Equities Gone Wild — Bubble or Beginning?
By Roxane Googin, Chief Futurist, Group 11 and Dovi Frances, Founding Partner, Group 11.
“The future has imploded into the present.
With no nuclear war, the new battlefields are people’s minds and souls.
Mega-corporations are the new governments. Computer generated info domains are the new frontiers
Though, there is better living between science and chemistry. We are all becoming slave-bots.
The computer is the new cool tool. Though we say, “All information shall be free,” it is not
Information is power and currency of the virtual world we inhabit. So we mustn’t trust authority.
Cyberpunks are the true rebels. Cyber-culture is coming in under the radar
An unordinary society, an unholy alliance with the tech world, and a world of organized descent”
Billy Idol, Cyberpunk Opening Manifesto, 1993.
Where to begin…
For many centuries humanity has envisioned a future where computational power is almost endless and automation is all-encompassing. Beginning with the development of the tally marks in ancient days, to the abacus, the slide rule in the 1600s, the automaton in the 1700s, the perpetual calendar machine, the differential analyser in the 1800’s, and of course the introduction of an analog computer, and then a digital computer at around 1938, humanity has evolved through countless generations to bring us to this moment of total man-machine symbiosis.
The breakthroughs of WWII brought upon us the first digital, programmable machine, The Colossus, and from there through the introduction of a Turing-complete ENIAC the road to PC was fast tracked.
The evolution accelerated after the World Wide Web was introduced to the public 29 years ago as the collective knowledge of billions of people interacting with machines in a quasi-symbiotic relationship paved the way for enormous technological breakthroughs.
Today, amidst massive demographic and technological changes, humanity has encountered a unique moment where physical interactions are interrupted by an external, biological threat which was initially considered unknown and life-threatening to our species.
In a coordinated effort, governments shut their borders and instructed billions of people to stay at home and so came about a global experiment of withholding physical presence whilst maintaining virtual connectivity to family, friends, and business through technology.
This six week global experiment has quantum leaped technology adoption by five years. While the remainder of this experiment is still ongoing at some capacity, the results of the experiment are similar to what modern day prophets, scientists, authors, script and song writers (yes, Billy Idol included) have long predicted:
A paradigm shift running in parallel across all industries and all people of all ages.
An utterly beautiful “Shock to the System” (also a great song from Billy Idol’s 1993 Cyberpunk Album but that’s besides the point) .
A Cyberculture complete take-over of our old economy and a new-world order that will soon ensue. The last move of the white queen to H5 prior to calling checkmate towards a full man-machine symbiosis.
September 1st 2020 — Today:
In light of the above movement, tech equities are rallying with strength in the face of a weak GDP and political uncertainty. Investors looking to leverage this trend are justifiably concerned about a 2000-like bubble. However, rather than a bubble, we believe we have entered a new normal. We are in a new wave of automation that really began with the vision that drove the 2000 bubble. While the power of cloud computing, AI, and internet proliferation has created giants of international scope and threatening market power, we believe they represent the tip of the iceberg of a next-gen automation wave rather than the end game. Driving this phase are COVID-led behavioral changes that accelerated this penetration of new tech by five years in six weeks. Importantly, this represents a time-shift of a new normal rather than a temporary pull-forward of existing demand.
Couple the proven power and reach of this new technology with a demographically led lack of investment alternatives and you get the perfect storm that is brewing now. It is important to appreciate that COVID accelerated existing trends more than creating new ones. One of those trends is a global, mature market baby bust that promises to cap GDP growth for decades. Reflected in flat to negative bond yields, this very long term trend is forcing debt investors to consider investment alternatives. One of those alternatives is dividend income from extremely stable tech giants such as Apple. We submit that vendors like Apple are becoming the new sovereign debt; that a whole new class of investors is valuing these equities not on a revenue or earnings multiple, but on a yield basis, and that with low alternative yields, that yield is very low. We are at the start of this multi-decade trend, not the end.
Current Adoption
The social distancing required by COVID-19 has by many accounts accelerated digital adoption 5 to 10 years. In their Q2 2020 earnings call Shopify management observed that e-commerce had moved from 10% to 30% of retail sales, reaching their 2030 30% goal in six weeks. While the claimed acceleration varies from 5 years (Microsoft) to Shopify’s 10 years, a multi-year jump in just weeks is ubiquitous among next-gen winners. This trend towards cloud-based, AI-enabled and consumer-internet-like self-serve applications for ever more complex business processes was already underway. What COVID did was make this migration mandatory overnight, especially in slow-moving industries such as healthcare and education. Seemingly, life goes on and users are adapting well to this new way of living. People generally do not miss going back to waiting in doctors’ offices, and city-bound white collar workers are flocking to the suburbs. Boomers are learning how to use QR codes and how to buy groceries online. Clearly, there is no going back. Fortunately, the Group 11 portfolio of companies fit into this paradigm well, with next-gen leaders like Next Insurance, TripActions, Tipalti, and HomeLight progressing towards unicorn status in a rather short span of time.
Scarcity Value
We define next-gen business process vendors by three primary criteria; they are cloud-based, they use AI to process vast data stores and provide intelligent service, and they leverage consumer internet self-serve user interfaces. These characteristics feed off one another to absolutely obliterate legacy client-server technology-based alternatives that often rely on manual intervention. The installed base of legacy client-server technology is vast and still powers the core infrastructure of legacy enterprises in industries including banking and insurance, travel, retail, manufacturing, and energy production.
Of equal importance is the fact that a successful next-gen attacker is rare. It is difficult and time-consuming to envision a new market, then develop the software and the corporate culture around that solution, and finally to attract users who feed that AI engine to the point it breaks from the pack. These maturation challenges, coupled with the fact the clock just moved up five years in a matter of weeks means alternatives to the existing winners really don’t have time to develop. It is now or never for new product adoption and those offerings need to be ready today. Therefore, in large measure the offerings you see today are the ones you will see in a few years. They have proven penetration into very large markets and we generally assume they will not stop growing until those markets have been completely transformed.
This is not a simple TAM replacement exercise. The simple truth often ignored by many of our peers in the VC industry is that new technology does not simply get added to an existing environment but rather, restructures it in its image thus opening many initially unforeseen doors. AAPL is not important because they are selling slick phone units but because they are transforming commerce as a result of selling phones.
(And oh yes, the dividend rocks.)
The GDP Problem
Just as adoption of next-gen solutions was at a tipping point anyway and COVID provided a pull-forward forcing function of adoption, so too will the threat of bankruptcy as technology adoption laggards soon represent a pushing function. We believe the persistently low interest rates in the bond market portend a flattening of global mature market GDP. Without GDP growth, unit demand especially for core industrial products including legacy financial services, energy, and autos stagnates. Importantly, all the profits in these high fixed cost industries come at the margin, when they grow. Conversely, if they shrink at all the impact is not subtle; they immediately go into negative cash flow, followed by desperate price cuts to gain enough share to cover those costs, leading quickly to restructuring and consolidation. We are predicting flat to down GDP performance in mature markets looking forward due to long-standing demographic issues precipitating just such a consolidation scenario.
The Demographic Problem
Perhaps due to the ever-growing cost of raising functional young people in a complex society, birth rates across mature markets have been falling for years. Starting in Japan, then spreading to Europe and even to China, birth rates below the 2.1 per woman needed to maintain a flat population have now even spread to the U.S. In fact, the 2020s should represent the first domestic working age population decline since perhaps the Civil War. In population-decline leader Japan, more people now die than are born. Domestically, the absolute number of babies born in 2019 was the lowest in 32 years when the general population was 25% smaller than it is today. The problem with these trends is that they are both long-term and impactful. They can only be solved via immigration or time; there is no quick fix.
The economic impact of population decline is pernicious. With fewer people, vendors have less unit demand, leading to the chronic over-supply that leads to the restructurings mentioned above. Fiscally, as a fixed number of vendors vie for fewer buyers, deflationary expectations creep in. The switch from inflationary to deflationary expectations becomes its own economic depressant as buyers delay purchases in search of a better deal. We suspect a growing fear of deflation was behind Federal Reserve Chairman Jerome Powell’s relaxing of Fed inflation targets on August 27. By shifting their focus to the maximum employment side of their dual mandate of employment versus price stability, he seemed to imply employment was more of a worry than inflation. We could not agree more; now he needs employment to stave off deflation.
The Bond Problem
Once broad concern investors have about the future is the persistent and growing trend towards negative bond yields. Perhaps because bonds are more economically sensitive than many equities, coupled with their long duration, bond investors have a better track record at predicting economic downturns than equity investors. Again starting in Japan, the trend to negative bond yields has spread to Europe and is threatening our shores. Anyone willing to commit to losing only 0.5% to 1.0% of their capital over a 30 year period must be pretty cautious about the future. However, given the demographic trends outlined above we believe they are right. In fact, we suspect Fed Chairman Jerome Powell is actually praying for 2% inflation more than trying to avoid it.
TINA to FOMO
A demographically-driven flat GDP outlook, coupled with unattractive bond yields and the prospect of vicious core industrial restructuring it implies, only adds to the demand for next-gen winners, explaining their recent rise. In the final stage where “software eats the world”, the only growth is digital disruption. In fact, There Is No Alternative (TINA) and investors have a Fear Of Missing Out (FOMO). We suspect that part of the rise in earnings (or now, revenue) multiples is simply due to the increased present value of future cash flows in a zero inflation environment. However, we suspect another significant impact is also in play, that of a capital reallocation of bond money into select equities. Digital disruption vendors with strong track records and stable dividends become bond proxies in this new world. Bond investors starved for yield will bid up certain assets (like Apple stock) not based on earnings or revenue multiples, but based on a dividend yield multiple. Importantly, in this environment they are happy with a pretty low yield. Thus, not only are new buyers crowding into a fixed number of names, but those buyers may be less price sensitive than traditional holders. These factors set the stage for the startling growth in asset values. Note that these drivers are both long term and fairly immutable in nature.
Conclusion
Investors have been shocked by the appreciation of next-gen vendor equities in the face of an uncertain overall COVID environment. Many compare this growth to that of the 2000 equity bubble. Rather, we see this is the start of a new normal, one that was at a tipping point anyway, but got cranked forward five years in six weeks. Once users changed their habits to accept these technologically-driven solutions over historic manual ones, they stuck. This places additional pressure on less digitally prepared vendors to either play catch-up or close their doors. Everyone realized that next-gen technology adoption was a necessity rather than a fashionable luxury all at once, leading to the adoption stampede we are witnessing at some of our more established portfolio companies such as Tipalti, TripActions, Next Insurance, HomeLight, Sunbit, Papaya Global, and also with some of our emerging portfolio companies such as Lili Bank and EquityBee.
But there is more. Long-standing demographic trends are starting to become evident in the larger economy. The gradual but constant spread of low and negative interest rates portend flat GDP performance in the years ahead. We believe this assumption is correct, and is driven by a baby bust that has also been spreading around the mature market economies for decades. No quick fix exists for demographic problems. Indeed the saying goes: “Demographics is destiny.” This yield and restructuring pressure makes the growth of digital attackers all the more appealing, drawing capital from other areas, including core industrials and bond markets. Importantly, some of those investors are content with low returns, forcing the price of growth equities up even further. It is because of the duration of these demographic trends we see this not as any bubble, but as the start of the new era into which we have just quantum leaped.
TO BE CONTINUED..
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About the authors:
Roxane Googin, Chief Futurist, Group 11
Roxane Googin is a world renowned authority on macroeconomic technology trends and as of August 2020, the Chief Futurist of Group 11, one of Silicon Valley’s most sought after FinTech investors.
Prior to joining Group 11, Roxane was the editor of High Tech Observer, a long running invite-only publication read by institutional portfolio managers focusing on the technology sector. Roxane’s research focuses on inter-modal competition between historically disparate economic models forced into direct competition by technological advancements, as these tend to be the most disruptive.
Her bold predictions included the Internet boom during the depths of the LTCM credit crisis in 1998, the internet bubble demise in September 2000, and the introduction of smartphones and cloud computing in May 2002 through her much acclaimed article “Six Simultaneous Equations”, to name a few. Roxane Googin has a BS-EE from the University of Tennessee, and an MBA from the University of Virginia. In addition to engineering experience in development and manufacturing, Roxane has experienced finance from the cradle to the grave: from venture capital, through equity analysis, to term and finally to asset-based lending. She uses her broad experience to envision the disruptions that are bound to come our way.
Dovi Frances, Founding Partner, Group 11
Dovi Frances is a financial services entrepreneur and founding partner of Group 11 (f.k.a. SGVC), a venture capital firm based in Los Angeles, California. Over the course of his career, Dovi has invested over $200 million in some of Silicon Valley’s most prominent and disruptive financial technology companies, including Tipalti, TripActions, HomeLight, SunBit, and Next Insurance. Dovi currently serves on the boards of Tipalti, SunBit, HomeLight, Papaya Global, Lili Bank, EquityBee, and Reali. He is also an Advisor to Addepar and TripActions, and is a member of the Advisory Council of Leumi Bank U.S.
