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Buybacks Are Bad for Shareholders

My old nemesis SoftBank was in the news today. Thanks to some big bets paying off in its $100 billion Vision Fund, it posted a record $46 billion profit for the last fiscal year.

I’m not impressed. In fact, I’ve never been a big fan of SoftBank’s Vision Fund. I’ve written a lot about why I don’t like the fund’s investing philosophy (click here and here to read some of my past articles).

And now I have a new reason to dislike SoftBank even more. In the face of flat income growth — it was actually in the red for 2020 — the company resorted to a huge buyback program. It bought some $23 billion of its own shares back. And because of that, SoftBank’s stock price rose 43% over the past 12 months.

To tell you how buybacks work, I need to explain earnings per share (EPS) first. It’s a key metric used to evaluate a company’s performance. EPS is the company’s net income divided by its total number of outstanding shares. EPS goes up when net income rises. It can also go up when the number of shares decreases. Because buybacks reduce the number of outstanding shares, they’re a quick and easy way to artificially push EPS up. 

Buybacks Are a Sign of Stagnant Growth

Companies have three basic choices for how to use their cash. 

  • They can reinvest it back into themselves to stimulate growth — which is what companies with healthy growth prospects do. 
  • They can give it back to shareholders in the form of a dividend. This is often the choice of slow/no-growth companies. 
  • Or they can use it to buy back their own shares as a “riskless” way to push up EPS and drive demand for their shares when income is flat. 

A company unwilling to invest in its own growth is a company that will eventually stop growing. Using buybacks to inflate stock prices is not sustainable.

Nor is it capital efficient. The Nasdaq is currently at or near the most expensive levels seen in recent history. Companies engaging in buybacks are going after very high-priced shares. Buying back shares when they’re cheap is one thing. Buying them at these inflated prices is short-term thinking at its worst. 

Companies are also inviting risk through buybacks. It’s not a matter of if but when. 

A couple of bad consecutive quarters would bring their share prices back to earth and shrink their cash reserves. If companies are determined to do buybacks, they should initiate them when shares are crashing. That way they’re able to buy back more shares with less money. That’s a much more tolerable approach to buybacks.

But alas, scores of companies are set to follow SoftBank’s example. U.S. companies announced $484 billion in share buybacks in the first four months of this year. According to Goldman Sachs, it’s the highest total in at least two decades. And the firm projects that share buybacks by companies will increase 35% from 2020 to this year. 

Shareholders Suffer

Companies claim their buyback programs are a great way to reward shareholders. Higher share prices benefit investors in a very real and direct way, they say. 

What they don’t say is buybacks reward CEOs and C-suite executives even more. They get huge bonuses for achieving higher share prices. Many also get bonuses for achieving higher earnings per share. And as I just illustrated, EPS is easy to manipulate.

Buybacks favor the immediate term at the expense of the long term. I view them as self-interested, bearish and dangerously risky. The CEOs who approve them show little faith in the company’s ability to grow at a pace that would impress investors and spur demand for its shares. 

I’m not particularly surprised that SoftBank committed to the move. But it makes me nervous that Apple, Amazon, Alphabet, JPMorgan and a host of other companies are following suit. 

CEOs are gaming the system. They are using buybacks to conjure financial rewards without any real commitment to growing the company. Shareholders are, in effect, investing in fake growth. 

If I were you, I’d take the money and run. Or better yet, put it in startups. They offer real high growth investment opportunities. And startups mostly stay away from buybacks. Every now and then, I’ll see a company promoting a form of buyback as part of an offering. But they’re outliers. And that should continue to be the case. 

Today’s “buyback bonanza” will be tomorrow’s day of reckoning. CEOs will have banked their big bonuses. And as usual with market manipulation, it’s the shareholders who will suffer the most. 

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When Is a High Valuation Worth It?

In recent months, I’ve talked a lot about how expensive some startup rounds are becoming. 

That doesn’t mean you should avoid every round that looks expensive at first glance. Sometimes startup investments seem expensive when they are actually more than fair. 

AngelList co-founder Naval Ravikant explains this concept succinctly. 

There’s also the Peter Thiel rule: When a company’s valuation climbs rapidly between rounds, that should attract you, rather than scare you off, because humans are bad at calculating nonlinearities. That’s true as long as a credible or top-tier investor leads the round. 

When you see a company’s valuation go up 5x in nine months, you might automatically think it’s overpriced. But that’s because your brain can’t handle the fact that a company might actually grow 10x in nine months.

When a startup is growing at a pace of 10x a year, it’s naturally going to have a higher  valuation. Sometimes you see companies that raised at $10 million a year ago and are now raising at a $150 million valuation. But that doesn’t necessarily mean it’s a deal you should automatically pass on.

However, interpreting this “Peter Thiel” rule gets tricky during bubbly times like we are experiencing now. It can be hard to tell the outrageously expensive deals from the reasonably priced ones right now.

In these situations, I like to look at the company’s revenue trend. Does it have a clear path to $100 million or more in sales? Is the model scalable? Also, who else is investing in the round? If it’s a bunch of brand new VC firms, that might be a signal to steer clear. If it’s an experienced group of investors and the valuation can be justified, then it may be worth investing in.

As I said, it’s a tricky balancing act. Ultimately, I go with my gut. For me, that means I won’t be investing in companies with $1 million revenue at a $150 million valuation. I can’t make that math work in my head. But if the company is growing rapidly with $1 million sales in the last year and showing 40%-to-50% monthly growth, that is certainly worth a premium. Ultimately, it’s up to each of us to decide if the deal is worthy of investment. 

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Government Spending Means Investors Should Seek Hedges

This week I came across a statistic that shocked me. It turns out that 34% of all US income currently comes from the government. Here’s a chart from an article on ZeroHedge showing the rise of government “transfer payments” to citizens.

Government Transfer Payments as % of Total Income

I just can’t believe that more than a third of the entire nation’s income is currently dependent on the federal government. That number includes stimulus checks, unemployment benefits, welfare, social security, etc.

Many people think that once the COVID-19 crisis is over, things will return to normal. But I don’t think so. Back in the 1960s, only around 7% of all income came from the government. That figure had grown to around 17% before this most recent crisis began. The pandemic merely accelerated a trend that was already in place.

Once a government benefit is in place, it’s very difficult to cancel it. We seem destined to enact “universal basic income,” where everyone gets a monthly stipend.

Workers Not Rejoining The Workforce

One of the most troubling aspects of all of this is the unintended consequences. When you give people just enough money to get by, there’s the risk that some of them will lose their motivation to work. What’s the point in working when you can collect almost the same paycheck by not working? 

Now that the crisis is winding down and many are vaccinated, companies are having trouble hiring. Bloomberg just ran a feature article about this “Job Paradox.” Here’s an excerpt talking about how some economists view the situation.

…the labor force participation rate remains well below pre-pandemic levels…

And anyone who previously made less than $32,000 per year is better off financially in the near term receiving unemployment benefits, according to economists at Bank of America.

Other reasons for people not returning to work include looking for jobs with benefits and jobs with a guaranteed number of minimum hours. Needless to say, I am extremely sympathetic to all the people put out of work by COVID-19. It’s an awful thing, and we do need to support these people until they can return to work. I am, however, also concerned about the direction we’re headed with all of this. 

We’re going to have to print money to pay for all these programs — and that doesn’t happen without consequences. I think we’re likely to see stagflation (slow growth and high inflation) that could last a while. 

I don’t really see any way to avoid what’s coming. More spending, more debt, more inflation. This, in short, is why investors need hedges.

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Don’t Count On More Explosive Growth in Remote Work

I just returned to the office this week. It was a strange thing. 

Before working at home during the past year, I spent most of my 40-year career in offices. And I’ve missed the water-cooler chats… the unstructured interaction with my fellow employees… going out to lunch with them. I even missed the spontaneous mini-meetings, where someone would plop down on a chair in my office to discuss an issue that needed resolving. 

My back-to-the-office experience this week was strange because it offered both the familiar and unfamiliar. I’m now working with just a couple of my colleagues in a remote office. It isn’t work-from-home. But it isn’t quite the office experience I was used to either. 

While I’m happy to be back in an office, employees and bosses have a wide range of opinions on the subject of work-from-home. JPMorgan Chase’s CEO Jamie Dimon and Goldman Sachs David Solomon are both looking forward to putting Zoom calls and a  remote workforce behind them. Netflix co-founder and co-CEO Reed Hastings couldn’t agree more. He doesn’t “see any positives” to remote work.  

Other tech companies have taken a more flexible view. Facebook and Twitter have put in place permanent remote working plans. Stripe has launched a “remote engineering hub” to support its remote workers. According to CTO David Singleton, the hub will help Stripe tap into “the 99.74% of talented engineers living outside the metro areas of our first four hubs.” 

For startup investors, what a post-pandemic workplace looks like is more than idle curiosity. More and more startups are getting into the business of helping other companies build distributed teams, create shared workspaces, capture and support new customers and manage new recruitment, onboarding and HR practices designed for a remote workforce.

What does the future hold for them? And what does it hold for companies supporting and servicing remote and/or hybrid conferences and virtual events? Here are my thoughts.

  • It’s a hybrid world. Even before the pandemic hit, a growing portion of the workforce was working remotely. Now there are dozens more tools available to help manage a remote workforce. 
  • Just as important, there’s a deeper understanding of the commitment that management of a remote company requires. It’s not as simple as replacing in-person meetings with Zoom calls. It’s taking steps organizationally and culturally to foster cohesion, work-flow inclusivity, clarity and productivity. Without this kind of commitment, companies going remote are doomed to fail.
  • But there’s a steep learning curve here. Companies that experienced market dominance with a predominantly in-person workforce will be reluctant to rethink the entire gamut of their operations and protocols. A lot of companies will simply refuse to go down the remote work path, in part because they don’t believe the benefits — while potentially significant — are worth the effort.  Other companies won’t because they don’t believe the benefits outweigh the drawbacks. This is a different calculation, based on the belief that the benefits are minor and the drawbacks are major.
  • I believe the benefits of remote work are big. Just in talent acquisition alone, it confers a huge leg-up for those companies that welcome remote workers and seek more diversification, particularly among women. 
  • But the drawbacks cannot be and should not be dismissed as “backward” thinking. The conversation I had when I sat down (in person!) with the founder of a startup a couple of weeks ago was much more informative — not to mention enjoyable — than the hundreds I had over Zoom during the past 13 months. This was not my imagination! The best parties aren’t by remote video linkup. Whether it’s fun or business, humans are built for person-to-person engagement. 

Whole businesses have been built to help remote work simulate in-person interactions. And they’ve thrived during the pandemic. But they’re also likely to face lessening demand. Many CEOs intend to bring workers back to the office, where they are seen as being more effective and productive. 

Netflix’s Reed Hastings says workers will be coming back to the office about four days a week. Top bank executives also want employees back in the office. They’re aiming for 4-to-5 days a week. 

Is it wishful thinking? Many employees have other ideas. They’ve tasted freedom. They’ve continued to do their job well (at least in their minds) while at home. There’s going to be pushback. So, who has the firepower — the employers or employees? 

There’s still a lot of people unemployed and hunting for the job that will put their life on course again. That should give an edge to employers. Yet, a recent Russell Reynolds survey of 1300 executives finds the battle for talent is growing. More than half of leaders cited the availability of key talent as one of the top factors that may impact their business in the next 12-to-18 months. This pushes the balance back towards employees, who may value the opportunity to work from home over other factors when job hunting. Dimon, Solomon and other bank executives may be forced to seek a middle ground when it comes to remote work.

I’m eschewing talk of massive business shifts and societal transformations. I think the longer-term gravitational pull will favor a return to in-office and in-person activities. And remote work will resume its pre-pandemic — healthy but not explosive — growth trajectory. 

Startups that have helped companies adapt to a remote workforce will continue to play an important role in an increasingly hybrid world. They’re operating in a growing but very competitive space. They get no extra points or demerits from me. The best will do well and thrive. 

It means, as usual, I’ll be doing my homework on these companies. 

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Focus on Traction When Investing in Startups

Traction is by far the most important signal for startup investors. That may seem obvious. But when I started out, I was more excited about investing in breakthrough technology. I often overlooked a company’s traction when I made my investment decision.

But really, there’s nothing more important than progress. How much have the founders done so far? If they haven’t done anything and are waiting to close their first round of funding, that’s an instant no from me. 

I like to see founders that do a lot with a little.  They either invest their own money, time or both and get things going immediately. Those are the type of founders you want to back.

I also want to see ongoing progress in the startups I invest in. Naturally, the best form of traction is usually revenue. But there are other metrics that are good indicators of success too. For social media startups, for example, you can track active users. Whatever the key metric for the business is, make sure the companies you invest in have made serious progress towards it. 

Of course, it’s OK to invest in a business without much traction occasionally. Sometimes you have to take long shots on opportunities with massive potential. But even if they don’t have much revenue yet, there’s always a way to judge how much progress has been made. Look at the software they’re building. Ask to see their internal dashboards and reporting. Focus on the product and how much work they’ve put into it.

I’d say that 90% of my best investments all had serious traction when I invested — like FabFitFun, Deel, Eaze, Cabify, Shipbob, Cleartax, Truepill. Even Density.io, which I invested in very early, had made a lot of progress with its tech. It didn’t have much revenue, but if you looked at the demo videos it was clear that this was a serious product. And Density.io’s early customers all had major potential to grow in size (which they did). 

So as you evaluate startup opportunities moving forward, avoid the mistakes I made and make sure to focus on traction. It’s possibly the most important characteristic for a startup investor to judge before deciding to invest in a company.

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Four Assets to Hedge Against Inflation

In April 2019, Bloomberg Businessweek magazine’s cover story asked “Is Inflation Dead?” The subtitle accompanying it was “Did Capitalism Kill Inflation?” 

I recall thinking at the time that this story was probably a contrarian indicator. It reminded me that nearly everyone in the financial world was ignoring the threat of inflation.

It also has similarities to an infamous BusinessWeek cover story from 1979 titled “The Death of Equities.” Stocks had performed miserably for a long time, and everyone was convinced that performance would continue to be horrible. But it actually marked the beginning of one of the greatest long-term bull markets.

Bloomberg Businessweek Covers

Today, inflation is starting to become more of a widespread concern. I detailed some of the latest signs in a recent article. And I recommend that all investors start hedging against the threat of inflation.

How I’m Hedged

My strategy against inflation is straightforward. There are basically four aspects to it.

  • Gold, silver and miners
  • Bitcoin
  • Foreign stocks
  • Startup investments

Let’s briefly go through each.

Gold, Silver, and Miners

I remain extremely bullish on gold and silver as well as quality companies that mine them. Realization about rising inflation is slowly setting in with some people — but most investors still have near-zero exposure to precious metals. 

As governments around the world continue to print unimaginable amounts of money and interest rates stay at rock-bottom levels, I believe demand for gold and silver as investments will soar. I think people are still underestimating the scale and length of what’s coming.

Bitcoin

Bitcoin is the only cryptocurrency I consider to be a viable inflation hedge. It’s a scarce, speculative store of value. Needless to say, it’s a lot riskier than gold and silver. But it also has much more upside. 

Bitcoin is a bet on continued reckless government spending and monetary policy. I still like that bet. See my recent article for more details on why I think bitcoin is an excellent hedge.

Foreign Stocks

If the U.S. dollar declines against foreign currencies, it may benefit investors to own stocks in foreign countries. Because the revenue of foreign companies is in a different currency, owning stock provides investors with exposure to the value of that currency. If the currency goes up against the dollar, the value of the investment will rise (approximately) the same amount. 

Startups

Startup investments have an incredible amount of upside. If you invest in a company when it’s worth $10 million and its value grows to $1 billion in five or so years, that’s quite a return. It’s one of the few asset classes that has the potential to outperform significant annual inflation. 

Needless to say, startup investing is risky. And it takes a while to get good at. So start out with small investments and be selective! I recommend going for companies with significant traction, at least at first. It’s the most reliable signal there is.

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Cultured Meat Startups Are the Trend to Watch

Heads up, meat lovers. Biden’s climate plan isn’t the biggest threat to the beef and chicken products you love so much. Neither is plant-based “fake meat.” The biggest threat to traditional meat is the “meat” being developed by new technologies right now. 

Rep. Lauren Boebert (R-Colo.) wrongly tweeted this week that “Joe Biden’s climate plan includes cutting 90 percent of red meat from our diets. They want to limit us to about four pounds a year.” 

She wasn’t the only politician raising a fuss. Rep. Marjorie Taylor Greene (R-Ga.) dubbed the commander in chief “the Hamburglar.” 

Hey, guys, there’s no meat on these bones. Their beef stems from a University of Michigan study that said if hypothetically we reduced our meat consumption by dramatic proportions, hypothetically we could lower greenhouse gas emissions on a similarly significant scale.

Limiting American’s real meat intake to four pounds a year is not on anybody’s political agenda.

But here’s something to chew on. Five years from now, you may not even care what’s “real” meat. We’re in the early stages of developing tasty alternative proteins. The space is only 7-to-10 years old. If faux-meat product companies Impossible Foods and Beyond Meat don’t do it for you, there’s plenty more alternatives nipping at their heels. 

 Cell culture is an intriguing technology that could challenge traditional meat. It allows meat “to grow” from cells obtained from animals. And the process to get the cells doesn’t kill the animals. 

Cell-cultured meat is already on grocery market shelves outside the U.S. And it’s getting close to reaching the U.S. 

There’s also academic research and startups working on sophisticated cuts of meat and chicken alternatives, as well as fish substitutes.

Some of these products are a decade or more away from commercialization. Others are right around the corner. Startup Eat Just is readying its latest product: cultured chicken (made from cultured cells). 

So is lab-grown meat real or not?

Eat Just CEO Josh Tetrick is adamant on this point. He says that as opposed to plant based, it’s real in every way. Just no chicken was killed. Eat Just’s product has been approved to sell in Singapore and is awaiting approval in the U.S. 

Another cell-based meat producer is Memphis Meats. It’s offerings include whole burgers, ready to sell to restaurants and stores right now. Memphis Meats is in discussions with the FDA and the USDA on how to “best” label its food products.

My favorite company in this space is Israeli-based Redefine Meat. I’ve been following this company for more than a year. It uses industrial 3D printing to create steaks. The “ink” is made of plant-based ingredients similar to what a cow eats. The technology fully replicates the muscle structure of beef. It is high in protein and has no cholesterol. And according to the company, it looks, cooks, feels and tastes like beef. Much to my frustration, I’ve never tasted one. But they sure look great…

An illustration of the 3D printed whole muscle cut of beef by Redefine Meat (Courtesy)

An illustration of the 3D printed whole muscle cut of beef by Redefine Meat (Courtesy)

 

Redefine Meat aims to sell its printers and cartridges to meat distributors worldwide, who will both print and distribute the meat once produced.

I believe meat lovers (including me) should rejoice at the new options hitting the market. We’re not under attack. On the contrary, startups want to please us. We’re a huge market. And a growing number of us want to eat healthier — but without giving up red meat. And with this new technology, we’ll continue to get our choice of cuts, organic meats, choose fresh or frozen, etc. None of that changes. 

But, thanks to startups, we’ll have additional optionality, choosing from an array of alternative protein foods, including ones that not only convincingly mimic meats but grow real meat. 

There are plenty of enticing startup investment opportunities here. I’m keeping a close eye on this space and will let you know if any good ones pop up.

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Use Your Personal Network for Deal Flow

Lately I’ve been spending more time looking for offline angel investments. I want to make sure that I’m not missing out on prime opportunities by focusing exclusively on online deal flow. So I’ve been reaching out to colleagues, friends and companies I’m familiar with to let them know I’m looking for great startups to invest in.

And it’s yielding positive results. I’ve only been doing this for a few weeks, but I’ve got a lead on a really great investment already. 

Our networks can be valuable sources of deal flow. Most of us know some really talented and smart people. Reach out to them, find out what they’re working on and what’s going on in their world. They may be able to point you towards opportunities that you would otherwise never hear about. And as a startup investor, finding unique deals is one of the best ways to spend your time.

Of course, I’m not investing in “pet projects” or small businesses. When I reached out to my network, I made it clear that I was looking for growth investments that can scale long-term. I recommend doing the same — just be clear about the types of companies you’re interested in and what you expect from an investment you make. It will help you avoid discussions about restaurants and other small businesses you’re trying to avoid.

There are great companies being built all around us. It just takes a network — and a little effort — to reach them. Building my personal startup investment network is going to be my project for the next few years. I’ll keep you all updated on my progress.

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Startup Insider: Medical Testing’s Golden Age

We have a special treat for you this week. Our First Stage Investor members (click here to sign up) regularly get to hear Andy Gordon and Vin Narayanan interview founders. This week, we’re releasing a very special interview they conducted Friday to the entire Early Investing community.

On Friday, Andy and Vin talked to Jonathan Cohen, the founder and CEO of 20/20 GeneSystems. Andy first presented 20/20 GeneSystems as an investment opportunity to our First Stage Investor members in 2017. In this wide-ranging discussion, Jonathan talks about why medical testing is more important (and more appreciated) than ever, how his startup is helping detect cancer early, why they decided to bring a rapid COVID-19 rest to the market, what they’ve learned from that experience, why the startup plans on being listed on StartEngine’s alternative trading system and much more.

We hope you enjoy this taste of First Stage Investor. And thanks for watching.

 

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Later-Stage Valuations Are Getting Out of Control

I’ve been invited to a few deals lately with mind-blowing valuations. I was being asked to invest in SaaS (software as a service) businesses with $1 million of revenue. They were showing about 150% growth rates. Yet they were being valued at nearly $250 million. 

This reinforces my view that we’re in the later stages of a pretty sizable bubble. 

Of course, there are still good startup deals to be found — mostly at the earlier stages. The valuations there aren’t ridiculous. And if you can find good deals outside of San Francisco, even better. 

But established Silicon Valley based software startups are almost uninvestable at this point. Sure, some will provide good returns. But at the valuations people are investing at, there’s almost no room for error. The difference between investing at a $25 million valuation and $150 million valuation is huge. And some deals I see today at $150 million would have priced at around $25 million three years ago. 

So I continue to steer clear of most later-stage deals, especially the ones at stratospheric valuations. 

To be clear, it’s often a good sign when a company’s valuation shoots up dramatically from round to round. But what I’m seeing now goes way beyond that. This is getting into bubble territory. 

The valuation bubble is even worse in the public markets. Look at the valuations of Coinbase, Snowflake, Tesla, etc. All good companies, all ridiculous valuations.

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