I don’t spend a lot of time reading academic finance papers, but there are a few that have been permanently etched into my brain. I have Chris Malloy at Harvard Business School to thank for this. His behavioral finance class ranked up there at London Business School, only to be beaten by David Yermack’s highly entertaining advanced corporate finance seminar. If you ever get a chance to study with either of these two profs, take it.
One of the best of these papers described how hedge funds rode the technology bubble. It was co-authored by Markus Brunnermeier at Princeton and Stefan Nagel, back when he was still at London Business School (he’s now at Stanford). There’s a widely accepted notion in finance that institutional investors outperform retail investors, often by trading directly against them. (There’s another good paper by John Griffin at UT-Austin that shows exactly how this played out from January 1997 to March 2000.)
Brunnermeier and Nagel’s contribution to the financial community was to show how hedge funds – the smart money in the market – who should have been shorting the technology sector and applying a correcting force to the bubble-era valuations did no such thing. Instead of acting as efficient market arbitrageurs, most of these firms fed the bubble by buying. These firms rode the market all the way up to its peak, at which point they all pretty much got out.
The data is staggering. The paper shows that smart money gets in and out at the right time, collectively, and can ride a clear asset bubble all the way up to the top, only to pull the proverbial ripcord before the market tanks. So much for efficient market theory. This, by the way, is consistent with George Soros’ theory of how reflexivity works in markets, which he outlines in a long-winded way in The Alchemy of Finance.
What made this all stick in my head is the paper underscored to me how far off valuations in the dot-com bubble were. Brunnermeier and Nagel quote another well known paper, DotCom Mania, by Eli Ofek and Matthew Richardson at NYU, writing:
Ofek and Richardson (2002) estimate that at the peak, the entire internet sector, comprising several hundred stocks, was priced as if the average future earnings growth rate across all these firms would exceed the growth rates experienced by some of the fastest growing individual firms in the past, and, at the same time, the required rate of return would be 0% for the next few decades. By almost any standard, these valuation levels are so extreme that this period appears to be another episode in the history of asset price bubbles.
Consider this for a moment as a technology investor. The market was so mispriced that that the future earnings growth exceeded the earnings growth of the fastest growing individual firms in history, and these earnings were all discounted back to present value at 0%. That’s insane. Valuations back in the bubble were downright ridiculous.
I might be going out on a limb here, but there’s no way these numbers are ever coming back. Gone are the days of software and internet companies going public, and getting to $10bn+ valuations on forward revenue multiples of 10x+ or higher (or even 5-7x+). I don’t think that’s going to happen, unless there is some kind of bubble for hedgies to ride and a bunch of retail investors who don’t know any better and are willing to be left holding the bag.
What does this mean for an early stage technology community? That’s for another post, but my fear is that unless you’re doing something incredibly strategic for one of the larger firms that lets you get out at a great multiple by having them become a buyer, or you’re riding a major growth shift or discontinuity in the market (likeGameforge, Playfish or Zynga are doing with online gaming) that lets you scale your revenue and EBITDA significantly, it’s going to be tough to build highly valuable companies. This affects investors, founders and even startup employees. The days of joining a startup, getting 10-25 basis points of ownership, and driving a Masserati four years later is going to be a lot fewer and farther between. It’s telling that since 2000, only one company has been founded with a $1bn exit to date (can anyone guess which one?). Anyone holding out for these bubble-era valuations to come back is living in an alternative reality. I don’t think this is necessarily a bad thing for entrepreneurship but this is probably all for another post. This is supposed to be about some of my favorite finance papers.
One of the funds that famously campaigned against the asset price mismatch and shorted the technology sector was Julian Robertson’s Tiger Management, which ended up closing shop as a result of this decision. There’s a saying that the market stays irrational longer than you can stay solvent. That’s exactly what happened to Tiger. Since then, Tiger has turned out to be the training ground for some of the best equity investors in the market today.
Another great paper that I came cross in a draft form back in the day was recently published, titled Best Ideas and co-authored by Harvey Cohen at Harvard Business School and Christopher Polk at the London School of Economics. Cohen and Polk show how managers who have highly concentrated portfolios, in other words demonstrating high conviction, outperform the market. It’s another arrow in the efficient market hypothesis, since if even mutual fund managers can actively outperform the market with this strategy, de facto the market isn’t efficiently priced. This paper builds on a few others that have all pointed out that managers who have high conviction, demonstrated by small, concentrated portfolios (ala Paulson or Einhorn), generate higher returns for investors.
I’ll also put a shout out to Chris’ paper that’s still forthcoming in the Journal of Finance. Sell-Side School Ties shows how social connections between investors and executive leads to higher returns, with the data in the period showing 5.40% to 6.60% of excess return. It seems obvious, but managers outperform the market when they have an educational tie to the executives of the company they are investing in. Yet another reason to go to a top-tier business school or undergraduate university if you want to be an investor. And the school that had the most links to senior executives or board directors? You guessed it. Harvard University.