As Q4 heats up and the US economy enters what is arguably the most important 4-week stretch of every year, investors are busy deciphering the biggest risks facing the markets. Sustained weakness in commodity prices and geopolitics are occupying the top spots, but concerns around private valuations persist. It’s fully understandable, given the murkiness involved in distinguishing the worth of such firms because, of course, they’re private. Is a bubble lurking around the unicorn family? We don’t think so. Here’s our logic:
The Context: To begin, let’s lay out the background. Growth, as a whole, has had serious attraction to investors of all asset classes given negligible bond yields, a general environment of slow global growth, changing consumption dynamics and wide-ranging regulatory reforms in a post-recession world. Even 7 years post-crisis, we’re staring at a top-line decline of 3% for 2015 for the S&P 500, per FactSet data. Granted, the strong dollar, energy, and materials are all weighing…but excluding them would paint an incomplete picture. With growth in short supply compared to historical norms, investors are willing to risk crowding into asset classes that are categorized as growth-oriented. Note, for example, that the Russell 2000 growth index has outperformed the Russell 2000 value index right since the March’09 recession bottom, with a return of 271% compared to the 247% as of November. This year itself, growth stocks are up 6.9% compared to value stocks’ -2.1% return, and the S&P 500’s 1.5% return. In an uncertain economic environment amid continued geopolitical tensions, wouldn’t you expect investors to shelter amid value stocks? Apparently not…because, in our opinion, the low interest rate environment has pushed investors out on the risk spectrum (some willingly, and some out of no choice) – and as a result, the few firms actually showing robust growth have shown equally stellar stock returns. Think Facebook, Apple, Netflix, and Amazon – each stock has performed phenomenally this year amid magnificent, totally macro-concerns-devoid growth rates of 20%+. Here, bring in the unicorns – the elite, $1 billion+ valuation firms in the private sphere, also showing similar if not higher rates. To summarize the point above, investors are scouring for growth, and consequently, the private world is also prospering. But more on this later.
The Size: Next, note that the Dow has returned -0.1% YTD. The S&P 500, meanwhile, is up 1.5%, and the NASDAQ is up far more, at 7.7%. Now, consider that the Dow has a median market cap of roughly $152 billion, compared to the S&P 500’s $18 billion, and even lesser for the NASDAQ 100. Can the Dow’s behemoths compete in today’s nimble, instant-gratification-driven, health-and-wellness-obsessed millennial economy? The long-running success of a majority of the Dow’s components was driven by operational excellence, phenomenal execution and financial efficiency under large corporate shields – think of the power of the GEs, 3Ms, and McDonald’s of the world. Historical data proves this. Per McKinsey’s estimates, as we touched upon in our Sept 28th column, Western firms tripled their profits over the past 30 years, from 7.6% of GDP to 10%, and accounted for over 60% of profits worldwide. Long term investors were well rewarded, with the Dow moving from around 1,370 three decades ago to today’s 17,700+ number, amid countless dividend payouts. Post-recession, however, the situation is different. Not only has the Dow underperformed YTD, but importantly, it’s been a laggard right since the recession bottom in March’09; since then, the S&P 500 is up 176%, the Nasdaq is up 256%, and the Dow is up only 146%, per Yahoo Finance data, not counting dividends. Essentially, the large, corporate titans thriving on scale economies may be entering a new era – one where bigger is not necessarily better, and local may be better than global. Again, the unicorns are driving this change more than you may think – Uber, and Airbnb, among others, are at the forefront of asset utilization, data transfer and information analysis. On this note:
The Unicorns: Today, we’re looking at approximately 140 firms valued at over $1 billion in the private world, with around 70% of them American, according to CB Insights. By all means, the number is greater than ever before – the total valuation of these firms is roughly $505 billion. While staggering, it makes sense to take a step back here. Let’s put this in perspective, the $505 billion value is roughly equal to Google’s $511 billion market cap, and far less than Apple’s $680 billion. Facebook, by itself, is nearly $300 billion; in all, private valuations are approximately 2.5% of the total US public market sphere. Investors, as we discussed above, have willingly paid for growth in the public markets – why should the private space be any different? Importantly, here’s the kicker: the public market remains as diligent as ever – with the lukewarm reception to the IPOs of Etsy, Pure Storage, and First Data all showing that spillover effects may be minimal if private valuations implode. Despite the rise of the unicorns in 2015, the NASDAQ is trading at 19x forward earnings – certainly not stretched, and tech IPOs have reduced dramatically this year – down over 50% since last year, according to the WSJ. The dotcom bubble remains fresh in investors’ minds; back then, 261 companies raised over $53 billion in 2000 through public offerings. Last year, it was only 53 firms, raising around $10 billion. This year? Less than 11% of US IPOs have been tech so far – and many of them have been lackluster, with more than 40% pricing near or below their most recent private valuations, per Fortune. Square’s IPO was a litmus test last week, and the caution shown by the public investment world was worthy of applause, given that mobile payments is a massive secular growth story, but just because a company is in the space, it doesn’t mean it will thrive. The private market may think what it wants – but as long as the public sphere’s attitude towards IPOs remains diligent – the way it has shown to be in 2015 – investors shouldn’t be too concerned.
What it means for you: The success of the Dow’s global titans was symbolic of the US markets over the past decades. In today’s generation, however, such legacy stories don’t hold nearly as much sway as, say, Facebook or Netflix; alongside, several firms in the private sphere have disrupted a range of industries already. Investors are loving growth, and while good washouts are always in order – be it any asset class or business cycle phase – the disruption arising from the private world is real. Classifying the entire private space as a bubble can make for some good dinner-table talk, but smart investors should separate out the worthy disruptors and watch the public markets for signs of complacency. Until cracks start forming via unjustified P/E expansions, lesser scrutiny on IPOs, and recently public stocks moving up without reason, we’re staying happily invested on Wall Street, as the consumer takes the limelight in the coming weeks.
