2020. Simultaneously, the price to earnings ratio for the S&P 500 rose from 7-8x in 1980 to 25x+ this year. No wonder most of the sub-10x earnings companies that many portfolio managers reminisced about vanished. When the entire S&P 500 was trading at 7x-8x, I’d imagine there were many sub-10x earnings stocks in this index of 500 companies. The term startup unicorn was not even around yet back then. We’d have to wait until 2013 when Aileen Lee, a venture capital investor, chose the word unicorn to represent a statistical rarity of a billion-dollar venture. It took only seven years to have all 495 of them!
As the debt got cheaper, we got more of it. The US public debt went from 32% of the GDP to over 100%. Household and corporate debt grew with it. Accommodating monetary policy with ever lower interest rates made it harder to earn interest on savings. I remember how only 15 years ago, I had a one year certificate of deposit with a major bank paying 5% annually. Today, it’s not only impossible to find such a rate but 10-year Treasury yields below 1% (Source: Bloomberg); finding any respectable yield has become more challenging.
On top of that, we witness a sea of negative interest rate bonds that reached $16 trillion recently. You have to pay the borrower to take your money. I remember defending my master thesis at the Warsaw School of Economics 17 years ago. One of the questions that came up was about credit risk. We discussed the need to compensate the lender for taking on the risk of lending the money to the borrower. Watching the growing number of bonds with negative yields, I wonder if the laws of economics have somehow been rewritten since I picked up my diploma? Today, we flipped the 5,000-year-old logic on its head. That didn’t happen without some unforeseen consequences and bizarre phenomena – tech unicorns among them.
In the name of maintaining economic growth, we embarked on a monetary and fiscal experiment that has numerous curious side effects. With the lack of yield in the bond markets and a shrinking number of dividend-paying stocks, price appreciation has become the primary goal for many investors. They felt forced to move toward riskier assets in search of returns. This phenomenon made substantial capital available to promising new ventures that can quickly reach very high prices, multi-billion dollar market capitalization still in the private market — the famous startup unicorns. Among them, you can find these days decacorns and hectocorns with over $10 billion, and $100 billion private market valuations, respectively. Deca and hecto are terms derived from Ancient Greek, similarly to a unicorn itself, which has been a wonder for humanity since Antiquity. It took the 21st-century financial creativity of zero interest rates combined with desperation for returns to breed not only unicorns but a whole new species — decacorns and hectocorns. We could only imagine what the Ancient Greeks would think of these inventions.
As students of history, and observers of nature, we see how both follow cycles, empires rise, empires fall, the ocean tides follow a similar pattern, so do the seasons of the year, and credit, business, and economic cycles are no different. We might be at a peculiar point in our financial history as it’s being written today. Tech unicorns are proving to be as common as US large-cap companies. Low multiple, good business, high dividend stocks seem to have become as rare as a fair-weather rufous hummingbird sighting in Alaska in January. We might have to wait a little longer than expected, but something tells us that tides will turn, as they have before. We believe investors will have abundant investment options again with yields and valuations closer to historical levels when the other unicorns make a comeback (my other unicorns might actually resemble more majestic rhinos, given their steady business and intimidating size). For now, I’d recommend two words (also borrowed from Latin and Greek): a healthy dose of caution and skepticism.
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