"Illiquidity Is The New Leverage And Flows Are More Important Than Fundamentals" - Eric Peters, CIO, One River Asset Management
Tulip mania.
The tulip mania in 1634 remains one of the most classic examples of how a frenzied rush can lead to exorbitant pricing. Tulips were something that was fashionable, and people pay for fashion.
"It was unimaginable to most people that something as common as a flower could be worth so much more money than most people earned in a year." - Anne Goldar, Tulipmania
When the hype ended, prices came crashing down and thousands lost their money.
It is not about whether the tulips were indeed valuable but the simple existence of flow, the flow of capital and goods - a willing buyer and a willing seller on both ends of the transaction.
Initial public offerings.
The holy grail of PE/VC funds, early stage investors and founders of companies.
Statistical studies have shown that the presence of cornerstone investors supports higher valuation multiples at IPO launch and sends an important signal to the rest of the market about the credibility of the issuer.
Very often, the retail tranche of these offerings tend to be oversubscribed, and upon listing, typically drives up the share prices further in the secondary market.
Hence a key unspoken difference in the way pitch books are being crafted by the ECM and M&A teams in investment banks:
A generic M&A pitch book is carefully curated, well thought through and systematic. It includes meticulously calculated financial data of the target company, possible synergies, the sale process, negotiation strategy and a range of prices in which the outgoing shareholders or prospective buyers are likely to accept.
An IPO deck is usually a storytelling process revolving around thematic information and capital flows, for example, what have the largest institutional investors been buying? Where in the world are investors putting their money over the next 12 months? What are the most attractive industry sectors right now? How big of a check are they writing? In banking jargon: Investor targeting.
For the company going public, all that shareholders are really interested in is whether the deal will go through.
A lot of institutional demand for a company's shares hinges on the 'flow quality' of a company's shares. This effectively translates to two things: (i) a sizeable public float and (ii) a large enough daily trading volume, oftentimes prioritised over profitability.
Because every institutional PM knows that regardless of how solid your revenue and profits are, they want the comfort knowing that they will be able to sell down their stake in the shortest possible time, just in case you f*&k up on the fundamentals.
Flows are critical because they can happen very quickly, whereas fundamentals can be slightly more complex to appreciate, they take a little more information spoon-feeding and time to digest.
Lehman Brothers.
At the peak of the financial crisis in 2008, Lehman Brothers had raised USD 11.9 billion of capital, an amount that apparently "more than offsets the impact of write downs", and the firm had one of the lowest leverage ever in its history of being a public listed company. Even in those tumultuous times, S&P even gave and stood by its 'A' rating.
But when KDB eventually terminated talks of a potential investment in the troubled firm, the shares tanked.
The downfall of Lehman Brothers was in a large part due to money flowing out faster than it was coming in, as with its clients and staff.
SVB.
The case of Silicon Valley Bank was a classic mis-step in asset-liability mismatch. Don't borrow 'fast moving money' to invest in slow-moving' money.
The firm made some bad calls involving the forced liquidation of long-dated government securities leading to asset write downs, but the real nail in the coffin was due to the fact that many of its clients had pulled their money from the bank accounts at digital speed.
CASA in banks are extremely short-term liabilities (effectively customer deposits) that can vanish quickly and significantly deplete a bank's cash position in a very short period of time. This was exacerbated with the rise of internet banking.
While cost of deposits might appear cheap, deploying these relatively short-term funds and putting it to work in long-term investments was an obvious recipe for trouble, no matter how stable you think those long-term investments are. In SVB's case, these were risk-free government securities.
Everyone in finance knows that the value of fixed-income investments goes down when interest rates go up.
So it ended up as a double whammy: No one had expected the sudden account withdrawals. Just as no one expected the Fed to increase interest rates ten-fold within a year in its unrelenting fight against inflation.
SVB could have held those long-term securities to maturity and not lose a single cent, no need for asset write downs, no need for panic.
But the inevitable still happened and it all came down to capital flows.
COVID-19.
One of the key issues about the COVID-19 pandemic wasn’t just about the high mortality rate.
Thousands of people young and old die from flu and pneumonia on a daily basis. Sure enough, cities and governments had to shutter their borders to put the spread of the virus under control.
But a bigger issue was also the fact that many countries weren’t equipped to handle the large number of cases. It wasn’t just about keeping people alive or having sufficient beds and ventilators. It was also about the fact that there are only so many doctors and nurses at any given point of time.
You can install top-quality healthcare amenities, bring in the best doctors and nurses and invest in state-of-the-art technology to develop the world's most powerful vaccine. But the system ain't shock-proof and just isn't designed to accommodate a scenario for which everyone visits the clinics or the hospitals at the same time.
The flow of people will simply overwhelm any resources we have in place and cause our existing infrastructure to collapse.
In the banking business, you can have the best relationship managers, the strictest compliance, the most bullet-proof risk management, excellent capital adequacy and a healthy net interest margin.
But you can still go out of business if an abnormally large number of customers decide to take their money out, all at the same time. We conveniently assume that no one will really do this.
Despite being robust and sophisticated, our banking ecosystem, capital markets, and state of our healthcare infrastructure just isn’t designed to handle extremities on any level.
When it comes to decision making, scientific reasoning can only go as far as the human mind can comprehend and accept.
For example, academic wisdom tells us to invest if the net present value of a project is more than zero. And we can always mathematically compute the value of a company based on future cash flows, but we still fall back on comparing IRRs across comparable companies and different industries to determine if we are getting a good deal on the table. Despite extensive research and studies in the area of finance, valuation in the real world is mostly driven by market comparison.
We also subscribe to the concept of risk-reward trade-offs i.e. if you buy something on the cheap, expect a higher chance of something not going according to plan. And if it does work out, expect a huge payout. But some times the world works in very funny ways: You can pay a lot for something just because you think the risks are low, and still lose everything to a tail event.
Also, valuation multiples say something about the correlation between the value of a business and its profits i.e. higher profits translates to higher value. Yet, trivially applying this to companies with low profitability can sometimes result in abnormally high or low multiples simply because sometimes the markets take a slightly longer time to appreciate the meaning of those profits.
Banking and investing is all about flows. The most highly paid investment bankers aren't the ones who provided the most astute advice to corporate stakeholders, neither are they rewarded based on the outcome of those deals. They are rewarded based on the size of transactions closed. Investment banking is a flows business.
Fundraising in the Southeast venture capital space hit a high of $2 billion in 2019, 75% more than 2018. No surprise that in that same period, the region was also coined as the "next tech battleground" for many large corporates, especially Chinese companies.
The tech unicorns (billion-dollar companies on paper) that emerged was no doubt largely credited to significantly huge flows of capital into the region. Whatever happened to fundamentals?
There isn't an exact figure, but it won't be surprising to know that even a large number of the most well-funded startups are losing money. Startup companies are meant to sacrifice profits in the short term for long-term gains.
I'm not saying these companies are lousy. It's just that in the real world, the flows often do not always reflect the fundamentals. It's important to have enough "stupid money" in the system. Regardless of how badly or well a company is doing, valuation always needs to be supported by flows in the capital markets.
“You can fight that trend, and invest in companies, for instance that are deeply undervalued and mismanaged – and some people are successful investing in the dregs – but very few over the long term. To use a whitewater kayaking analogy, freshwater seeks salt water, and you can fight that if you want, but paddling upstream eventually is likely to become highly problematic.” - Ron Maciver