The tech unicorn initial public offering madness that has engulfed the market for the past two years finally came to a head recently. WeWork, a preposterously valued startup company headed by a consummate self-promoter and flim flam man, was finally exposed as all sizzle and no steak.
Yet, warning signs abounded long beforehand. WeWork CEO Adam Neumann described his company as a “physical social network,” and he repeatedly and earnestly claimed WeWork would “elevate the world’s consciousness.” Such claims were a huge red flag.
When the company filed its mandatory S-1 registration statement with the SEC, investors, for the first time, were provided with material information about the company not previously disclosed. What was revealed was a labyrinthine corporate structure, insider, non-arms-length contracts and self-dealings with the company.
Many value investors, such as Seth Klarman (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), viewed this latest addition to the “hot” IPO market with a jaundiced eye.
Where did all those investors, who almost followed the Pied Piper of WeWork right off the cliff, go wrong?
Rational valuation models were tossed aside
Many of the “tech” unicorn investors believe that because investing in the brave new world of the 21st tech economy is unlike all periods that preceded it, the fundamental rules underlying all sound and prudent investment decisions could be cast aside. The old rules no longer apply and should be replaced by novel conceptions of value and accounting.
This mindset gave birth to the notion that traditional discounted present value models had become passé for some new “tech” companies; new-fangled analytical concepts needed to be created or devised to address the latent potential of disruptive companies that had, financially speaking, suffered only losses.
For those easily duped investors and analysts who wondered when his company might become profitable, CEO Randall Neumann offered the mystical measure of “contribution margin,” which he claimed would allow investors to “analyze the core operating performance of our locations.”
This accounting technique was so misleading and susceptible to fraud that Scott Galloway, a New York University professor, questioned whether there was a role for the SEC to step in more aggressively when companies “start trying to contaminate traditional accounting terms.”
WeWork was valued at 10 times that of its principal profitable rival, IWG (LSE:IWG, Financial). However, the excessive valuation and eager anticipation was not due solely to manic, “tech hungry” individual investors. Analysts at Sanford C. Bernstein & Co. put We’s valuation around $23 billion, and in an August note wrote that We’s “business model is sound and the pace of growth phenomenal.”
Historical lessons from Graham and Dodd
When assessing today whether WeWork's $49 billion valuation was rationally related to the prospects of its underlying business, one is reminded of Graham and Dodd’s description in the 1934 edition of "Security Analysis,"Â and of the pre and post-WWI manner in which investors valued stocks. The pre-war method, as the authors recount, was a traditional financial or fundamental analysis-based model. Analysis was confined to a company’s average earnings in relation to the stock price and the stability and trend of that company’s earnings.
In many ways, the pre-war model resembled what we would call value investing today. In 1919, the validity of the pre-war fundamental analysis model was called into serious question due to the rapid rate of economic change during the period of 1919-1929, which rendered many otherwise sound and prominent companies less stable. Given its poor record, the fundamental method was supplanted by the price model underlying what Graham and Dodd called the “new era theory” of stock valuation. Valuation in the new era, the authors stated, could be summed up in the sentence, "The value of a common stock depends entirely upon what it will earn in the future."
Investors in the new era were concerned exclusively with a company’s earning’s trend, i.e. the changes in earnings expected in the future. The underlying premise of the new valuation measure was that, “A continuous increase in profits proved that the company was on the upgrade and promised still better results in the future than had been accomplished to date.”
Past earnings were only significant for purposes of indicating what changes in the earnings were likely to take place in the future.
"The result was that investors now ignored the “price of a stock in determining whether or not it was a desirable purchase."
As Graham and Dodd realized:
"The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-ear theory led directly to this thesis."
Even though Graham and Dodd were describing the environment of the 1930s, couldn’t the same fundamental irrational mindset apply to the tech unicorn madness? In the wake of the WeWork flameout, perhaps the most important lesson for investors today is to be mindful of how Graham and Dodd demonstrated the sheer folly of the new era school of analysis.
"Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell but even upon the price at which it would deserve to sell."
Seth Klarman: 21st century disciple of value investing
Substitute “sales growth” for “rising trend of earnings,” and the similarities between the unsound, post-WWI valuation models chronicled by Graham and Dodd and the 21st century tech unicorn valuation models become especially significant for our speculative environment, which Klarman has facetiously characterized as dot.com 2.
Seth Klarman (Trades, Portfolio), a devoted disciple of Graham and Dodd, restates for investors today the distinction the authors of "Security Analysis" made between those who fail to relate the value of a business to the price they are willing to pay and those who practice sound investment strategies:
"Speculators generally regard stocks as pieces of paper to be quickly traded back and forth, foolishly decoupling them from business realty and valuation criteria. Speculative approaches — which pay little or no attention to downside risk — are especially popular in rising markets.
In heady times, few are sufficiently disciplined to maintain strict standards of valuation and risk aversion, especially when most of those abandoning such standards are quickly getting rich. After all, it is easy to confuse genius with a bull market."
Investors should learn from the WeWork experience and realize that although there are those who claim value investing has been on the wane over the past decade, the fundamental principles espoused by Graham and Dodd remain especially pertinent today.
Disclosure: I have no position in any of the securities referenced in this article.
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