On their Vitalogy album, the 1990s megaband Pearl Jam has a track titled “This is Not For You.”
It would make a good theme song for initial public offerings (IPOs), as in: When you see a hot initial public offering and feel tempted to buy it, remember: “This is not for you.”
Hot tech IPOs are liquidity events for the venture capital firms that built huge stakes for pennies on the dollar years earlier, and payday bonanzas for connected Wall Street firms that receive large share allocations at the official IPO price days before the opening bell.
The idea is that public investors — a mix of retail investors and money managers — come in on IPO day and bid the share price to nutty valuations.
This allows the big Wall Street firms and their preferred clients to cash out quickly — they were already long at the official price, prior to the opening bell, and can sell at their leisure — while the venture capital firms get paid astronomical sums after their lock-up period expires.
It’s a hugely profitable game for those with an inside track. DoorDash (DASH) and Airbnb (ABNB), two tech IPOs that hit the market last week, saw their share prices rocket higher, with ABNB more than doubling on its first day of trading.
Snowflake (SNOW), a cloud computing play that went public in September 2020, also rose more than 100% on its first trading day. Those three 2020 vintage companies — DoorDash, Airbnb, and Snowflake — are in the top 10 for the biggest IPO share price pops of all time.
Meanwhile the top three spots for first-day share price gainers — belonging to Palm Inc., Corvis Corp., and Infineon — are all from the year 2000.
In multiple ways, the IPO mania of 2020 has exceeded that of 2000:
- Bank of America Investment Research shared a chart showing a historic spike in call buying relative to put buying, calling it “the greatest call-buying frenzy since the dot-com bubble.”
- More than $50 billion has been raised in the past 11 weeks, according to research firm Dealogic, and at least $157 billion year to date — the most since the final push of the 2000 boom.
- The investor frenzy for Airbnb (ABNB) was so strong on IPO day, a robotics maker called ABB Ltd. saw its call option volume surge. Why? Because their stock ticker, ABB, was one letter away from the new Airbnb stock ticker, ABNB, and participants in the greed stampede were confused.
The eye-bulging venture capital paydays we see now are also reminiscent of the year 2000.
As an individual investor or independent money manager, it is very important to understand how the system actually works.
In order for capitalist economies to grow, new technology has to receive funding. Innovation requires investment, and sometimes wildly speculative investment, to get the ball rolling.
Fortunately, all throughout history, investors have been willing to provide the funding for technology innovation out of a greed motive. Booms and busts have been happening since time immemorial, dating at least as far back as Roman times.
The funding process is messy, and a lot of capital gets wasted. This is also a feature of how it has worked practically forever. Some hot new theme or concept takes hold, investors as a group get wildly excited, and they pour a river of capital into the new area.
Most of the capital winds up wasted or destroyed, but a vital portion of it — usually a modest percentage — winds up funding the companies that change the nation or the world.
Meanwhile, there are insiders in the business who get paid from the cycle, and they get paid every single time. They are like the guys who sell picks and shovels to gold miners in the gold rush. It doesn’t matter if most of the miners go bust. They get rich on the picks and shovels business.
Or, barring a profit from picks and shovels, the insiders make very early investments in speculative startup companies and then reap huge returns — on the order of tens of thousands to hundreds of thousands of percent — many years down the road. The huge returns, meanwhile, cover all the losses on investments that didn’t make it big.
This is why the splashy tech IPO is a major payday for two main groups, three if you count the company founders: The venture capitalists who backed the company, the company founders and early employees, and the Wall Street sales machine.
Those groups make out like bandits in IPO booms, because they are insiders who have been in the game for years.
For instance, take the venture capital firm Sequoia, the largest outside investor in Airbnb. Sequoia has been investing in Airbnb over the last nine years through various capital raising rounds. Its earliest investments, split-adjusted, have an average cost of less than one cent per share.
After the ABNB share price doubled on IPO day, the value of Sequoia’s Airbnb holdings reportedly exceeded $10 billion, with an internal rate of return on the earliest outlays as high as 7,000X. That is not a 7,000% return, that is a 7,000 multiple, which is more like 700,000%.
So, look: The technology-funding process requires investors to pour in large amounts of capital, most of which ultimately gets destroyed. The IPO process, meanwhile, happens late in the game and is meant to provide liquid riches to those who have been playing the game for years. The investor trying to buy these things at the very end is, more often than not, the sucker left holding the bag.
The reason it gets bad at the end — and the reason the dot-com bubble led to a meltdown, and the 2020 tech mania will, too — is because the valuations make no sense. The math stops working.
At a certain point in a bubble, and especially in an IPO frenzy, the math goes out the window. The prevailing attitude of those who want to participate becomes “buy me shares at any price.”
Wall Street analysts, meanwhile, then encourage the frenzy in a respectable way by reverse engineering some crazy story to justify the valuations at hand.
While the wild run-ups in DoorDash and Airbnb were mania-level impressive, the king of mania valuations might be Snowflake (SNOW), the cloud technology play that went public in September.
As of this writing, SNOW has a market cap of $100 billion on less than $500 million in revenues, while booking hundreds of millions in losses. It is hard to express how off-the-charts nuts that is.
We can do some quick math to see how crazy the SNOW valuation is:
- The super-profitable tech juggernauts — Alphabet, Apple, Facebook, Microsoft — tend to have net profit margins in the 25% range give or take, which means they make around 25 cents of profit off every dollar in revenue. (Amazon’s profit margin is consistently much lower, but that is because they reinvest in a hyper-aggressive way.)
- For Snowflake to justify its current market cap of $100 billion, it will need profits in the $3 to $5 billion range at least, which would presume a multiple of 20 times to 33 times earnings.
- The best profit margins Snowflake will ever have — absolute best case — have to be around 25%. That is what Microsoft and Google get, and what Amazon would presumably get if they weren’t reinvesting so heavily — and Microsoft, Google, and Amazon are all in direct competition with Snowflake (via the cloud business).
- This means that, to buy Snowflake at a valuation of $100 billion, you have to presume they will be able to grow their revenues by a multiple of 25 times to 40 times — 2,500% to 4,000% — and do so while swinging from big net losses to world-class profits — and do all of that while competing in the cloud against the three biggest, baddest competitors on the planet.
But wait, it gets better, or rather worse: Buying SNOW at the current price means anticipating future growth that is worth the risk, above and beyond a price that already discounts the implied outcome of this company growing sales by 25X to 40X, while earning world-class margins to boot, competing against three tech juggernauts.
It doesn’t make sense. But then again, it isn’t supposed to make sense, because this is how it works. Snowflake will eventually register a huge, gut-wrenching price decline, just like Tesla will, and heck, just like Amazon did before finding its footing (Amazon investors were down 94% at one point post-2000).
This thing — where investors lose their cool, and wind up holding the bag and paying off insiders as part of the innovation funding cycle — could practically be part of a David Attenborough nature documentary. It is the behavior of homo economicus in his natural investment habitats. It is just what investors do, over and over, with a rhythm as old as the hills of Rome:
- “Easy money” and loose credit conditions act as kindling for innovation to light a spark.
- Investors get all whipped up in a frenzy via the cheap money and hot story combination.
- Investors buy based on emotion, forget the math, and basically take leave of their senses.
- Insiders — venture capitalists, Wall Street firms, and founders — cash out hugely.
- The boom goes bust, 90% of investor capital is destroyed, and 10% is put to good use.
- Investors get burned, but insiders enjoy a huge payday and gear up for the next cycle.
- With a sufficient passing of time, investors forget how they were burned the last time.
- A decade or two later, it happens again — repeating on an endless loop for centuries.
We wouldn’t say that 2020 is exactly like the year 2000. That isn’t how it works. No two manias, and no two boom-and-bust cycles, are ever completely the same. But certain parts of the script are highly recognizable, and we know full well how this type of movie ends.