Can decacorns retain its attractiveness?

Ten years ago, a startup being valued over a billion dollar was a rare event. But now unicorns have become so common that to regain an exclusive status for a startup, people came with a new buzzword – Decacorn – A startup valued at ten billion dollars or more. Uber, Xiaomi, Pinterest, Snapchat, SpaceX are few names that have been valued over ten billion dollars. These firms may seem as, or in fact are big names with big prospects. But from an individual investor’s perspective, are those firms worth investing: through mutual funds or in an IPO?

To analyze this scenario, let’s understand how startups are valued. Take a hypothetical example that Uber is looking for funding and a venture capitalist decides to give Uber ten million for a 1 percent stake, thereby valuing Uber at a billion. The amount of investment and the percentage of stake is decided by a series of negotiation between the founders and venture capitalist. The key determinants of the outcome of negotiations are growth potential, founder’s expectations and earnings of the company (if any). Even if the company may have negative earning, positive future earnings are expected along with supernormal future growth. Thus, a unicorn or maybe a decacorn is created. This paper value, the higher it is, the favorable reception it will receive during its IPO or during its further valuation rounds, thereby rewarding early investors at the cost of later investors.

Another perspective to look into it is the difference in the value per share of these startups. A recent WSJ article, “Mutual funds flait at valuing hot startups like Uber”, states how mutual fund firms vary in the valuation of private stocks. As per WSJ, tech unicorns had 12 instances where a same firm was valued differently on the same day. So which value should an investor look at? Closely related with this perspective is the recent IPO of Square, a mobile payment platform by Jack Dorsey – CEO of both Twitter and Square. Private valuation for Square was 6 billion, but then its IPO placed its value at $3.9 billion. Seriously? A difference of 1.1 billion!

IPOs are a window of opportunity for the founders to cash in on their idea/s. No one knows the firm and its perceived value better than its founders. Hence, founder can choose a time whereby they can receive the highest possible price for its stocks to maximize their returns, thereby reward the time and effort they have put in for the firm. But on the other hand, the loser is the general investor who buys its stock in the IPO.

Given how well tech stocks are performing after its IPO, the idea of those stocks being overvalued may seem absurd. But, it was absurd to believe that holding “dot-com” stocks was a bad idea, during late 90’s and early 2000’s.

Do hedge funds serve their purpose?

“…Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.” – SEC, Hedging your bets: a heads up on hedge funds and funds of hedge funds.

“A hedge fund is an actively managed investment fund that seeks attractive absolute return…. Hedge fund managers are active managers seeking absolute return.” – Robert A. Jaegar, All About Hedge Funds (2003)

“Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return, or alpha, for their investors.” – Investopedia

To summarize, the ultimate purpose of hedge fund is to earn attractive return, preferably seeking positive alpha and that’s how the hedge fund managers market their fund – making positive alpha. But are the funds serving this purpose? Do they really make above market returns every year? Have these funds been able to beat the market in the long term, say 5 years, 10 years?

To come up with an answer requires some study since hedge funds are mostly limited partnership and free from all the regulation that mutual funds are subject to, Hence there is limited information about the short/long term performance of the funds.

Morningstar Broad Hedge Fund, which encompasses more than 500 hedge funds serves as a useful index for benchmarking and is also a good estimate of performance of hedge funds. Based on annual return starting 2009 through 2014, the historical rate of return for this index has been 4.3%. At the same time, it has been 10.5% for S&P 500.

Year 2014 2013 2012 2011 2010 2009
MBHF 16.46 20.56 1.77 0.14 6.12 11.77
S&P 500 11.39 29.6 13.49 0 12.78 23.45

(Data extracted from Morningstar)

Even when individual years are compared, hedge funds have been able to beat S&P 500 only 2 out of 6 times. So even though investing in the market seems a viable investment compared to hedge fund, still hedge funds are popular and attract investments from accredited investors. The popularity for hedge funds can be associated to these causes: Gains are announced. Out of the many existing hedge funds, there are few standout firms that are earning substantial returns, sometimes even during market turmoil. These are the funds that get media coverages, thereby garnering attention. On the other side, limited regulatory requirement means limited disclosure of information i.e. no need to publicize losses. A decent bet. Hedge fund are essentially a good lottery to bet on. Since its open only for accredited investors, they won’t feel as much financial pain as would a non-accredited investor. On the up side, you have better chance in winning in a hedge fund than in winning a lottery ticket.

In essence, hedge funds do not serve the purpose they are supposed to serve. However, given the limitation of data, it is necessary to further assess this scenario with sufficient data to support this conclusion.

“Black Monday” – what, why and what next?

Trillions of dollars were wiped out from the financial market on Aug 24, 2015. Starting from China, it had its effects on other major markets of Europe, Asia and USA. The Shanghai composite index dropped by 8.5%, the biggest one day percentage fall since 2007, wiping out all the gains for the year. This raised fear of a near recession among the global investors, leading to a global sell off. Here’s what happened in the major economies on Aug. 24:

USA: Dow Jones lost more than 1000 points and ended the day down by 588 points

UK: £74 billion value was wiped off from the FTSE 100 index

Europe: Stock market suffered their worst trading day since 2011

Japan: Nikkei fell off by 4%. (The Guardian 2015)

Meanwhile, China in an effort to save the stock market plunge decided to cut the interest rate and inject liquidity to the banking system by lowering the bank’s reserve requirements. Despite, the move, Shanghai Index fell further by 1.3% the next day. As of now, a slightly bullish trend in most of the major economies can be seen.

Why?

Economist have long been predicting a slump in the Chinese financial market. It was just the question of “when?”. One of the major question of concern was “Is China really growing at a rate of 7%?”. Several prediction expected growth to be lower than that, raising concern on the reliability of the statistics provided by China, thereby indicating a slowing Chinese economy.

The Yuan Devaluation. In a move to put a stop to wiping off of huge amount of money in the financial market in recent months, China decided to devalue the Yuan, the biggest fall since 1994. Although this move was expected to boost the economy and stabilize the stock prices, it backfired. Investors interpreted this as a sign of slowing Chinese economy. It was evident that there was a stock bubble in the securities prices, the question only remained as of when the burst would occur? On Aug.24, when prices began to drop combined with the signal of a weak economy(evident through Yuan devaluation), there was a huge sell off, leading to stock market depreciation, not crash though! China can put in huge amount of money available in its reserves, before the stock market crashes, which might not be a scenario that shall occur anytime soon.

What Next?

The Fed has an important card to play on the interest rate. The much expected rate hikes in September is now a bit less expected following this turmoil. William Dudley, NY Fed Chief and a close ally of Yellen said that the September rate hikes look less likely. But these statement may just be a move to inspire rally in the equity market. Strong economic data from consumer confidence, housing data and the like signal a rate hike would be appropriate in context of United States. But before deciding as such, Fed Chair Janet Yellen has to weigh in on whether to hike interest rate based on strong economic data of US or postpone it for future date to play a more global role in the world economy and also protect the American firms with significant chunk of money coming from overseas.

It is all about wait and watch the Fed’s next move, which is most likely to postpone the rate hike decision to the end of year.