For the year to the middle of March, special purpose acquisition companies, or SPACs, raised $79.4 billion globally compared to $79.3 billion throughout 2020. These companies have attracted all sorts of investors, with many high-profile sports stars and financiers signing up to help manage these businesses.
One of the unique traits of SPACs is that they are allowed to issue earnings projections in their prospectuses.
In a traditional initial public offering, companies are generally prohibited from including forward-looking financial projections in their prospectuses. What's more, companies are barred from publicly sharing additional information until 40 days after the stock starts trading, in what is traditionally called a quiet period.
That's not the case with SPACs. These blank-check companies are allowed to make forecasts about how they reckon their businesses will develop in the future due to a quirk in Securities and Exchange Commission rules. As a SPAC is considered a merger rather than an IPO, it is not subject to the same rules. Therefore, SPACs can make look forward-looking projections, which just would not fly in a traditional IPO process.
Some sponsors have taken advantage of this rule, pushing outlandish growth forecasts to try and increase the value of their SPACs.
The risks of forecasting
Charlie Munger (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) have been warning investors about the risks of relying on forecasts for the past few decades.
For example, at the 1995 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual shareholder meeting, when speaking about projections, Munger declared the following:
"Most of them are put together by people who have an interest in a particular outcome. The subconscious bias that goes into the process and its apparent precision make it fatuous and dishonorable. Mark Twain used to say 'a mine is a hole in the ground owned by a liar' and a projection prepared in America by anyone earning a commission, or by an executive trying to justify a particular course of action will frequently be a lie - not a deliberate one, but one where the man has come to believe it himself, and that is the worst kind."
This quote seems incredibly appropriate for the current SPAC boom.
Another statement from the two billionaires that comes to mind includes a saying from one of Buffett's favorite fabulists, Aesop. As the investor wrote in his 2000 letter to shareholders:
"The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?"
As it is impossible to know how many birds are in the bush, Buffett went on to add, it is impossible to work out the value of an enterprise.
How many birds?
Many high-profile SPACs try and push investors to believe there are a certain number of birds in the bush, but there's no guarantee they will ever emerge.
As some investors have found out, when these birds emerge, there have been fewer than the promoters of the SPAC claimed there would be.
Romeo Power Inc. (RMO, Financial), a $1.3 billion battery manufacturer for commercial vehicles, claimed in its merger presentation that its revenues would hit $140 million in 2021, up from $11 million in 2020.
That was at the beginning of November. Five months later, the company forecasts revenue for the year of just $18 million to $40 million.
Buffett has been talking about Aesop's principles for the past four decades. The fact that a high-growth company has failed to live up to expectations shouldn't surprise anyone who has been listening.
Disclosure: The author owns no stocks mentioned.
Read more here:
- These Best-Performing Funds All Have One Thing in Common
- Reviewing Portfolio Performance Over the Past Decade
- What We Can Learn From Archegos Capital's Downfall
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
