M & A Rainmaker

You’ve got to know when to hold ’em
Know when to fold ’em
Know when to walk away
Know when to run
Kenny Rogers – The Gambler

My esteemed colleague, Ben Horowitz, essentially makes four arguments: 1) look at how relatively cheap Apple, Google and Amazon stock is, compared to their growth; 2) major technology cycles tend to be around 25 years long, with the bulk of the purchases occurring in the last five-to-ten years—the major adoption wave for the Internet technology platform is due to hit within the next 8 years; 3) the economics of building internet businesses has changed; and 4) the markets are much bigger.

Therefore, he concludes that a boom is coming…but asks if you want to miss it because it has the possibility of becoming a bubble?

If this were a magic act, we would suggest that Mr Horowitz’s arguments are misdirection. To answer the question before the house, “Are we in a tech bubble?” he offers that as Apple, Google and Amazon survived the dot.com crash, we can ignore the fate of the thousands of failed public and private dot.com companies when the bubble burst in March of 2000. The issue is not whether we are on a 25-year tech cycle or that the next eight years are really going to be great. The issue is whether the next 100+ tech IPOs carried by this bubble will be worth their offering price in eight years.

One of the least understood parts of a bubble is that there are five types of participants: the Smart Money, the Shills, the Marks, the True Believers and the Promoters. Understanding the motivations of these different groups helps to make sense out of the bubble chart below.

Smart Money are the prescient angel investors and venture capitalists who started investing in social networks, consumer and mobile applications and the cloud three, four or five years ago. They helped build these struggling ventures into the Facebooks, Twitters, and Zyngas before anyone else appreciated that these companies could have hundreds of millions of users with off-the-chart revenue and profits.

In a bubble, the Smart Money doubles down on their investment in the awareness phase, but—when it starts becoming a mania—the Smart Money cashes out. (Really Smart Money recognises it is a bubble, and bets against it.) They manage this all with knowledge of the game they are playing, but they do not hype it, talk about it or fan the flames. They know that others will.

The Shills are the middlemen in a bubble. They profit from the boom times. They are the mortgage brokers and real estate agents in the housing bubble, the investment bankers and technology press in the dot.com bubble. Since it is in their interest to keep the bubble going, they will tell you that housing always goes up, that these bonds are guaranteed by a big bank, and that this tech stock is worth its opening price. All the stories peddled by Shills have, at their heart, why “it is a new age” and why “all the old ways of measuring value are obsolete”. And why “you will be an idiot if you do not jump in and reap the rewards and cash out”.

The Marks are your neighbours or parents or grandparents. They are not domain experts. They know nothing about real estate, financial markets or tech stocks, but they do not want to miss the “investment opportunity of a lifetime”. They hear reassurance from the Shills and take their advice at face value, never asking or questioning the Shills‘ financial incentives to sell you this house/mortgage/tech stock. They see others making extraordinary amounts of money at the start of the mania—”just buy a condo or two and you can sell them in six months”. What no one tells the Marks is that, as they are buying, the Smart Money and institutional investors are quietly pulling out and selling their assets.

The True Believers do not financially participate in the bubble like theMarks (for lack of assets, timidity, or time) but they would if they could. They have no rational evidence to believe, but for them it is a “faith-based” belief. By their numbers, they give comfort to the Marks around them.

The Promoters are the ones who keep the bubbles inflated even when they know that the asset exceeds its fundamental value by a large margin. While Shills have no credibility, Promoters have “brand-name” credibility that makes the Marks trust them. What makes thePromoters‘ role egregious is that they are a small subset of the Smart Money. They loudly tell the Marks and the Shills that everything is just fine, enticing them to buy into the bubble, as the Promoters are liquidating their own positions.

To support his position Mr Horowitz used a quote from Warren Buffett that I wish I had found, “The only way you get a bubble is when a very high percentage of the population buys into some originally sound premise…that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action.”

The “facts” raised by Mr Horowitz, that “the size and scale of these new markets have never been seen before; some of these applications and companies will reach billions of customers, generate unprecedented revenues and profits” are likely true. But they do not support his argument about the bubble valuations that we are seeing across all the companies filing for IPOs (Pandora Media just priced its IPO at $2.6 billion dollars, while admitting it will have operating losses through the end of fiscal 2012). But to justify his position, he lists the low price/earnings ratios of Apple, Amazon, Google and Salesforce.com. He argues that, if we are in a bubble, these companies ought to have their prices inflated as well.

A bubble does not work that way. Bubbles attract Marks and Shills to new shiny toys, not existing ones. Apple, Amazon, et al are not the current objects of desire that this bubble is about. The question is, are we in a new tech bubble? Does the new wave of social/web/mobile/cloud companies going public have valuations which exceed their fundamental values by a large margin (today and in the foreseeable future)?

In other words, “Would you want your mother to buy these stocks to hold them—or to flip them?”

Every bubble is a big-stakes game—played for keeps. In it, the usual cast of characters appear: the Smart Money, the Shills, the Marks and the Promoters.

There is a saying in poker, “If you can not figure out who the Mark is at the table, it’s you.”