Actively Speaking Podcast

Blitzscale and Hope

August 08, 2019 Epoch Investment Partners Episode 4
Actively Speaking Podcast
Blitzscale and Hope
Show Notes Transcript

Epoch Global Strategist Kevin Hebner makes his first appearance on Actively Speaking to talk about his most recent whitepaper, "Blitzscale and Hope." Kevin dives into the current hype about two-sided digital platforms and the surge in IPO listings, their share class structures and the potential for regulation in the tech sector. (August 08, 2019)

Speaker 1:

Hello, and welcome to Actively Speaking. I'm your host, Steve b Weiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager. Hi everyone. Welcome to another episode of Actively Speaking. I'm Steve Bber, and my guests today is somebody that I'm hoping will be a frequent guest on the show. Uh, Kevin Hener, who is Epic's Global investment strategist. Kevin and I have actually known each other for over 20 years. We've worked together at three different firms. He is the author of several very good white papers on our website, www.eipny.com. And we're gonna talk about the most recent one of those today. Just prior to joining Epic, uh, Kevin was a foreign exchange strategist at JP Morgan. Before that, he was a strategist at Third Wave Global Investors, and prior to that he was the firms that where we worked together, including Citigroup Asset Management and Credit Swiss Asset Management. And we first met, uh, when I was managing Japanese equities at GRE Swiss, and you were a Japanese, uh, market strategist at Warburg Dillon Reed back in the mid 1990s. Kevin spent time working at the Bank of Japan, too. The white paper we're gonna talk about today is your most recent one, and it's called Blitz Scale and Hope Unicorns IPOs and the Fear of Repeating the late 1990s. So why don't you start by telling us what that title means, blitz scale and hope.

Speaker 2:

So, blitz scale, the, the scale part of, of the term refers to digital platforms in which network effects are very important. So gaining scale, becoming big, uh, very quickly is important. The, the expression Blitzscaling has been popularized by Reed Hoffman, who is co-founder of PayPal LinkedIn, among other firms. He's an active venture capital investment teaches, um, a course on this subject at Stanford. And just to give an example of the, um, subtitle of his book is The Lightning Fast Path to Building Massively Valuable Companies,<laugh>, uh, that's actually how Reed Hoffman talks<laugh>. Um, but what we mean by blitz scale, um, the hope part is a lot of these companies, the unicorns, which are going public, um, um, they've been in business for a while, uh, the vast majority of them have yet to produce profits. So the hope part is that investors are hoping eventually, um, they'll be producing sustainable cash flow,

Speaker 1:

Right? So that's right there, there's an interesting distinction between what happened in the late 1990s. So, cuz that, so your subtitle, you mentioned the fear of repeating late 1990s, and it's perhaps shocking for us to realize that there are plenty of people in this business who were not in this business in the late 1990s. That was 20 years ago now, you know, we remember well the things like pets dot com's, the most notorious one with the, the TV commercial, with the sock puppet, uh, these companies that came along went public often very quickly, didn't have any, weren't making profit, like you say, like some of the companies today. Uh, but, uh, what's interesting to me, one thing I was, we had talked about what we were gonna talk about today, uh, before this podcast and after that conversation, it occurred to me that one of the differences, and we'll get to similarities and differences, you know, 20 years ago, people openly mocked the idea that you actually needed to make profit. You know, there was that, there was all that stuff about the new economy, and if you pointed out that, well, you know, it's still capitalism and you're putting capital at risk, people who are putting it up expect to make money, otherwise, why would they put money into the company? And you were, uh, just mocked as being hopelessly out of date for having that view. And it was, it was all about eyeballs, et cetera. So at least today people seem to acknowledge the show. Do you, would you say that's a big, uh, difference versus 20 years ago people acknowledge that you have to make money?

Speaker 2:

Yes, you can obviously have an I P O in which you're not making money, but people are very much focused on the pathway to profitability and there has to be some transparency about that. Overall, IPOs this year have done very well in the market. Two exceptions have been Uber and Lyft. And, and those are cases in which there are many questions about this pathway to profitability will that happen? And I think there's a lot of quite sensible debate as to whether they have unique business models that are sustainable, if they have digital moats, and if they will in fact ever be cashflow positive.

Speaker 1:

Right. Okay. So let's, let's talk about what are some of the differences between 20 years ago and today or, or some mitigating factors that that might, uh, make some of those things you just talked about a little less concerning.

Speaker 2:

There, there are quite a few differences and, and I think that's why overall we're less concerned than we, we would've been. Um, and certainly given the characteristics 20 years ago, one of the differences you mentioned earlier, during the.com boom, the median age of companies going public was four years. Uh, companies like ETOs web van pets.com in some cases we're only created, founded a year before their ipo, and in some instances a year later went bankrupt with the current crop of IPOs. The median age is 12 years, so they're about three times older than they were 20 years ago. Similar with sales during the, the tech bubble, some of the companies had just been founded were just developing their business models at very small sales. Uh, the current crop, they've been in business longer, they've developed a reasonably robust business model. Revenues are about three times higher, and revenue growth in most cases is quite strong. So I, I think that's one important difference. Uh, a second difference is that when we think about IPOs, uh, relative to market, and this is important, if we're concerned about liquidity issues, the market is much bigger than it was 20 years ago. So even a phenomenal terms, the value of IPOs this year is greater than 1999. In fact, the value of IPOs expressed as a percentage of market cap is below its 20 year mean. So we don't really think it's putting a lot of pressure on market liquidity.

Speaker 1:

Uh, you had a chart in the white paper that I found really interesting. Uh, one of many that I found interesting<laugh>, um, which it was something I really didn't know, is that this mix of, uh, the biotech IPOs, which basically, I think you said, none of which are profitable, but they make up a much bigger percentage today than they did 20 years ago. And that's affecting these numbers, these aggregate numbers for profitability. Yes,

Speaker 2:

The, the biotech industry is very important, and as I think, uh, many of our listeners know, this is an industry with developments in genetics and so forth is booming. Most biotech companies, not only do they not have profits, they don't even have revenues, they don't have any sales. The products are under, under development. The research companies, uh, many of these companies probably will not have revenues and profits ever, but the view is that if some of them do come up with treatments and drugs that are successful, that they will do extremely well. But that is a very big difference from 20 years ago.

Speaker 1:

Okay. You also talk about, um, some other differences that maybe aren't so positive, uh, such as the number of companies that are going public with dual share classes that enable insiders to still maintain control of the company.

Speaker 2:

Yes, I think that's, that's a big concern for most of the, the modern history of the US equity market. The New York Stock Exchange has not allowed due class share issuance by firms. Um, this has been relaxed over recent decades, and particularly since the Google i p o in 2004, this tendency has really accelerated. Currently about 35% of tech IPOs have dual class shares post Google. Recently, we've even had some issuances in which the shares have zero voting rights overall. This has become quite controversial. For example, with, with Facebook during the, the, um, the June meetings, a large majority of shareholders wanted to separate the rules of CEO and chairman. And, and broadly in corporate governance, this is considered best practice to have a separation of rules. Um, the CEO o Mark Zuckerberg of Facebook controls a majority of voting rights and Facebook. So he effectively has control. And this, this has become a, a big issue as, as in many instances or many senses, Facebook's become the, the poster child for corporate governance challenges in the tech sector and in America,

Speaker 1:

Right? Yeah. These, these, all these points raise, you know, a couple of other questions like what does it mean to be, are you truly a public company? If, if one or two people still control everything, even though there are shares that can trade, there's a market. I guess, you know what the, what we mean by quote public is you can trade the shares easily in a market, doesn't necessarily mean you have the ability to actually actually exercise much control over the company. So it's sort of a weird hybrid state.

Speaker 2:

Yeah. So it's a, a strange thing. If you have a company like Facebook, which is cashflow generative, we don't think it's likely to go need to go to markets to, to raise cash. And then one person controls the majority of the shares. Why does the company need to be public and in what sense is it public, um, in the view that shareholders have some type of ability to influence a company, some type of degree of control, right? So it is a strange hybrid.

Speaker 1:

Yeah. And then, and then the other thing that springs to mind is, you know, you talked about the level of, uh, VC involvement these days in, in all these companies that are going public. And it, it raises this question, why do companies go public? You know, if you go back to 20 years ago when they were going public at a very young age, it was because they needed the capital. You know, even if they were spending it stupidly, like on a one commercial for the Super Bowl, which I, as I recall, one company did, that's why they went public to raise money to buy Super Bowl commercial. So even if they didn't spend it wisely to point is they needed the capital. But nowadays you've got these companies that have, as you point out, they've been around, they're 12 years old, they've got plenty of revenue, they've got venture capital backing. Why go public?

Speaker 2:

Well, I think for the 85% of tech companies that are not profitable, they will need cash, particularly as they need to blitz scale. Additionally, they've gone through a couple VC rounds and there are a lot of investors that do want to cash out. They specialize in analyzing new and upcoming companies, and they don't want to necessarily be investing in companies that've been around for 10 years plus and, and are maturing. So I, I think for the VC industry to get out, and then that's quite similar to, to pe p investors, we'll often have a 10 year horizon. We want to be working with this company making some operational changes, but at some point we do want to be cashing out. So I think it is a way for VC investors to cash out so that they can go back and look at new upcoming firms.

Speaker 1:

Right. And of course, when you say PE you mean private equity, not pe re price earnings ratios. Yes. Um, but that, you know, that brings up a point, uh, that I made in the, the recent white paper from last year about the limits of theory about some, one of the flaws in the modern portfolio theory conclusion that you should buy everything that's public is that sometimes, uh, when a company goes public, maybe that's not the best time to be buying it. If, as you say, it's really just because the, the VC investors are looking for a liquidity event to get their money out, that's not necessarily proof that it's, it's a good business right now and that you should wanna own it. You know, and the conclusion of that paper was you should not surrender that judgment as to whether a business is a good business and, and simply buy everything that's, that's part of the market. I suppose we should be grateful that these companies are going public though, because, and, and going back to another one of your earlier points about the, the ratio of the value of the companies going public today in terms of the market cap relative to the overall market, you pointed out that that's lower than it was 20 years ago, which is kind of remarkable because the number of publicly traded companies is actually down quite a bit in the last 20 years because we did go through a period where there was not a lot of I p o activity, but there was still a lot of mergers and acquisitions activity, and so the number of publicly traded companies actually was shrinking. And so I guess we should be grateful that at least they're, they're adding to the, uh, to the supply of publicly traded companies. And that really has implications for active managers like us. Uh, I would, don't you think?

Speaker 2:

I I think it has a number of implications. If you think that a liberal capitalist democracy is a good idea, then presumably public equity markets are important. You wanna have vibrant public equity markets. And the fact that the number of companies in public markets in the US has declined precipitously over the last 20 years, this is a concern. So you'd think that we wanna encourage new companies, emerging companies, unicorns and others to be joining public markets. I think this is, this is an important thing for society broadly, in terms of what it means for active managers. There has been a concern over the last decade when so much of market movements have been driven by qe, that we have one factor driving all prices, and there's very little dispersion across securities. In fact, when you look at IPOs, there's enormous, and, and pre i p uh, VC returns, there's enormous dispersion across countries. Uh, in fact, VC investors lose money on over 50% of their investments, but once they, they go public, the average, uh, I p o has a first day return of about 14%, and then afterwards, some lose a lot of money, many go bankrupt. Others have returns, uh, over the next say, uh, two to three year holding period greater than a hundred percent. So there is enormous dispersion among post i p o companies than you'd get among more, more mature companies. And one would think that active managers could go in, do their analysis using criteria such as ability to produce free cash flow and sustainable basis, ability to allocate capital appropriate and their policies towards returning capital to shareholders, that using these sorts of criteria that they would be able to distinguish the wheat from the chaff and should be able to outperform on the basis. So I would think this should be something that's, um, very positive for the active management business.

Speaker 1:

Okay. Let's talk about something that's in the news right now. Uh, so we're recording this on July 25th and earlier this week there was an announcement that the Justice Department, uh, is initiating, uh, some antitrust investigations into some of these very large, uh, tech companies. Uh, I think they named Google and Apple and, um, a couple of others. Does that, uh, call into question the, the validity of this whole quote, blitz scaling strategy? Because the criticism of the tech industry in recent years has been that, you know, where are the antitrust enforcers? Why, why you've got these people with these huge market shares and no significant competition and, and why hasn't there been more action? And we hear people, some politicians calling to break up companies like Facebook, um, or Google. And the response by some people has been to say, well, where's the harm to consumers? It's not like, you know, Google is free. That kind of thing. It's not like they're using, they're taking advantage of that monopoly position to raise prices. Although, of course, the question of what is the price of some of these things has never been fully thought out by many people. Uh, you know, they don't realize that the data, it's your data that they want and that's how they're making money and, and, uh, that's why it's quote free, but it's not really free. You're giving them something of value, uh, at least to something that is valuable to them. Antitrust people are not just interested in harm to consumers, they're also interested in other things like pricing in terms of, uh, if, if prices are stable or falling, that doesn't mean that, that there's no antitrust issue, that there can be, uh, other issues. So the question is, if, if we're moving back into a world where there's more vigorous antitrust or different interpretations of antitrust when it comes to these large blitz scale companies, what's that gonna mean, uh, for strategy of these of these companies? Are they gonna still be able to do this and go public?

Speaker 2:

Yeah, the, the do j announcement two days ago was very important. There are gonna be reviewing, um, some of the large companies, the digital tech companies to see if there are behaviors that are anti-competitive. In particular, it's clear that this is gonna take a very long time. And historically these sorts of reviews leading to investigations, leading to different types of remedies, have taken years, in some cases decades to go through. Um, there's no sort of one size fits all solution. They will have to go in, look at particular companies, look at particular, um, examples of, uh, anti-competitive behavior and come up with very specific remedies for those. So this is gonna take a long time. Clearly the only criteria they'll use isn't whether is this good for consumers or not, because standard oil was extremely efficient. It lowered the price of, of oil increased distribution. It was doing lots of good things, but is also engaged in quite a few types of behavior that were clearly anti-competitive. And breaking it up, uh, led to a wave of innovation. It also led to massive returns for shareholders. Many people think that antitrust actions will necessarily be negative for shareholders, uh, particularly when they're referring to divestitures. I don't think that's likely to be the case at all. Um, the big case is historically standard oil at and t Microsoft, IBM in many cases resulted in waves of innovation afterwards in, in shareholders, uh, doing quite well in these cases. And the current example, um, the review has just started and, and I think it's important that they recognize that there are a lot of concerns. This is a bipartisan issue, concerns about the, the concentrated power, the lack of consumer choice for some of these digital companies. If we don't get, um, some type of antitrust behavior, we might get regulation. And it's very clear from the regulatory actions taken by European authorities, the regulations have impeded innovations, haven't really helped consumers and have really hurt the tech sector development in Europe. So regulation is probably not the right way to go. This is very complex. The current legislation is probably appropriate for dealing with digital firms. The DOJs antitrust division does have a lot of experts in digital firms, platform firms. So I think they will come up with the right decision, but it's not something that's gonna be happen quickly.

Speaker 1:

Right? I think, uh, and you've made the point, uh, elsewhere that, uh, the case against Microsoft, for example, uh, which was the bundling of, of Internet Explorer with, with, uh, windows 20 years ago, that forced them to stop doing that. Uh, that's what enabled companies like Google, uh, Yahoo, et cetera, to come along and actually, you know, give them space to exist. And that, so that, that innovation aspect of this I think is very important, that it's not just about pricing, it's about, it's about stifling innovation.

Speaker 2:

Yes. Yeah. Um, so certainly people talk about that with both Standard oil and, um, the Microsoft case, similar with at and t. They started in the seventies, but ended in the early eighties and after the, the changes to at and t, we did have the internet revelation really start. So there was a wave of innovation associated with that. So there's a host of examples in which big dominant companies, even companies that were well run, were good for consumers, had low prices, um, but were viewed as being stifling innovation and anti-competitive. These measures ended up being very good for markets, very good for consumers, very good for innovation.

Speaker 1:

Okay, thanks Kevin. Uh, once again, the title of the white paper is Blitz Scale and Hope Unicorns, IPOs, and the Fear of Repeating the late 1990s. Uh, co-written by Kevin and also by Bill Priest, our c e o and Co c i o. You can find this and all our other white papers and previous episodes of, of this podcast on our website. Kevin, I hope you'll join us again, uh, sometime in the future.

Speaker 2:

Thank you very much,

Speaker 1:

Steve. And that's it for today. Remember to subscribe to actively speaking on Apple Podcast or Google Play. You can find all of our previous episodes and additional content on our website, www.eipny.com. We'll talk to you again soon.

Speaker 3:

The information contained in this podcast is distributed for informational purposes only, and should not be considered investment advice or recommendation of any particular security strategy or investment. Product. Information contained herein has been obtained from, from sources believed to be reliable but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but is subject to change any performance information. Reference in this podcast represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this podcast are forward-looking statements and are based on epic's research, analysis, and assumptions made by Epic. There can be no assurances that such projections, targets or estimates will occur, and the actual results may materially be different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the returned or performance of any accounts and or funds managed by Epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable.

Speaker 4:

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