Beyond The Headlines
When the Appetite for Risk Disappears
It was 2010, and I was sitting at an IPO (initial public offering) lunch in Manhattan shortly after the 2008-2009 financial crisis. This was one of the companies going public soon after a dry spell of the previous two years. It had a big market share, highly profitable business, a strong balance sheet, a growth story to share, and most of all, a very reasonable valuation. You’d think it was a stockpicker’s dream. The interest was tepid at best, though. Investors seemed to have lost all their earlier appetite for risk and… returns for that matter. Reminiscing about that IPO, and looking at the last two years, and especially the abrupt year-to-date investor hesitation both in public and private markets, I started thinking about the ups and downs of the infamous – appetite for risk. What is it? Why does it matter?
Here at Sicart Associates, we have a habit of following some more interesting IPOs, and we’ve had a record number of them in the last two years. We always have a great appetite for returns but no appetite and rather limited tolerance for risk, especially unnecessary risk. We know well that there is no such thing as free lunch in investing, though. There is a level of risk we are willing to accept, but only if the returns more than compensate us for it.
IPOs are usually younger companies that became big enough and hopefully mature enough to have their shares offered to the general public. As a matter of fact, almost all companies we have bought year-to-date weren’t even public at the time of the earlier mentioned IPO lunch. They have all grown to become well-established leaders in their respective industries. The recent investors’ risk aversion offered some compelling buying opportunities for us.
In our opinion, some IPOs may be too expensive or not compelling enough at first. Down the road, when the enthusiasm fades, price comes down to earth, and the business solidifies, they may become investable from our perspective. We take the time to get to know them, and we wait for an opportunity to buy them. It’s not rare to see a once-hot IPO trade at half the price or a fraction of the valuation only a few short years after its initial listing.
That particular 2010 post-financial crisis IPO caught our attention. We ended up owning it later on. After a bit of a rollercoaster ride, it got acquired at a large premium by one of the major players in the industry. They were willing to pay almost ten times the price the company was listed at only eight years later — was the appetite for risk back up again?
What was striking about that IPO lunch was the difficulty faced by a quality business finding interest among public investors only two years after the 2007 hot IPO market. It was also only a decade after the dot-com bubble when a company didn’t need to have an actual business or a dollar of sales and could still fetch a multi-billion dollar valuation. The appetite for risk tends to go from hot to cold and back.
In May 2007, CNN reported, “Risk abounds in hot IPO market.” Thirty companies a month would get listed at the time. Levels of debt and profitability were secondary. The bull market was strong. House flipping was a quick path to riches. The appetite for risk was high.
If we were to compare 1999 with 2007, the former seemed to have reached an even higher level of risk appetite. Interest rates were cut, and the capital gain tax was reduced – talking about pouring gasoline on the fire. The Internet browser was invented, and the dot-com bubble was getting hotter and hotter. It was the era of price-per-eye ball valuations and massive growth in the use of the Internet. Lycos, a web search engine and portal, was the fastest company to go from inception to IPO (2 short years) and reached a $12 billion valuation in 2000, only to sell for $36 million ten years later. Sales and profits didn’t matter, and the life of dot-com companies was measured by its burn rate. In other words, how quickly the company will burn through the capital, it raised. That money went to Super Bowl ads, high-end office chairs, and more.
Nasdaq Composite rose 400% between 1995 and 2000, only to fall 78% in the next two years. Overnight, the epitome of risk appetite — venture capital became no longer available, and only a handful of dot-com stocks with more conservative management and credible businesses survived, among them Amazon.com.
It’s worth noting that Amazon survived, but still, its price dropped some 90%. Jeff Bezos, at the time, opened his annual letter to shareholders with a single yet powerful word: “OUCH!” One of my grad school finance professors must have been among those who lost their shirts buying Amazon shares at the peak because we never heard the end of his criticism of this online everything shop.
There were other heavily bruised dot-com survivors. Priceline lost a digit and fell from $94 to $4, only to rise from the ashes and become a big player in the online travel world as Booking.com in the following two decades.
Now, the Internet changed the way we live, work, do business, educate, inform, communicate, and even meet future spouses – there is no doubt about it. So many new opportunities, efficiencies, and connections became possible, but also so many businesses became less relevant, shrunk, and had to reposition or vanish.
Innovation has been changing the world from the invention of the wheel to railroads, phones, cars, radios, computers, the Internet, and more. When investing in innovation gets disconnected from fundamentals and disciplined investment process, it may prove to be an all-risk, and no return or all loss proposition, though.
One could argue that the dot-com and 2007 IPO participants were rational buyers, speculators rather than investors. Someone explained to me once the housing bubble era rationale, which may as well apply to any bubble-era speculation. Those flipping homes had a thirty-day investment horizon. They wanted to sell the property higher before the first mortgage payment was due. Similarly, some or many IPO buyers in the bubble era days might have wished they got in and got out quickly enough to book a profit and avoid the downfall.
It reminds me of a hot potato game, where players toss an object around while the music is playing, and whoever holds it when the music stops losses.
History shows that the music usually stops when the proverbial appetite for risk peaks. It’s impossible to tell at the time but easier to pinpoint looking back.
The “hot potato” speculators sleep with a thumb on the “sale” button. We do the exact opposite. We say that we’d be happy to hold what we own even if the stock exchange choose to close for a few months or years.
The last two years of pandemic investing have been ones for the books. We had a big market sell-off, a rally, and a more recent mild correction. With interest rates at zero (only rising lately), lots of fiscal and monetary help, COVID-driven distortions in supply and demand, the appetite for risk flourished on many levels from many hot IPOs (in 2021, there were 2-4 times as many IPOs as in most previous years), meme stocks, to SPACs (special purpose acquisition corporation) to cryptocurrencies, NFTs and more. Some even argued that the pandemic turned more people into thrill-seeking digital speculators looking for excitement in gamified stock trading apps.
When the appetite for risk goes up, investors not only seem to care less about the sales and profits of the investments they buy, but they also are willing to accept less liquidity in their investments. They are willing to lock in the uncertainty for many years, investing in exotic-sounding private deals and adventurous real estate investments. The term “alternative investments” gets thrown around yet again. Suddenly, a whole swath of allegedly new investment assets appears that would otherwise be of no interest to any discerning investor. Talking heads on TV proclaim the rising appetite for risk among investors.
It’s impossible to tell what the rest of 2022 will look like. What we do know for sure though is that there are always some quality businesses out there joining the ranks of publicly traded stocks. They are offering valued services or goods and figured out a way to turn a profit. They have a long runway ahead of them and a loyal and expanding customer base. The key to success is figuring out the price we are willing to pay and the patience and discipline to hold them long-term.
Warren Buffett once said that it is wise for investors to be “fearful when others are greedy, and greedy when others are fearful.” At times for most investors — no amount of risk and uncertainty is too much to accept; other times, no amount of risk and uncertainty is small enough to stomach.
We like to share that we always have a great appetite for returns but no appetite, and rather limited tolerance for risk, especially unnecessary risk. This investment approach allows us to identify and capture the long-term upside of good businesses and avoid the downfall and pain of highly risky investments. It doesn’t mean we will avoid drawdowns and volatility. We accept it. We know there is no free lunch in investing.
We remember well that the appetite for risk comes and goes leaving behind painful losses for some and buying opportunities for others — slow and steady wins the race.
The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.
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