A Troubling Scenario That Will Infect the Markets This Year
By Bryan Beach
The initial public offering (“IPO”) of Lyft shares in March is only the beginning…
The financial press drowned the public in the news. I’m sure you saw at least one headline about it. Despite never having sniffed profitability, the ride-scheduling firm still commanded a market valuation of more than $22 billion at its IPO on March 29. For many of us, nothing about the Lyft IPO really made sense. It’s troubling, but also predictable…
Deep down, most investors want to believe the stock market makes sense. They want to believe it’s fair… that it works. They want to believe that most stocks are more or less valued properly, based on publicly available information. If you cling to that belief, then three enormous IPOs this year will test your faith.
Wall Street is about to cram some horribly run, cash-burning businesses down the throats of millions of unwitting American savers… an interesting test of what academics call the “efficient market theory” (“EMT”).
Generations of academics have written about the “efficient market”…
This is the belief that the universe of investors automatically (and accurately) synthesizes all known information about a company, so its stock price always reflects its real value. As a result, individuals have no shot at beating the market. The only sensible thing to do is simply put all your investing capital into a big index fund and leave it there.
If that’s true, how do you explain legendary investor Warren Buffett, who for years posted annual returns of around 20% investing in high-quality stocks? If he can’t know something the market doesn’t, how is that possible?
The real answer is that the market is generally efficient – except when it isn’t.
Ben Graham, the father of value investing, touched on these dynamics in this oft-quoted bit of wisdom: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
On any given day, the market is just adding up relatively meaningless “votes” in a glorified popularity contest… But eventually, the market gets it right, and the true “weight,” or value, comes to light.
Take, for example, Tesla, the enigmatic electric-car maker and money-burning machine. Many Tesla bears even consider its business to be worth somewhere in the neighborhood of zero dollars (yes, $0). Its CEO is crazy, its financial statements are quite possibly fraudulent, and its business – building electric cars – is something that every established automobile company in the universe is also working on.
The market seems to forget this, but behind its shiny veneer, Tesla is an enterprise that the public has a 100-plus year history valuing… It builds cars. I’m not sure Tesla is worth $0, but there is absolutely no reason it should sport a stock market valuation typically reserved for tech darlings like Google or Amazon.
Tesla is a pocket of inefficiency in a mostly efficient market. Millions of times per day, the market “votes” on the value of Tesla, and each time, its value rings in higher than $0. Whether the Tesla bears are right or wrong, we know that eventually the company’s true value – or “weight” – will be recognized by the market.
But it’s not just Tesla. For the last couple of years, I’ve been following a couple of the largest “pockets of inefficiency” I’ve seen in my career – and Lyft’s $20 billion IPO valuation is, unfortunately, just the tip of the iceberg. Today, there are a number of large companies that sport nonsensical valuations. To appreciate just how absurd these values are, let’s indulge in a short thought exercise…
Imagine you suddenly have $2 million to invest…
Say a generous benefactor gives you the capital, and you immediately put half the money to work. You spend $1 million to buy 10 houses for $100,000 apiece in a neighborhood of identical houses.
After six months, nobody else is buying houses in the neighborhood, so your purchases are essentially the only “comps” – or comparable sales – around.
You become disappointed that your 10 houses are still languishing with a value of around $1 million… So you buy two additional houses in the same neighborhood, but…
This time, you pay $250,000 for each house.
This latest transaction immediately jacks up the local comps… So your original portfolio of 10 houses is now instantly worth $2.5 million ($250,000 per house times 10 houses). In other words, you spent an additional $500,000 to enjoy a $1.5 million paper profit on your original $1 million investment.
That’s right, folks… On your financial statements, you can claim the value of your initial $1 million investment as $2.5 million, and your total $1.5 million investment as $3 million ($250,000 times 12 houses).
Anyone with an ounce of common sense understands that the $3 million number isn’t the actual value. It’s a nonsensical value based on your willingness to throw additional funds at an unproven investment. It’s an easily manipulated “valuation fallacy.”
For the past couple of years, this valuation fallacy has been playing out – on a huge scale – with private companies. And most important for you as individual investors, these valuation fallacies will infiltrate the public markets in 2019. So…
How did we get here?
The nexus of this valuation travesty is a Japanese businessman named Masayoshi Son…
Son, who often goes by the nickname “Masa,” founded a computer-parts store called SoftBank in 1981. He eventually made a name for himself by investing in Yahoo back in 1995 and Alibaba – China’s version of Amazon – in 1999.
When the tech bubble burst, Masa suffered paper losses of $70 billion.
But things have turned out just fine for him… Today, SoftBank is an international conglomerate worth more than $100 billion. And Masa is one of Japan’s richest men, with a net worth of roughly $23 billion. (That’s impressive, but it’s only a fraction of his net worth before the dot-com bust.)
Meanwhile, in Saudi Arabia, the country’s sovereign fund is in an unusual situation…
Blessed with what may be the most lucrative business venture in the history of mankind, the Saudis find themselves trying to diversify away from oil. It’s an interesting controversy. In February, the Wall Street Journal noted that one Saudi oil executive asked a simple question a couple of years ago in a public meeting…
[The Saudi Arabian Oil Company] spends $5 to extract a barrel of oil and then sells it for 10 to 20 times that much. Where else, he asked, could Saudi Arabia possibly invest to generate such returns? No one had an answer, the executive said.
Enter Masa… In 2016, the Saudis gave him the first of many investments that have come to total $100 billion. Masa’s mission: to diversify the Saudis out of oil and into surefire tech home runs.
For the past couple of years, this valuation fallacy has been playing out – on a huge scale – with private companies.
Through the venture known as the SoftBank Vision Fund, Masa has spent much of the past two years spending the Saudis’ money as quickly as he possibly can.
Putting $100 billion to work isn’t as easy as you would think… But Masa has been dutifully seeking out a portfolio of dumpster fires into which he can heave fistfuls of Saudi money, and he has found one particularly pitiful Tesla-esque dud…
It’s WeWork, a company whose business is as simple as it is unoriginal.
WeWork enters long-term leases for office space, adds desks and couches, then splits the area into smaller spaces to rent for shorter terms. WeWork profits from the difference between the cheaper long-term lease rates and the more expensive short-term rates.
It’s not a new idea. The firm IWG (formerly known as Regus) has been doing this since the 1980s. After emerging from bankruptcy in 2004, IWG now generates positive cash flows and sports a modest valuation of around $2 billion.
WeWork, though, put a spin on the old Regus plan… by pumping music through its office spaces, outfitting the offices with an “industrial chic” vibe (read: exposed wooden beams), and most important, providing free beer. No joke. Free beer.
Since its founding, WeWork has lost money at an astounding rate. Even though it has doubled its annual revenue, it manages to outspend its sales year after year.
For example, the Wall Street Journal reported WeWork’s 2017 revenue totaled $886 million, double its 2016 sales. Unfortunately, its losses also doubled to $933 million. WeWork manages to lose $2 for every $1 that comes in the door. It’s like Tesla… but for cubicles.
Since its founding, WeWork has lost money at an astounding rate. Even though it has doubled its annual revenue, it manages to outspend its sales year after year.
WeWork would argue it was investing for growth. At one point, it predicted December 2018 would be the “turning point” to profitability. Not only did WeWork miss its target…when the books closed on 2018, we learned that WeWork’s losses are growing faster than its revenue. Only the worst businesses manage to lose money at a faster rate as they grow larger.
In 2017, Masa invested $4.4 billion of the SoftBank Vision Fund into about 20% of WeWork, boosting the company’s valuation to around $20 billion.
Critics noted this is roughly 10 times the valuation of IWG, despite the fact that IWG had more than 2,000 locations and WeWork controlled a couple hundred.
To no one’s surprise, few other investors lined up to buy in at Masa’s sky-high valuation. So in June 2018, Masa began backing up the Saudis’ truck yet again – this time offering an incredible $16 billion in cash for 35% of WeWork – giving the company a valuation of around $45 billion.
A ‘state of consciousness’…
If you’re keeping score at home, a $45 billion valuation means paper profits of roughly $5 billion on the SoftBank Vision Fund’s initial $4.4 billion investment, all without a hint of movement toward profitability for WeWork. It’s the exact same scam you would’ve been running in the hypothetical real estate example we discussed above.
To their credit, the Saudis pushed back on Masa. Their main concern wasn’t just that Masa was about to dump another $16 billion of their money into a consistent money loser. Their main issue was that they had intended for Masa to make technology investments… and not glorified real estate plays.
At $47 billion, WeWork sits just behind Uber when it comes to the biggest U.S. startups.
In response, WeWork CEO Adam Neumann began playing up his company’s “techy-ness” in the press… explaining how traditional valuation methodology just doesn’t apply to the company’s innovative mix of exposed wooden beams and free kegs. As Neumann explained to the New York Times in early 2018…
To assess WeWork by conventional metrics is to miss the point. WeWork isn’t really a real estate company. It’s a state of consciousness.
A “state of consciousness”?
In January, as part of an effort to shed the “just a real estate company” image, Neumann announced the rebranding of the business as The We Company. It includes WeWork spin-offs WeLive, a residential incarnation of WeWork (that’s still real estate, Adam)… and WeGrow, a coding academy and for-profit school that promises “a curriculum that emphasizes socializing and entrepreneurship for three-year-olds on up.”
Neumann also believes the company is now in a position to execute some of his previous ambitious ideas, like a “European-style” hotel concept with shared bathrooms called WeSleep (more real estate)… something called WeBank (no details)… and WeSail (Caribbean charters).
The Saudis remained unimpressed and still passed on the second round of investments.
So instead, Masa invested $2 billion of SoftBank’s money into WeWork at a $47 billion valuation. It’s interesting to note that, when investing the Saudis’ money, Masa was willing to put up $16 billion… But on his own dime, he would only pony up $2 billion.
Either way, the $47 billion valuation – and related $5 billion in paper profits for the SoftBank Vision Fund – remained intact. At $47 billion, WeWork sits just behind Uber when it comes to the biggest U.S. startups.
Massively unprofitable
Unlike WeWork, the ride-scheduling market leader has a history of innovation… Uber’s phone-powered software that links drivers and riders solved an actual problem and revolutionized the way many Americans get around today.
But like WeWork, Uber is massively unprofitable… While its losses are narrowing, Uber still burns through nearly $2 billion
per year. Both Uber and WeWork are about 10 years old… and neither is close to profitable today.
So how does a company like Uber lose $2 billion a year and still end up trading in the private markets at nearly $70 billion – only slightly behind benchmark S&P 500 Index stalwarts like investment giant Goldman Sachs, package carrier UPS, and drugmaker Bristol-Myers Squibb?
The answer is Masayoshi Son.
You see, Masa has also been working his valuation fallacy magic with Uber…
In January 2018, Masa invested $7.7 billion of the SoftBank Vision Fund into Uber at a valuation of $48 billion. And just last month, the SoftBank Vision Fund weighed helping bolster Uber’s cash-draining self-driving unit by investing nearly $1 billion in cash at a valuation between $5 billion and $10 billion.
News service Bloomberg recently pointed out that Uber’s self-driving technology is rated as one of the worst around, according to market-research firm Navigant Research. It’s worse than the technology from French firm Navya, a company that sports a valuation of less than $70 million.
So if Masa’s SoftBank Vision Fund wants a piece of the self-driving phenomenon, why would it spend nearly $1 billion on Uber’s inferior technology? Instead, it could shell out around $70 million to buy Navya outright.
The answer, of course, is that the artificially high valuation of Uber’s self-driving technology will inflated Uber’s overall valuation, pushing it toward a $80-$90 billion target price for its IPO. (Uber ended up falling slightly short of that target, despite Masa’s best intentions.) And that’s more than twice the $45 billion valuation of Masa’s initial investment. As Bloomberg noted…
If [Masa’s Softbank Vision Fund] fronts three-quarters of the planned $1 billion, it’ll be paying $750 million but helping more than double the value of its total Uber investment [of about $9 billion].
Those three letters – “IPO” – are what take this story from funny to terrifying…
While Masa didn’t directly invest in Lyft, it has been widely reported that his generous funding of Uber led indirectly to Lyft’s rich valuation. You see, Masa’s rival – another Japanese billionaire named Hiroshi Mikitani, who founded e-commerce and Internet conglomerate Rakuten – helped to fund Lyft.
Last week, Uber went public at a valuation of $70 billion. WeWork’s IPO won’t be far behind. Even worse, Wall Street investment bankers are pushing for the SoftBank-pegged valuations. The Lyft and Uber IPOs demonstrate that Masa and other early backers could get close to those SoftBank-pegged prices.
If you think that the market is too efficient to allow this to happen, you’re wrong… Masa’s privately funded valuation fallacies are already infiltrating the New York Stock Exchange.
Uber is massively unprofitable… While its losses are narrowing, Uber still burns through nearly $2 billion per year.
Last May, Masa committed $2.5 billion in cash to car and truck giant General Motors’ (GM) self-driving division at a valuation of $12 billion. Almost immediately, GM shares shot up 20%. A Deutsche Bank analyst concluded that the business may be worth $30 billion – and GM shares could double. In other words, the public markets pinned GM’s stock to Masa’s valuation fallacy.
Now, I need to warn you… You’ve already been inundated with stories of Uber’s IPO. I’d tell you to avoid the shares, but if you’re not paying attention, you won’t be able to.
With Masa-approved valuations of $70 billion and $45 billion, respectively, both Uber and WeWork will be force-fed into dozens of the index funds that make up America’s retirement savings accounts.
Thankfully, the S&P 500 Index includes subjective criteria that will keep both Uber and WeWork out. But behemoths like the Russell 3000 Index contain no such protections.
To avoid exposure to ticking time bombs like Lyft, WeWork, and Uber, make sure you understand the indexes behind your index funds. Specifically, steer clear of the widely held Russell index funds, which indiscriminately hold all large companies. Instead, focus on indexes with qualitative and quantitative screening criteria – like the S&P 500.
Without taking these simple precautions, Lyft, Uber, and WeWork will almost certainly be making their way to a retirement account near you. It’s a scary proposition… because Ben Graham was right… eventually, the markets will figure things out. In turn, shares of these companies will tank.
Remember… the last time Masa went all-in on technology companies, he personally lost $70 billion. If you’re not careful, this time it could be you left holding the bag.
Bryan Beach is a former “Big Four” auditor and a CPA who holds bachelor’s and master’s degrees in Business and Accounting. He spent six years in public accounting, and then a number of years as a controller and director of publicly held software companies. Today, he is the editor and analyst of an advisory service focused on small-cap value investing.
