Moontower #30

Friends,

I started paying the 6-year-old interest on his piggy bank. I figure it will be a neat way to get him to engage with numbers while teaching him about money in the process. Computing percentages is above his pay grade so instead, we created an interest schedule. For example, on Saturdays, he’ll report his savings and if he has between $0 and $200 he’ll receive $.50 interest. If he has between $200 and $400 he’ll receive $1.00, and so forth.

If you produce evidence that you a) share 50% of my genes and b) are not my sister then you too can open a Moontower Savings Account.

The fact that you are drooling at the implied APR tells us so much about financial environment we live in today. Let’s explore.

Your money has nowhere to go

Interest rates are historically low, basically in line or even less than the low inflation rates we are experiencing. In other words, keeping your money in savings accounts means the value of your savings is slowly eroding. This is by design as global monetary policy is meant to encourage you to invest in risky assets or spend your cash. Whether or not the policy is justified, it has certainly affected markets.

Interest rates are low, meaning bond prices are high. Annuities are historically expensive. Real estate is expensive. Stocks are expensive. We are awash in liquidity and attractive investment opportunities are scarce. Another way to say investments are expensive is to say that implied forward returns are much lower. People are willing to pay a lot today for a dollar of cash flow in the future. In reference to the purchasing power of your savings, I regretfully say “your money has nowhere to hide”.

Now what?

Buying assets near all-time high valuations feels like chasing a ball into the middle of a busy street. How do you take the other side of the trade? If the market is supplying infinite cash for investment today, ask yourself: “What is the market begging me to do?”

A sensible thing to do is refinance and you should, but this feels like you’re taking an inch when a mile is on the offer. Another option is to take a low-interest rate loan. But what do you do with the money? Buy an expensive house? That’s like staging an intervention only to find yourself getting drunk with the person you are trying to help.

How hustlers respond to loose capital conditions

• Entrepreneurs

While investors are crying over the lack of attractive investments at reasonable valuations, entrepreneurs focus on the opportunity. The investors are the customers. Investments are the product. So give them what they want. “You need to put a billion dollars to work and the SP500 ain’t doing it for you? Here invest in my scooter company.”

• Funds

In the reach for yield, investors want access to riskier bets to have a chance at more meaningful returns. While traditional stocks and bonds have a mature fund industry bridging the gap between capital and companies, hordes of angel syndicates and venture funds have set up shop to raise money for these start-ups. But the funds who were smart enough to recognize this demand also recognize a market truism — the amount of capital that goes into a sector is inversely correlated with its future returns. The funds are like drug dealers who need to assure their clientele that the drugs (the supply of start-ups) are safe to smoke. So what story do they tell? (I have noticed the VC world is especially obsessed with comedian’s craft, improv, the ability to write, present, influence, convince, sell, promote. This is worthy of its own discussion as a microcosm of what is feeling like an increasingly postmodern world to me. Sorry to be a tease, but that’s a story for another time.)

To understand the pitch is to understand that the story’s most important feature isn’t its feasibility, it’s the scalability. Fake meat. Scooters. Office rental space. Ride-sharing. All of these stories are low margin, low probability of success but…they address humanity’s biggest needs. Food, transportation, occupancy. They have the capacity to absorb oceans of capital. If you need to raise $1mm, nobody cares. Need a billion, just call Softbank. In the equation for expected value, EV = P(X) * X, all eyes are on the magnitude of the payoff, X. The probability is more of an impression than something to inspect with a microscope.

This isn’t irrational. Venture funds need to hit massive home runs on their winners to make up for the many losers since they are investing when companies are very young and extremely speculative. But if we jam more money into venture, they aren’t going to be able to generate the returns by marginal increases in their ability to choose better investments. Instead, the size of the home runs will be the largest factor in the fund’s returns. Play venture capitalist for a moment — would you rather improve your hit rate from 10% to 20%, or maintain a 10% hit rate and increase your payoff from x to 10x?

While the mood in the traditional finance labor markets is besieged by automation and disintermediation, there are growing segments such as fintech and crypto. These are areas where one can find opportunity and a tailwind to reap the benefit of loose capital.

The peace dividend of overvaluation

For investors, these bidding wars will lead to buyer’s remorse. Their loss will be many others’ gain. Entrepreneurs will be paid in opportunity. Matchmakers in fees. But guess who else? Consumers.

You get the ability to hail a ride from your phone and the sum of the world’s knowledge at your fingertips. The fiber optic bubble of the late 1990s wiped out investors but successfully laid the undersea cable that billions of 0s and 1s travel across every second. In fact, the consumer surplus resulting from the overinvestment may be the biggest bounty of all.

Simply:

overvalued companies —> low cost of capital —> funding for crazy ideas

If you wanted a shortcut for identifying the most speculative themes in markets you can browse the highest-valued ideas on Motif, take note of what themed ETFs are coming to market, or check out platforms for angel and pre-IPO investments (see under Private Investing).

Communism has been described as a system where the intentions are good and the outcomes bad. Well, capitalism is the demonstration of greed leading to good outcomes. The investors, without intention, subsidize innovation and by extension humanity.

Opportunities lie in the inversions

It’s useful to remember that the flipside of overvaluation is a low cost of capital. By funding speculative companies aggressively, the market is signaling a desire for big payoffs and big dreams. Entrepreneurs and funds organize around this incentive to provide the market what it wants.

Instead of crying about the Fed, lack of fiscal discipline, the lack of reasonable investment opportunities, remember that overvaluation cannot exist independently of a low cost of capital. It’s your job to find it then use it for what it begs for…enterprise and creativity.

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Some parenthetical stuff:

(The mental inversion of “overvalued” to “low cost of capital” is adaptive because it mentally re-orients you from thinking “How do I short this?” to “How do I use this?“. Shorting companies requires borrowing shares to sell them. This doesn’t create a new supply of shares but changes how they are distributed to cause downward pressure on a stock. It is supply that is eventually required to be repurchased. Permanent supply can only be created by secondary issues or by capitalizing more companies and competitors. Here’s my explanation of the brutal math of shorting.

Note that a symmetric inversion is to re-cast “undervalued” stock as companies’ with low implied forward rates of invested capital…traditional so-called “value traps” come to mind. Thanks to Eric for introducing me to the concept of “implied forward ROIC”.)

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Climb Higher

In a matter of weeks, WeWork went from being a $50b unicorn to being mentioned in the same breath as the “b” word. I won’t rehash the We saga, but a recent interview with Scott Galloway who has been spitting acid on them for 2 years is one of the best things I’ve read this year. His colorful metaphors and ruthless candor need to be enjoyed in their full glory. Enjoy.