Will Crowdfunding Turn Private Markets into the New Public Markets?

Crowdfunding has existed forever. It has recently become popular via Kickstarter, where companies could raise money by promising to deliver product or a service at a future date. This is not the type of crowdfunding I refer to in this post. By crowdfunding, I mean obtaining equity in private companies.

So, why is this subject so important to someone like me, whose entire edge is in public markets?

First, let me remind you of the main purpose of Initial Public Offerings.

Companies go public:

– to offer liquid exits for founders, employees and private investors;

– raise capital to expand;

– achieve higher valuations;

Investors buy public companies in order to:

– participate in the growth of various businesses;

– protect the purchasing power of their capital;

– diversify income stream;

– achieve higher returns than bond, real estate and cash markets offer;

– speculate.

The IPO market has changed a lot over the past decade. Companies go public at much higher valuation today for several fundamental reasons:

– they raise more money while private, while it takes less money and time to build a major company today;

– companies remain private longer, because they could raise all the money they need from private investors. It used to be that when a company reaches a 100mil valuation, the only viable exit was an I.P.O. Not any more;

– companies reach maturity a lot faster; they go public at much later stage in their growth cycle; most of the value is created while a company is private. There’s a lot less meat left on the bone for the public investors.

Hedge and Mutual Funds have long realized these trends and started to allocate capital to private markets, essentially accelerating the above mentioned developments. As a result, public investors have been in a way excluded from many high-growth opportunities

Don’t get me wrong. Public markets continue to offer incredible opportunities to investors, but today’s markets are very different than the public markets of the 90s, 80s and even before that. Back then, there were hundreds of 100-baggers. The number of 100-baggers in 21st Century could be counted on the fingers of your two hands and only if you timed your purchase properly. One could make a lot of valid arguments of why there haven’t been many gigantic public market winners in the past 15 years. The main argument is certainly the extremely high valuations at the beginning of the period, but there are also some secular trends (reasons) that are not going away.

It has become a lot easier to invest in private companies

Angel List has changed the investment universe for many accredited investors, which be latest counts are about 7 million, only in the U.S.

Each company, looking to raise money on Angel List, provides detailed description of its business – number of employees and their experience, revenues, current investors, previous funding, etc.

Angel List also provides easy and cheap access to experienced investors via Syndicates. Syndicates charge a performance fees, therefore they are only accessible to accredited investors. You could invest alongside Fred Wilson, Joanne Wilson, Brad Feld, Howard Lindzon, Jason Calacanis and many more VCs and angels with proven track record or just follow their footsteps.

The JOBS Act, Title III is about the change the investing game for non-accredited investors. It is expected to go in effect later this year. There are clear limits on how much non-accredited investors are allowed to invest in a given year:

  • For income below $100,000, invest a max of $2,000 or 5% of income or net worth
  • For income over $100,000, invest a max of 10% of income or net worth
  • Investments made in a Title III crowdfunding transaction can’t be resold for a period of one year

Every new law has its pros and cons.

The pluses:

– many people will be forced to become long-term investors; there will be no daily quotes for their investments;

– companies could raise money without the intermediation of Investment Banks, which probably means lower valuation for those companies, when there are no professional sellers to tell an intriguing story. Truth to be told, there will always be huge demand for good salesmen and the best salesmen in the world are Investment Bankers. They will probably engage in those private offering and help companies to boost valuations – just like they do today for wanna-be public companies.

– you will have the opportunity to invest in a business you understand and use at early stages of its growth cycle.  Imagine if you could invest in Uber, Twitter, HotelTonight or AirBnb when you first used them and loved them. You would be a lot richer today.

– companies will have more options for funding – instead of a few hundred VC and a couple thousands angels; they could raise money from millions of people, which should help boost valuation and foster innovation; By no means I say that good VCs and angels will go obsolete; They don’t provide just money, but also indispensable connections and advise that are essential to young companies;

– you will be able to invest in concepts that don’t have a viable alternative in public markets. For example, companies that are currently building the blockchain infrastructure;

– you could potentially enter a lot early in the growth stage of a company that could be huge 5 or 10 years from now;

The minuses:

– no liquid secondary market; this will probably partially change with time, but not being able to sell for a year will be a huge hit on liquidity; no liquid secondary market means no Technical Analysts – an indispensable tool for many investors; Valuation will matter a lot more, but then how do you value a tech company with no revenue, but huge potential. Maybe you just don’t invest in such companies. Reading and following experienced angels and VCs might be your only edge here. A few good starting points are – Fred Wilson, Marc Andreesen and his entire team at A16z, Howard Lindzon. Also research sites like  Mattermark and Crowdability and Techcrunch.

– there will be a lot of zeroes, a lot of frauds. Private companies don’t have to report every quarter; people will have to learn to diversify properly and look at private companies as just one asset class in their overall portfolio. Learn position sizing and diversification – if you are only allowed to invest 10k a year in private companies, allocate 2000 to five different companies or even better – 1000 to 10 different ones.

Secondary, Public markets will continue to play an important role in traders and investors’ lives, but there’s a new asset class coming on the horizon – an asset class that hasn’t been available for the majority of investors for a very long time. This asset class will open the doors to some incredible opportunities. It will also open the doors to some incredible frauds. In public markets, being wrong is not a choice, but staying wrong is. In private markets, you might not have the choice not to stay wrong, so choose wisely, use equal position sizing and diversify.

The Difference Between You and George Soros

When asked about the most important lessons that Stan Druckenmiller learned from George Soros, he says the following:

I’ve learned many things from him, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity

Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.

In my previous post, I talked about the incredible power of using small position sizes. I also mentioned that some of the best performing and most popular investors in the world, have made names for themselves by using ginormous position sizes. George Soros is one of those investors.

On September 16, 1992, Soros’ fund sold short more than $10 billion in pounds, profiting from the UK government’s reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism countries or to float its currency.

Finally, the UK withdrew from the European Exchange Rate Mechanism, devaluing the pound. Soros’s profit on the bet was estimated at over $1 billion. He was dubbed “the man who broke the Bank of England”.

Stanley Druckenmiller, who traded under Soros,  was the genius behind the idea. Soros just pushed him to take a bigger size. In this case, the bigger size was one of the reasons why this trade worked. What is more important here is to highlight their position size. They risked their entire YTD gain (they were up 12%).

Just to give you a perspective of how ballsy it is to risk 12% of your capital on one trade, consider the following simplified example:

Let’s assume that your trading capital is 200k and you want to buy a stock at $50 with a stop at 47; hence you risk $3 per share.

Risking 12% of your capital, means 12% * 200k = 24,000.

Divide 24,000 by the amount you risk per share ($3) to get the total number of shares you could afford to buy, which in this case is 8000 shares.

8000 shares * Current Market price of $50 = 400k. You would have to take on a 100% margin in order to risk 12% of your capital.

It is said that concentration creates wealth, diversification helps to protect it. The reality is that big returns are often just the opposite coin’s side of big drawdowns. Trading big position sizes is not for most market participants. If you still want to do it, you could learn a lot from people that have actually done it for a living. What are the four lessons from Soros’ s adventure with the British Pound:

1. Size matters.

When you manage billions of dollars, there are only a few great, high-liquid opportunities each year that will allow you to achieve substantial returns. The only way to achieve those bigger returns is to take on a bigger position size. The smaller your capital base, the more great trading opportunities you have in the market and you won’t have to risk big on any one of them.

2. Earn the “right” to trade Big first

They were up 12% for the year.  It wasn’t an incredible return, but it wasn’t bad either. In their eyes, they were able to afford the luxury to trade big. Here’s what Stanley Druckenmiller says on the subject:

It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it.

The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.

3. Proper Timing is Everything when you Trade Big

A good entry point allows you to go through normal market reactions.  An amazing entry point allows to use tighter stop and therefore bigger position size. Here’s hedge fund manager Scott Bessent on Stan Druckenmiller:

One of the things that I learned from Stan Druckenmiller is how to enter a trade. The great thing about Stan is that he can be wrong, but he rarely loses money because his entry point is so good.

4. Have a contingency plan

They were prepared for the worse case scenario. Despite their conviction, they knew that they might lose money, so they had an exit plan.  They made sure that they could afford the loss and stay in business.

Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.

 SOURCES:

INSIDE THE HOUSE OF MONEY, STEVEN DROBNEY, WILEY, 2008

Schwager, Jack D. (2009-10-13). The New Market Wizards: Conversations with America’s Top Traders. HarperBusiness. Kindle Edition.

Wikipedia – George Soros

A Lesson In Position Sizing – How You Could Lose 25% in Two Stocks and Still Have A Great Year

Let’s assume that at any single time you hold 50 high-beta positions with relatively equal capital allocation of about 2%. Your intention is to hold them for as long as their trend last. You expect some of them will remain your holdings for more than a year and others will get booted in a couple of weeks. When you get stopped in one of those positions, it will be replaced by another. You are constantly 100% invested. When you see signs of distribution in the market, you hedge by buying put options on the indexes or by shorting them. (There will be some very rare periods of extreme weakness when you own less than 50 stocks, because there are no signals in the market.)

You aim for a stop loss of approximately 6% for each position on average. You realize that some of your positions will give you a bigger than 6% loss if it happens that they gap down.

Let’s assume that it is earnings season and two of your holdings miss earnings badly and each drop 25%. What would be the overall damage to your portfolio of 50 stocks? Since each stock has a starting allocation of about 2%, a 25% drop would mean 50 basis points damage to the overall portfolio or 0.5%. In this case, two of your stocks are down 25%, which means that the total damage to your capital is 1%. Since those two have probably violated your stop losses, they are going to be replaced by other two that show promise for future appreciation. Not so bad when it is looked from this perspective, right? Your overall return and good sleep don’t depend on the performance of any one stock.

How do things look on the upside?

Let’s assume that one of your positions triples in a year. What is its impact to the overall capital return. Since each position starts with a 2% allocation, a 200% gain would mean a contribution of 4% to the overall portfolio’s return. Not so impressive when it is looked this way, isn’t it? One stock is not going to make your year.

When your position size is small, a few big winners and a few big losers don’t matter as much to the overall portfolio.

This does not mean that the overall return of your portfolio will be subpar.

Let’s assume that in any given year you have 120 winners and 80 losers. They are more than the 50 positions you constantly hold, because when a stock hits your stop loss, it is sold and replaced by another. The average size of your loser is 6%, the average size of your winner is 20%.

What is your total return?

Since each stock starts with an equal allocation of 2%, the impact of each loser will be (-6%)*2% = 0.12% or 12 basis points. The impact of each winner will be 20%*2% = 0.4% or 40 basis points.

The total impact of all losers will be 80*(-0.12%) = -9.6%
The total impact of all winners will be 120 * (0.4%) = 48%
In this case, the Total capital return is 48%-9.6% = 38.4%

We need to also account for transaction cost in such calculations. The smaller your capital, the bigger the negative impact of transaction cost. Unless you are using a broker like Interactive Brokers, which charges about $1 per transaction or Robin Hood, which promises free transactions or Motif Investing, where you could buy and update whole portfolios for $10.

You don’t need bigger concentration to achieve decent returns. You don’t need to put all your money in two or three names.

Then why some of the best performing money managers in the world use very different, much more concentrated approach?

Soros and Druckenmiller have made names for themselves by taking outsized risks and concentrating big portions of their capital into one or two ideas. When an idea works, they make a ton of money. When it doesn’t work, they lose a lot of money too, but the average size of their big winners far outweighs the average size of their losers. This is a topic I will elaborate on later this week.