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Variance In Income and Certainty in Discount Rate

Marc Andreesen’s recent comments on professional investors and Piketty struck me as fairly interesting. Here is the link to the last tweet:

As a professional investor I thought I’d comment on this. In recent years we have seen much lower variance and a general trending down of inflation. Some of this looks cyclical – growth has been weak since 2008, “new normal” or not – and some of it looks structural with regards to demographics – check out fertility rates in Iran and similarly involves a number of technical changes. Energy (thanks to solar) looks like it is becoming part of the Moore’s world paradigm and not the Hubbert’s peak / finite resource exhaustion paradigm and there are nascent signs that with a lower population, improvements in agriculture that inflation is likely to be a purely monetary / human organization problem. If you have a housing shortage it is not because we are collectively running out of space, it is because of zoning.  Similarly, we could end up destroying the capital base by having a major war – lookin’ at you Vlad – but the message is pretty clear. We have the technology and the technology features indicate that the cost of a lot of “stuff” is going one way from here, unless society makes seriously dumb choices. When you build discounted cashflow models, you are generally assuming some baseline return that reflects the opportunity cost of a risk free investment plus a risk premium appropriate to the asset. The problem we have today is that while there is definitely some goosing of funding rates due to monetary policy in a number of markets, even if you assume some “normalized” discount rate – say 12 month CPI plus the real return premium / term structure / choose your approach – you still, still get a pretty low number. Now if society does not do anything stupid, then it will probably stay low unless the full helicopter route is taken. Globally we do not face a shortage in liquidity – if we do not install enough solar or grow enough hydroponic lettuce then savings are not finding their highest and best use it is not because of some Club of Rome or Paul Ehrlich type of scenario. If the chart below is any guide, we face inflation barely over a percent and a premium for it that is likely a bit too low due to QE but unlikely to explode anytime soon.

As a result of this you get *very* low starting discount rates which is great for building nice boring stuff like infrastructure and explains why busted toll roads sell for all-in IRRs of 7-8% today rather than 10-11% pre crisis. This does not, however tell one that much about how to value risky securities like VC, corporates or the like. In fact, the variance in valuation explodes. Lets assume a company is a rock solid annuity, so we value it using a Taylor expansion as earnings divided by the discount rate. If the discount rate is 10%, it should trade at a 10x PE (1/0.1). If the discount rate is 5%, it should trade at 20x. You see where this is going – all other things held constant, valuations go up in this world. But all other things are not constant and the valuation of large capitalization US tech companies is a clear indication of this.

Large US tech trades at a discount rate of anywhere from 8-12% to current earnings. So why is there no “bubble” in large cap tech? The answer likely lies in materially reduced barriers to entry in technology (hosting cheaper, building stuff easier, selling it via app stores etc) which mean that competitors can readily come from just about anywhere. If you are a corporate with a $100bn market cap how much bigger can you get? Similarly, if you are a startup you cannot get a lot smaller. These things do not happen overnight or in the space of a single quarter but paying up a lot of large market cap companies does not make sense if you see more and more industries being like technology and having fast cycles of creation and destruction. Conversely, paying option premia for distruption in VC “they haven’t got any earnings!” does provided you buy the options at the right price. Fundamentals will matter, but you are betting on the distribution of fundamentals a few years out, not what you have today and hopefully getting return reflective of the risks taken if you are right (10-100x, pick a number).

In this world, investment management is harder. People tend to start paying up for stuff which looks like its working and individual security sensitivity to a single quarter is huge. Companies start to be valued more on narrative and the consistency of that narrative such that changes in the facts like new competitors or a slowdown in subscribers can be devastating. The mark-to-market and leveraged world struggles with this because the volatility is enormous. Look at Q1 2013 in the long- short space. Being right on a 5 year view is hard in VC, being right with leverage is harder. Pimpin’ ain’t easy.

So if fair values of securities are rationally hyperkinetic and we are in  time where the pace of creation and destruction is picking up then WTF is Piketty talking about? His data is fantastic and his argument rests upon the assumption that an heiress or recipient of a patrimony can somehow relax and earn a rate of return well in excess of nominal GDP in perpetuity with relatively little risk. This seems fairly incongruent if you think most of the investable universe is structurally risky and getting riskier. Similarly, the decline of labor seems odd if the mission critical input in making great code is great people. Comcast and net neutrality aside, no one seems to be even close to reaching a position of abusive market power in technology like Microsoft in the late 90s.

The answer lies in my comments about inflation and particularly zoning, property and resources. The patrimonies of today look a lot like those of the 19th century. Owning property gives one input on zoning decisions and a vote in a locale which in turn allows one to marginally control the price of your own assets. Cornering markets in securities is unequivocally not ok, in property it is fair game. If we do have inflation, it will likely be due to continued regulatory capture by the 1% who tend to own a lot of property. That, combined with the seemingly global perception that “property is different” and must be taxed at lower rates than corporate or labor income will ensure their high return, low risk future.

Focussing on the tech sector and finance is a waste of time. The focus should instead turn to concession to property income and difference between labor and capital gains taxation. In twenty years time a lot of these tech riches will be gone and the hedge fund managers will have underperformed and retired. They will likely own a lot of property and be clearing a lot of capital gains and if nothing gets done about that then nothing will change.

 

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