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After underperforming for the most part of the past 6 months, Cirrus Logic ($CRUS), which is one of Apple’s suppliers, gapped down again this morning after giving a disappointing guidance. In a about a year, $CRUS went from $19 to $45 back to $19. This is a typical momentum story in a condensed period of time. What are some of the lessons its story reminded of:

1) Once a stock breaks out to new 52-week high from a proper base and on fresh earnings-related catalyst, you don’t know how far the re-pricing could get and for how long the new trend could continue. One of Stanley Druckenmiller’s famous quotes in ‘The New Market Wizards’ book goes something like this:

I never use valuation to time the market. I use liquidity considerations and technical analysis for timing. Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction.

I wholeheartedly agree with the first part, not so much with the second. I don’t think anyone knows in advance how far a stock could go after it breaks out and any projections are just guesses.

2) Price trends often start and end before earnings trends. When $CRUS destroyed the earnings estimates in November of last year, many people were shocked to see the market reaction – a gap down from $41 to $37. At the time, it was perceived as a buying opportunity by many, citing the spectacular earnings growth. It has been all downhill ever since. The lower the stock went, the more attractive it looked to many, only to be disappointed as surprises often follow the direction of the established trend, until in the end – knowing when that elusive end could be is extremely useful. Poor reaction to what is perceived to be a good earnings report is usually one of the first signs that the price trend is over and since the price is the only thing that pays us, it is the main trend we should pay attention to.

3) Stay away from stocks with low relative strength, especially if they have been recent momentum leaders. In the majority of cases, you will be served better if you stay away from stocks making new 3-month lows (even worse – new 52-week lows) during bull markets. Most of stocks are there for a reason. No matter how appealing the seem from whatever perspective you chose to look at them, you will do yourself a favor not to touch them and go fish somewhere else.

Since Gold and Silver are crashing and are on everyone’s mind, here’s an extract from last year’s Berkshire Hathaway’s annual letter to shareholders, where Buffett eloquently reveals how he thinks about the shiny metal:

The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying
binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The
170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Last Friday, I had the opportunity to attend LindzonPalooza – a networking event that Howard Lindzon hosts once a year. At such networking events I like to listen a lot more than I talk and to ask as many “stupid” questions as I can. One of the more interesting brief conversations I had was with Gavin Uhma, who is one of GoInstant’s co-founders. GoInstant is a leader in web cobrowsing and it was acquired by Salesforce in July 2012 for $70M.

Me: Do you see yourself starting a new company in a few years and would you prefer to finance it yourself instead of taking outside money?

Paraphrasing Gavin – Even if I was able to finance it myself, I would still take outside money from selected sources. You get a lot more than just money when you work with the right investors. The insightful advice and connections you could receive are just as valuable, if nor more.

Then the whole conversation went into discussing the role of money in funding.

If you are a publicly traded company, you will sell your shares to the ones who pay the highest price and your bonds to the ones willing get the lowest interest rate. When it comes to funding startups, money is not a commodity and depending on its source, it comes with a lot of strings attached, not only in terms of advising as Gavin mentioned, but also in terms of exit strategies, which is a theme of a whole different conversation.

Where am I going with my rant? You have probably all heard of the JOBS act, which main purpose is not actually to create jobs, but to:

1) reduce the paperwork needed to become public, but in the same time allow companies to remain private longer

2) allow non-accredited investors to put money in the early stages of private companies

It is admirable that the JOBS Act will potentially give the opportunity to non-accredited investors to participate in the early growth stages of companies they love and which services and products they use. It could actually make many people better investors. The beauty of angel investing is that you are forced to be a long-term thinker and investor. You don’t have the comfort of liquidity. Once you are in, you are stuck for good. Long-term investors invest in people for one simple reason – regulatory and competitive environment could change, but people’s ability to adopt and seek success could remain a constant, if you bet on the right people.

The question is, if money is not a commodity in startups funding, will non-accredited investors actually benefit and have access to the “best” deals. Proper education and transparency could partially solve that problem and Angellist has been a pioneer there, but I can’t help but think that reflexivity plays a huge role in startups’ fortune. Funding is not just about enough money to keep the lights on and scale. Money always comes with some strings attached. In the case of experienced and well-connected angel investors and venture capitalists, it comes with valuable advice and a network that plays an important role in startups’ potential and success rate.

What really bothers me more as a public investor is the part about private companies being able to stay private longer and potentially go public at much higher valuations and a lot later in their growth cycle. I look at people like Howard Lindzon, who is extremely smart and he is spending so much more time, attention, efforts and capital on private markets. Does that mean that public markets are not what they used to be and don’t offer the same opportunities they once did?

Here is an old post (2011) by William Quigley, where he explains how the investing equation might have changed:

Let’s also keep in mind that public companies are generally a lot less risky than private ones. Less work and lower risk. That is how it used to be for public shareholders, but that era has ended for good. Let me give you some perspective on how much things have changed since the last tech cycle…

The investors who bought Microsoft shares at its IPO and held onto it for the same amount of time it was a private company – 11 years – were treated to several hundred billion dollars of capital appreciation, not the $650 million that Bill Gates, Paul Allen and the other early employees earned for their 11 years of grueling start-up work. Compare the Microsoft, Cisco, Amazon or eBay examples to what we see in the post-Google era.

VMWare went public in 2006 at a $12 billion valuation. It quickly rose to a $30 billion market capitalization. Thus, the existing investors (parent company EMC in this case) captured over one third of the company’s likely terminal value. Google’s founders, pre-IPO employees and early investors also did quite well, capturing a respectable 25% of the companies likely terminal value. And what of those earlier tech giants – Microsoft, Cisco, Amazon and eBay? The founders and early investors of these extraordinary businesses captured less than 1% of the terminal values of their businesses while they were still private.

The valuations of today’s private tech leaders – Facebook, Zynga, Groupon and possibly Twitter – are such that I believe upwards of 50-75% of the terminal values of these companies will be captured by the folks who did the real work and took the real risks, those who quit their jobs and begged, borrowed and cajoled friends, families and angel investors to take a chance on their far-fetched idea.

Here is the important, and game-changing, point: in order to participate in the great wealth creation taking place in this and future technology cycles, you will have to be a founder, an early employee or a private investor. The so-called easy money will be earned before a company goes public. This is a radical shift from earlier technology cycles.

A couple years later, we can see that Quigley was right when it comes to the aforementioned popular tech companies. Facebook, Zynga, Groupon have been disappointments after their IPOs. The majority of value was created for founders, private investors and employees. Maybe it is too early to judge those companies? Maybe, we should wait 10 years, before we make any drastic conclusions?

The more important question. Now that there is so much money, allocated to private investments and so many of the companies go public a lot later in their growth stage and at higher valuations,  are we screwed as public investors or there is a way we could still make a decent amount of money? There is always a way.

There are just as many examples of recent IPOs, which have been extremely profitable for public investors as there are examples of IPOs that have been tragic.

Lululemon ($LULU) went public in the summer of 2007, when the market was crazy volatile, but near all-time highs. It was a $2 Billion company on its IPO day. It is a $10 Billion dollar company today.

Rackspace ($RAX) went public at some of the worst possible time – the summer of 2008, when most most people hated stocks and wanted out at any price. The rule of thumb says to ignore companies that go public during financial crises, because raising money in crappy maarkets is usually a sign of desperation. $RAX was about $1 Billion dollar company on its IPO day. Today, its market cap is about $6.5B. It was $10B only a few months ago.

Vips Holdings ($VIPS) was one of the only two Chinese companies to get listed on U.S. markets in 2012. It opened as a $200M company in March last year. Its current market cap is $1.4 Billion.

Many of the best performing IPOs of the past 5-6 years had an element of surprise in them. They either came from sectors that everyone hated or they went public when people were hating equities in general – in both cases, nobody expected them to perform well, which probably means that their valuations weren’t too elevated. There was one more very important ingredient they all shared – they spent a lot of time on the all-time high list.