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 (like Gameforge, 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.

Like all initial acquisitions in an emerging region, the acquisition certainly validates the market. Some of the fastest growing websites, on a percentage basis, are either in Arabic or Middle East focused, primarily because the region is still catching up to the rest of the world from an internet usage perspective.

Faisal’s title is spot on – Maktoob does give hope. Entrepreneurs in the Middle East are operating in a climate that is remarkably challenging, at least from a technology and company building perspective. I know in Jordan Queen Rania and others are trying to open up the business climate; in Saudi, there is an effort to build a world-class research university that the sponsors are hoping will lead to a knowledge economy; there have been a couple of (mostly failed) attempts in Dubai during the boom era to do the same; and even Libya is getting in the mix with its NECD.

But from a venture perspective, the region has a long way to go. Twelve years leading to a ~$80m outcome is just not a great return from a venture perspective. The Arab world isn’t alone in this conundrum. Despite all the buzz around India, it’s as challenging for an early stage company targeting the domestic Indian market to grow into a large, valuable enterprise. The largest exit there is around the $500m mark, which is certainly not good, but not what investors on the venture side need to see on the largest possible outcome.

Until entrepreneurs in the region start building companies that target large, addressable markets outside the Arab world, I don’t think you’ll see really large outcomes in the region. I’ve looked at the data for GDP/capita and growth rates, and the economic fundamentals just don’t justify very valuable businesses on the early stage consumer market if the company is only targeting the Arab market. Perhaps I should share some of this data in a later post. I could be wrong here – some of the things I’ve seen in the online gaming space suggest that you can build rapidly growing companies even on the back of low GDP/capita countries, but that’s my two cents.

I wish it was different. I’ve studied Arabic for several years now, first at Stanford (poorly), then in Sana’a for a year (poorly) and most recently at London Business School (again, poorly), where I was the only student in my class to use Arabic to fulfill the school’s second language requirement. I’ve traveled throughout the Middle East, spent time in Fes at the Sacred Music Festival, backpacked through most of Jordan and Yemen, visited Jerusalem, Cairo, the Sinai, Dubai and made the pilgrimage to Mecca. To say I have an affinity for the region and language is a mild understatement.

But I’m glad to see entrepreneurs trying. I’ve heard of someone building a chip startup in Jordan, another doing the same in Egypt to commercialize some academic research around silicon that does decimal math vs binary math (which reduces the need for a pokey software translation layer that is often prone to errors in finance), and Zvi Schreiber’s G.ho.st (Global Hosted Operating System) is an interestingly ambitious project, not just because of its raw technology challenge, but also because it’s being developed jointly by Israelis and Palestinians in Ramallah and Modiin. Similar to what happened in India in the last decade, I’m starting to hear about engineers in the Bay Area think about returning home to the Mideast to build companies. A lot of these will probably be good founder-return businesses (another post) but hopefully there will be a few with broad ambitions to build global companies that might lead to good investment returns. I just think we’re still another five years away right now.

• Great investors know how to give strategic advice without being in the operating weeds of a company
• Great investors get to know whole management teams, not just CEOs — in fact, great investors become part of the extended management team of their portfolio companies
• Great investors invite you to do diligence on them by giving you a list of every CEO they’ve ever worked with and asking you to pick the ones you want to talk to
• Great investors ask great questions
• Great investors don’t publicly take credit for the success of their investments, even if they were major drivers of that success
• Great investors show up for meetings on time and don’t spend the meeting using their smartphone
• Great investors treat their portfolio companies’ money as if it were their own money when spending it on things like lawyers or travel
• Great investors look for connections to make between their portfolio companies or relevant people but have a strong relevance filter and don’t send junk
• Great investors never have a ready-made list of the ways they add value to companies — and they specifically never talk about the help they give in recruiting executives or making sales/bus dev introductions
• Great investors recognize when they have a conflict around a portfolio company and are clear to represent their separate points of view separately

These are good rules of thumb for investors. I’d add five more:

• Great investors provide great insight and market intelligence their companies otherwise wouldn’t have
• Great investors provide their entrepreneurs with shortcuts – these are things the companies could have done or reached on their own, but the investor makes it that much it easier
• Great investors know when to push and when to coddle, even when the entrepreneur feels neither at the time is necessary
• Great investors are hyper focused on building valuable companies, not just good companies
• Great investors help their companies stay financed through their lifecycle