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The Fed Is Not Invincible

U.S. 100 Dollar Bill

The basic idea behind “Don’t fight the Fed” is that you should buy stocks when the Federal Reserve is “easing” (keeping monetary conditions loose).

And this has been fantastic advice for the last decade. We’ve been in one of the longest sustained periods of easy money in history. The stock market has gone almost straight up.

Now some people are starting to say this situation can last… forever. For example, Bob Prince, one of the top executives at Bridgewater (the biggest hedge fund in the world), was recently interviewed at the World Economic Forum in Davos, Switzerland. When discussing how the Federal Reserve tried to hike rates in late 2018, failed and reversed course, Prince said the following (emphasis mine):

But I think lessons were learned from that and I think it was really a marker that we’ve probably seen the end of the boom-bust cycle.

So he’s saying the Fed “learned” that if it tries to raise interest rates, the market goes down. So it’s not going to raise rates… ever? And Prince appears to think that this means the boom can continue indefinitely. He’s caught up in the bubble… but he may be onto something here.

Bull markets can’t go on forever, of course. But history shows us that they can go up sharply before they crash.

The 1998 Example

In the mid-to-late 1990s, the U.S. stock market was on a historic run. Tech stocks were starting to go “parabolic” (straight up).

Yet by the fall of 1998, economic growth was starting to top out. To get things going again, the Federal Reserve shocked everyone by lowering interest rates three times in a few short months. Here’s CNN reporting about the second cut in October 1998 (emphasis mine):

The move, the second time the Fed has cut rates in less than three weeks, shocked investors, sending U.S. stock and bond markets soaring…

As news of the rate cut hit the floor of the New York Stock Exchange, traders actually cheered and investors rushed to buy stocks and bonds.

The Dow Jones industrial average surged more than 330 points to 8299, the third-largest one-day point gain in history. Bond markets also rallied with the benchmark 30-year Treasury issue surging 1-1/32 in price to 108-9/32.

In October 1998, the Nasdaq index traded as low as 1,300. When the index peaked in March 2000, the Nasdaq traded at more than 5,000.

Call and Response

So, yes, the Fed is juicing the market higher. And judging from history, this bull market could go on for quite a bit longer. But in the very long run, prices are likely to drop dramatically. Don’t buy into this theory that the market can go up forever. It never does.

Stocks can, however, go up a long time. So if you’re trying to time the U.S. markets, I recommend holding and using a stop loss of 25% or so.

Whenever the market does crash, the Fed will likely respond with even more force, printing more money and lowering rates even more.

It’s a printing megacycle. And eventually, I think it will cause serious inflation. I’m confident this is how we will get rid of our debt problem. Paying it off responsibly isn’t even an option. (I wrote more on that here.)

Inflation will run rampant, but it’ll be disguised by “gains” in things like the stock market.

The boom-bust cycle will be alive and well. It will just be in a slightly unique form.

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2020 Will See a Surge of Accredited Investors

Open Door

“Big Brother” seems to follow me wherever I go.

Even when I go halfway around the world.

In the 1990s, I ventured off to Southeast Asia to run a trading company. And there was an unapologetic paternalism among the wealthy and highly educated.

While most Asian countries held elections, the majority of them were limited, highly stage-managed and often fixed. Dictatorships were common and accepted. Benign ones ruled in Malaysia, Thailand and Singapore. And not-so-benign ones lorded over the population in Myanmar, Cambodia, the Philippines and elsewhere.

In Indonesia, where my Asian headquarters was, the government was as ruthless as it was corrupt. But its pro-Western leanings and anti-terrorist policies allowed it to carry on relatively free of censure from Western watchdog agencies.

Almost all my business associates defended local authoritarianism. They said the population was too poor and uneducated to be trusted with something as important as electing a head of government.

Of course, this wasn’t just an Asian mindset. It existed (and still does exist) everywhere. I disliked it and argued against it in Asia. And I dislike it even more when I come across it here in the U.S…

Which I do every day.

That’s because I ply my trade in the startup space. And according to the U.S. government, the startup space is a dangerous place. So dangerous that the government has banned the vast majority of people from investing in hundreds of startups that raise money from accredited investors every year.

And accredited investors qualify as such solely on the basis of their wealth. Accredited investors must make at least $200,000 (or $300,000 with a spouse). Or they have to show a net worth of at least $1 million (not including their primary home).

Being an accredited investor allows you to invest in companies raising under Rule 506(c) and 506(b) exemptions. And that’s critical to how much money you can make from your equity investments. It’s the difference between investing in companies with enormous upside and being walled off from them.

The current definition of accredited investor allows around 10 million U.S. households to invest in these types of deals. That’s roughly 8% of households. But it’s not the numbers I have a problem with. It’s the idea that wealth and only wealth should determine access to opportunities that have incredible upside and whose risk factors can be managed. (If you’re curious about how to manage your risk, we’ve written dozens of articles on the topic.)

For the past three years, the Securities and Exchange Commission (SEC) has flirted with the idea of broadening this definition. So far, it’s been a lot of talk and procrastination. The SEC has written reports, formed committees, asked for feedback from the public and completed studies based on these reports and the feedback they generated. Frankly, I was losing hope that anything would happen in my lifetime (or my children’s).

But this long and winding road is finally coming to an end. The SEC, believe it or not, is in the final stages of expanding accredited investor qualifications.

The SEC began its latest round of activity last June. It (once again!) solicited comments from the public on ways to improve the accredited investor definition. Suggestions came in both for and against expanding the definition. After it reviewed the comments, the SEC issued a 153-page report proposing to expand current qualifications, including two categories NOT related to wealth:

  • Individuals holding certain educational or professional certifications (which will most likely include Series 7, 65 and 82 licenses)
  • Individuals constituting “knowledgeable employees” of certain kinds of private funds (as it relates to investing in such funds).

Just accounting for the above professional certifications would give an additional 691,000 individuals the right to invest in 506(c) startups, says the SEC. That’s a decent boost. But the numbers really start to get big with the SEC’s other proposed changes.

It wants to add several new categories of institutional investors, including…

  • Registered investment advisors
  • Rural business investment companies
  • Limited liability companies having total assets exceeding $5 million (and were not formed for the purpose of acquiring the subject offered securities)
  • Entities directly owned by individuals who qualify as accredited investors, or indirectly owned by another entity comprised of equity owners who qualify as accredited investors
  • Entities owning investments in excess of $5 million (and were not formed for the purpose of acquiring the subject offered securities)
  • Family offices or family clients having at least $5 million in assets under management (and were not formed for the purpose of acquiring the subject offered securities) and whose prospective investments are managed by “a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.”

Family offices alone manage more than $1.2 trillion in assets. And labor unions alone hold a significant portion of the estimated $9.8 trillion in assets under U.S. pension and benefit plans. Other entities that would become eligible under the new rules include Native American tribes, sovereign wealth funds, 529 educational savings plans and other governmental (and quasi-governmental) bodies that hold trillions and perhaps tens of trillions of dollars.

So if approved, this expanded definition will transform the startup space virtually overnight. At the very least, it will set the stage for early-stage startup investing to go from being worth tens of millions of dollars to hundreds of millions (and perhaps trillions) of dollars.

The proposed changes are still in the 60-day comment period, which ends in mid-March. Interestingly, current comments push back more against expanding individual investor rights… and much less against expanding certain investor entity rights. So the more impactful of the proposed rules stand the best chance of being approved.

That said, I’d be extremely disappointed if more individuals aren’t granted access to startup investing opportunities. This updated definition would be the SEC’s biggest reform to the startup investing space since mid-2015, when new Reg A+ crowdfunding rules were announced. Institutional investors shouldn’t be the only ones that benefit.

Current deal flow raising under 506(c) is absolutely top quality. Meanwhile, the long-in-the-tooth bull run has made many public companies poor investment bets. Public market risk has never been greater. So there’s no better time than RIGHT NOW to allow everyday investors to diversify away from the overpriced public stock markets to startups brimming with upside.

The SEC needs to do the right thing. And 2020 is the year to do it.

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Podcasts That Expand Your Investment Horizons

Wearing headphones on Computer

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The Problem With Ratchet Terms

Businessman Protected

Three summers ago, my brother took me to one of his favorite bars in New York. (He worked for a hedge fund at the time.) Later that evening, there would be live music and a large raucous crowd. Conversation would be impossible. But while it was relatively quiet, my brother discussed a recent investment proposal he turned down.

It was brought to him by a startup that’s now a household name. It wasn’t a well-known company back then. But everyone in the startup investing business knew about it. And everyone wanted a piece of this startup – except for my brother.

His problem wasn’t the company’s founders, growth or business model. It was the investment terms.

“I wanted ratchet terms. And they said no,” he told me.

He said that while the company might do great in the public market, he didn’t have to take that risk. “If I can’t get ratchet concessions from this company, I’ll get it from another really great startup.”

The Problem With Ratchet Terms

Ratchet terms can include senior liquidation preferences – meaning investors with those preferences get paid first if a company gets sold or goes under – and the right to block an IPO. They can also guarantee a minimum price on shares in an IPO that avoids a loss. So let’s say an investor paid $10 per share for a 5% stake and IPO shares were issued at $8 per share. Investors have the right to convert their current shares to $8 per share, increasing the shares they own by 25% to maintain their 5% stake.

But why the heck would a startup agree to essentially pay back investors hundreds of thousands of dollars from its own coffers to make good on any losses incurred in an IPO? That’s not how investments in anything are supposed to work. Investing requires risk. Investors make money as a reward for taking on risk. Even investing in government bonds involves a measure of risk.

It’s a simple equation. The more risk you take on, the greater your potential return should be. If investors are not taking on risk but still expect super-high returns, something else must be going on.

In this case, the quid pro quo is not between risk and reward. It’s between risk and valuation. To get a higher valuation, founders are granting either risk-reduced or risk-free investments.

And with the investing environment reeling from the post-IPO underperformance of WeWork and others, I expect this risk aversion to increase. And that means concessionary terms could once more be on the rise. A survey by the law firm Fenwick & West around the time when WeWork’s IPO plan unraveled shows a mixed picture…

Unicorn Investors Seek More Safeguards

There’s a sharp increase in senior liquidation preferences from Series D investors, but a decline for Series B and Series E. Series C is flat. This is surprising for two reasons: One, that concessionary terms have migrated down the funnel to Series D, which is not considered late stage. It’s more mid-stage, also called growth stage. And two, that Series E is NOT showing an increase in these terms.

Over the past four months, every SoftBank-led funding discussion for late-stage and mid-stage startups has involved tougher terms, according to a person familiar with these discussions.

So I’ll be shocked if Series E and all the rounds that follow it don’t show a big increase in senior liquidation and other ratchet terms this year.

I’ll also be following Series C and D trends closely. Will ratchet terms continue to rise for Series D investors? And will they begin to increase in rounds as early as Series C (or even Series B)?

A Rigged Game

Ratchet terms are not right. In fact, they stink. And that’s exactly what I told my brother. He disagreed, of course.

My brother said ratchet terms benefit everyone. Founders get the valuation they want. Investors get the risk they’re comfortable with. Capital keeps flowing. And everybody wins.

But that’s not quite the case. Protection for mid- and late-stage investors comes at a price, especially when startups are bought out at less than stellar prices. What happens, for instance, when a company with $400 million of liquidation preferences gets bought out for $600 million? Investors with ratchet terms get their guaranteed cut. But all the other investors are left with little to show for their “unprotected” investments.

That might even include very early investors who take on the most risk and, therefore, deserve the biggest gains.

Ratchet terms turn startup investing into a rigged game favoring deep-pocketed institutional investors. Sorry, bro, but this practice needs to end immediately.

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A Shift in Private Markets

Money Tree Drought

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Startup Investing Master Class: How to Bag a Unicorn

Startup Insider Master Class

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Are Stocks Divorced From Fundamentals?

Stock Market Trading Chart

The last 18 months have been a crazy period for the U.S. stock markets.

In the second half of 2018, it looked like we were going into a sustained interest rate tightening cycle. The Fed had interest rates on autopilot, and they kept going higher.

The markets weren’t happy about it. In November 2018, I wrote the following:

If equity and real estate markets get hit hard – which will probably happen if rates get back to 5% – everyone will be begging the Fed to lower rates and eventually restart quantitative easing. CNBC’s Jim Cramer is already screaming at the Fed to pause rate hikes so stocks don’t go down. So is President Trump.

Then, December 2018 was the worst December ever. Stocks declined 20% from peak to trough. Tech giants were hit especially hard. Apple shares dropped from more than $200 into the $140s.

The bear market didn’t last long. In January 2019, the Federal Reserve announced it was “pausing” interest rate hikes. I wrote the following around that time:

The Fed has the power to juice markets higher at the press of a button (using lower interest rates and bond buying), and it has become intoxicated by that power.

Whenever the stock market declines, the Fed lowers interest rates, or even buys bonds to dramatically increase liquidity and keep rates low.

Coincidentally, U.S. stocks bottomed around this period and raced higher.

The Fed wound up cutting interest rates three times in 2019. The market continued higher, and we continue to hit new records today. Apple shares now trade at more than $300, valuing the company at $1.4 trillion. The S&P 500 ended 2019 with an impressive 31.5% performance for 2019.

Disconnected?

Unfortunately, it appears U.S. stocks have gotten well ahead of fundamentals. For most of the time since the 1950s, corporate profits and stocks have been closely correlated.

There are two big exceptions: the 2000 tech bubble and today. It sure looks like stocks got ahead of fundamental profits in both these cases.

So I’d say that stock prices are somewhat divorced from reality today.

The big question is this: How long will this bull market last? My guess is that it will go on longer than many of us would expect.

Central banks can have incredibly powerful effects on stock markets. When they cause artificially low rates, as most central banks do today, the yield on bonds goes down. Therefore, the yield on stocks looks more attractive by comparison.

So if low interest rates continue (and I expect them to), stocks could remain more expensive than usual for a long time.

And if the Fed keeps pumping liquidity into the system through repo (repurchase agreements) and other bond purchases, it could send prices even higher.

The key factor I’m watching is stock buybacks. Companies buying back their own stock is the primary driver of share purchases today. These buybacks are starting to slow, and if this trend continues, the bull market could be in trouble.

Overall, I remain cautious on U.S. markets. I think shares are expensive, but they could get more so. So I’m definitely not shorting.

But I’m not buying U.S. stocks either. I’ll continue to put money into emerging markets, which are finally starting to pick up steam. Emerging markets have underperformed severely over the past decade, and I think we’re close to a reversal in this trend.

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SoftBank Is No Longer Getting a Pass

Tokyo, Japan - SoftBank

WeWork was one of the biggest debacles of 2019. It was on the verge of IPOing at a $47 billion valuation as a high-flying tech startup oozing with untapped upside.

Instead, investors saw a flawed and poorly executed real estate play.

Its valuation plunged by $40 billion… all the way down to $7 billion. And that was its best-case scenario.

If not for the bailout from its biggest investor, SoftBank, WeWork would probably have gone under. And its overpriced real estate holdings would have been sold off for pennies on the dollar.

That didn’t happen. Still, WeWork should have served as a hard lesson for its biggest investor, SoftBank. Its $100 billion Vision Fund reported an operating loss of $8.9 billion in October related to WeWork and Uber. (It’s about $500 million underwater on its Uber investment alone.)

SoftBank’s CEO, Masayoshi Son, even muttered words of repentance in the wake of the bailout. He promised to be more discerning. SoftBank would give greater weight to a company’s ability to show profits at some foreseeable point in the not-too-distant future, he said.

You’d think this is Investing 101. But not in startup land. The bottom line takes a back seat to the more valued imperative of super-fast growth. The idea is to become a dominant player through the sheer size of one’s operations, sales and customer base. Not making a profit is tolerated. Actually, it’s often encouraged.

And hypergrowth takes money… lots and lots of money. SoftBank may not be great at choosing superior companies, but it does have deep pockets. For better or for worse, the $100 million (or more!) checks it writes fit perfectly into the startup investing handbook’s core idea of growth above all.

In most cases, it’s for worse.

I wrote about SoftBank’s problematic approach in July 2018. And in the wake of the poor post-IPO performances of Uber, Snap, Tesla and a dozen other startups, I feel more strongly than ever about this.

Handing enormous sums of money to startups that haven’t quite figured things out yet and then telling them to go crazy and break things is one of the stupidest things I’ve come across.

If too much power corrupts (something I absolutely believe in), too much money is just as corrosive. It makes founders and CEOs sloppy. They try things with a low chance of success because, unlike bootstrapping companies, they can.

I take the opposite view of SoftBank’s philosophy: Failure is a luxury that no startup should be able to afford.

Empty Promises

2019 was not a good year for SoftBank. The downside of its investing philosophy was exposed in a big way.

But there was a potential silver lining to all this bad news. SoftBank could have emerged as a humbler investor, with a keener understanding of the limits of what big money can accomplish.

Unfortunately, that didn’t happen.

While SoftBank was declaring a new attitude late last year, it was also making a number of big investments. SoftBank wrote big checks for Indian financial technology startup Paytm and Chinese real estate tech company Beike Finance. It also participated in six other mega-rounds of more than $100 million, according to PitchBook data.

So much for turning over a new leaf.

Son keeps doing this because he seeks the biggest returns startups can give. The billion-dollar exits that many venture capital companies go after are below the minimum that SoftBank seeks. It wants multibillion-dollar exits.

And conquering these huge global markets takes loads of money.

But SoftBank’s big money cannon approach doesn’t work nearly as well as it thinks it does. And there’s a growing perception that it doesn’t work, period. Its second Vision Fund has raised a measly $2 billion to date. The two sovereign wealth funds that contributed nearly half of the original Vision Fund – Saudi Arabia’s Public Investment Fund and Abu Dhabi’s Mubadala Investment – have yet to commit to the new fund.

Son’s investing philosophy is no longer getting a free pass. In light of recent events, another point of view has emerged… that bigger doesn’t mean better. And a big vision backed by big money does not guarantee big success.

The startup investing world is moving on. Son’s vision of multiple $100 billion Vision Funds is dead in the water.

Thankfully, his first Vision Fund will also be his last of that size.

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How to Get the Most Out of Your AngelList Account

Saving Coins in a Jar

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ei

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