Aesthetics and returns

“The number of true theorems is, I believe, infinite. And the number of definitions that one can make is infinite. All these things are out there, but on the other hand, you don’t know this, there’s no book of all these things, because there’s an infinite number of possible theorems and definitions. The key in doing mathematics is to find a good definition, a definition that will get you somewhere, that will unify perhaps other things, and so on, that’s a creative act. It’s a creative act to find something interesting in an infinite field, in an infinite collection of things. It’s out there, but you have to find it, and have good taste… in finding something that will really go somewhere.”

“The word beauty permeates mathematics. There’s an aesthetic to it, and that’s why we use that word.”

From this, the segue into finance is the concept of compound interest, the “eighth wonder of the world” according to another mathematician.

“Our research goes on all the time,” he says, before the cigarette gets lit.

In the footsteps of giants

Sometimes, such as now, when the market’s watchers seem entranced by day traders and their daily whims, it’s fun, behind the scenes, to add another layer to the picture, imagining a silent smiling figure among the watchers, pressing a button here and there, infrequently and almost casually, which causes everything at once to scramble and change course. Like an elephant or some such giant walking slow and heavy through a jungle, oblivious to specimens that scurry down below, the frenzy of each giant step that’s taken.

It isn’t fair for either the big or little specimens to think about such things (for one’s amusement), because it isn’t altogether like that in the real life of the market or the jungle, but when we watch things from afar we simplify. For fun or not. And in this case the walking influential giant, for fun, embodies the investment funds’ limited partners. The limiteds, in parlance.

This ultimately is the money source that calls the shots, if only indirectly. It can move funding and commitments from here to there; it can deposit big amounts or take these out; it can go the private or the public route, equity or debt, early- or late-stage, alternative or what have you. And sometimes, if it wants, it takes from one pocket and transfers to another, all casually like – as mentioned, the cartoon is for amusement – and even when that happens all the market watchers and the traders and what have you, scramble.

Remote work, entertainment, supermarkets
Institutional Investor
Who’s writing the first checks
“On Wall Street, the rich aren’t easy to rob.”

The cheapening of market presence

The winner-take-most statistical power law effect we’ve seen in many emerging business categories is a phenomenon that network scientists have noticed in their natural investigations for some time. It is a trait in certain business models where network effects can reinforce a market presence, sometimes exponentially and to the marginalized exclusion of competitors who are relegated to a long (and narrow) tail, which is dreaded. The Big 5 techs, so-called, are more truly the Big 5 networks (in the broad sense), and it apparently will take some kind of intervention to keep their dominance in check. There are other examples.

An overlooked example in this way of seeing the network power law phenomenon in market presence, is on the funding side of the equation. That is to say, there is a winner-take-most parallel in financial markets, which has as much to do with the nature of the underlying business target as it does with the network nature of the markets themselves. Bubbles form sometimes, concentrations gather, attention focuses or fades, and thus the masses of financial capital shape similar leaderboard formations at all their many levels. The portfolio positions of fund managers tend to overlap, the structure of securities go in and out of fashion, certain institutions amass growing troves, and so on etc. (The wealth gap that is growing, perhaps, is also part of the event and its network effect drivers.)

And just as the individual products, messages or links that pass through the Big 5 networks (and others) tend to commoditization by sheer undifferentiated volume in these network concentrations, it’s possible to see financial flows and products the same way. That is to say, the financial category and its varied funding elements that accumulate, are contributing to the cheapening of these, if you will. And the return opportunity fades.

In this context, some news items from the financial press the other day, which, like everything described herein, is a participant in the gatherings.

The RH traders and the Treasury

The diverging positions of RH traders and bankruptcy financiers, in the end, is a difference in outlook: the distinction between, say, the letters V and L. The former signifies a sharp and expeditious economic bounce after an artificial short-lived stoppage that did nothing to the business fundamentals; the latter is a slower drift, where the asset value remains permanently damaged.

It is conceivable that if the broader funding market were to see the future the same way the RH traders seem to, at least implicitly, the bankruptcy scenario – its valuation exercise, its ranks and splits, perhaps even its timing – would be different. In this scenario, perhaps, the scope of the proceeding would be more mechanical in nature than financial; in other words, a short bridge to protect the company for some missed near-term payments. Until the rapid rebound that’s in this scenario expected.

In essence, the described position is similar to federal stimulus initiatives enacted at the outset of the economic lockdown. The PPP loan structure, for instance, intended to preserve small business payrolls with a short-term bridge to the V-recovery’s other side, the unemployment benefit boost set to expire a few months after implementation, the 90-day tax extension to mid-July, are all predicated on a quick economic bounce and return to “normalcy”.

In this sense, the RH traders and the Treasury department are more or less the same, although the latter holds more weight (because sophistication). In truth there is no way to really know, at least not yet, whether the V or L, or other shapes and letters that are kicked around, will be upcoming reality. But where the RH traders might reverse their bets at any time with ease and at a relatively small potential loss, all things considered, the federal institutions may not be as nimble or inconsequential.

So far at least, both seem well set and almost stubborn in their opening positions. Let’s hope that they are right, for our collective sakes and theirs.

In the world of guesses

It’s in a way convenient to point to Hertz day traders and lol, or smh if your mood tends to the reflective. The phenomenon of a bankrupt company’s common stock surging in value, out of nowhere and for no good reason, is unheard of. Clearly, it is said, a company is in bankruptcy to begin with because it can’t support financial obligations, and thus the value of these ranking liabilities is written down, while the deeply subordinated equity layer is left worthless. If there is any worth at all for common stock, it’s some tiny option value; and tiny for good reason, it is said, because it’s only in the mind of hopeful and imaginative gamblers. When that value surges, the gamblers have lost their collective mind. Or, so it goes.

The reflectives and the laughers are, from a financially educated and market knowledgable point of view, correct. Especially when history is taken in consideration. But, just for kicks (in keeping with the subject), it’s interesting to think about a world where the event makes sense. What if, in such a world, minds haven’t been lost, option value hasn’t been distorted, financial obligations don’t get written down, the market is as it ever was, and there is nothing strange about Herz or its day traders? A wonderful and fascinating world: admittedly, a speculative fiction, per the masthead.

In this world, all value is predicated on financial outlook, a perspective of the future that gets discounted to time present; and, since perspectives vary, the market clears at some point of common ground. There is give and take, there is supply and demand, but, in this world it’s recognized and factored into calculations that, really and if one is being honest, it’s all a guess, no matter how educated.

In this same world, when the estimated value of the asset dips below its corresponding liabilities, this is an indication that the collective market guess has caused it to be so. Just as a short-term dip in earnings (or even a continuing multi-year series of financial losses) may not matter to the long-term value of a stock because the market guesses a bright future, so in bankruptcy the market guesses a future less bright, and takes corrective action. In this world, the difference between the first and second case is merely one of the accepted guess and the degree of its acceptance.

Sometimes, additionally, there are in this world cases of circularity. The more the commonly accepted guess prevails, the more it becomes self-fulfilling. They call it reflexivity in this world, where there are countless instances of market guesses driving capital access (in either direction), which in turn contributes to the guess’s plausibility.

Finally, it sometimes happens in this world that very large disturbances of questionable precedent will cause the markets to guess wildly. The turbulence, in such a world, serves to increase option value, as possibilities get magnified when almost anything is possible. Sometimes letters get assigned to various shapes of future outcome – V, U, L, W, M, and even K, it is said – the growing alphabet of which only draws attention to the assortment in the rich bouquet of guesses and their almost equal probability.

It would seem absurd, in such a world, although it has been known to happen, for one group to treat another with righteous indignation about the nature of its guess…

All things considered, that would seem even more absurd than the guess itself, and its multitude of consequences…

The pocket and the tech

Some of the best finance reading of 2019 was the S-1 filings for the year’s class of IPOs. It’s nice to see the 2020 editions start to surface, and just as there seemed to be a theme across the 2019 publications, so also 2020 seems to have a subject of its own, thus far.

If 2019 was the year of consumer marketplaces – Uber, Lyft, Peloton, Pinterest – this year’s product seems to go in the direction of tech-enabled resellers. (I am thinking about Lemonade and Vroom in particular, which have attracted some attention.)

There are some common elements and there are distinctions between the two categories. Stripping the business models down to their basic elements – data network effects and user network effects, which go together – I feel like where the marketplace scenario depends on the former in support of the latter, the reseller model does it in reverse. If the edge in the marketplace model is the community of buyers and sellers that is formed and the efficiency of the transaction that results, the edge in the reseller model is the efficiency of customer acquisition and the economic offload of the product to an incumbent vendor. If the marketplace model and its network effects result in a winner-takes-most competitive landscape determined by a naturally growing presence on both sides, the reseller model is perpetually competitive and dependent on continuous efficiency improvements.

Perhaps a good analogy to illustrate the difference is the telecom segment of the ’90s. The network infrastructure, which had taken decades and many dollars to build, was increasingly overlaid by certain CLECs, DSLs, ISPs, and other forms of resale where the underlying lines were used (with owner’s approval) to market to end-users more efficiently than the incumbent did, or to enhance the incumbent’s reach through what was effectively outsourced marketing. The economics were split based on contracts that defined the term and financial responsibilities of each, among other things, and in many of these cases the telecom was essentially rented out by the marketing organization. In a sense.

There is a risk that comes with that, for either side. For the deep-pocket incumbent, it’s that the marketer becomes the magnet and consumer-facing brand that over time may take over. For the marketer, it’s that the deep-pocket incumbent may at any time pull the plug. It’s a delicate balance in what is almost a frenemy equation, each side dependent on the other and thus distrustful with a warm smile on its face; each motivated to increase its self-reliance, as the efficiency of the incumbent and the capital access of the upstart both improve.

I’m thinking about these things as I read about the reinsurance model and its financial risks and benefits to the data-driven tech-enabled insurance startup…

Form S-1

… and the “asset-light” strategy of the used car operation.

Form S-1

It’s a race, just like before, to see which of the sides prevails, the deep and capital intensive pocket that might catch up with the tech, or the deep and data intensive tech that might start pocketing the capital.

What looks large from a distance *

The investment thesis to support the market’s apparent disconnection from [everything], according to some, is that on the basis of a long-term forecast model, the current year and maybe next will hardly show up. The following from Matt Levine summarizes the idea:

Bloomberg

It all comes back to the same financial principle. Regardless of the valuation methodology – earnings multiple, revenue multiple, cash flow multiple, some multiple of an accounting fabrication, etc. – these translate to, imply, or are directly underpinned by a financial forecast. This forecast yields a present value calculation in which the terminal or future value – a shortcut for what future markets will bear in perpetuity – makes up the vast majority of the result.

Quote extracted from the same article

The issue has always been the same, only now even more so… The market thinks it’s “very forward-looking.” But it isn’t:

If we would backtest the idea 30, 50, 100 years ago on the timeline, we’d by likely to find that the subject company no longer exists, or if it does it isn’t the same company that traders bought or sold back when, or maybe it’s now a subsidiary that bears little operating semblance to the original asset.

In other words, the valuation model and all that it implies, is predicated on a forecast in which we might assume some growth or shrinkage, in which the first year or two probably don’t materially matter, as has been pointed out, but in which we are almost certain to be wrong about the nature of the asset in the future to begin with. It isn’t a question of how big or how small it will become, but what actually will it be? In perpetuity… which is a very, very long time.

The discount rate that reduces the guess back to present value, arguably, can take care of the conundrum. But not really:

First off, the terminal value in the model tends to be so disproportionately large (a multiple that magnifies the projection’s final year, by which time the operation has been typically shown to grow), that even on a discounted basis its impact on the overall is massive; and secondly, these days, the discount rate is more than likely low (ref., the risk-free T-yield curve).

Perhaps a more correct approach in what is mainly an academic exercise – because the market’s voice and judgment are what ultimately matter – is to substitute some long-dated option value for the future value in the model. Depending on the business type and profile, its fate may or may not reflect adaptation or survival, let alone leadership or following. And in a time like we’re in now, this great unknown but always possible discounts back to a highly subjective and interpretive guess.

Note *: Borrowed song lyric in the title.

The assumptions revisited

It seems like an eternity ago that chiefs were out performing with some semblance of conviction, at least some variant of guarded caution, to an expectant audience that always pushed for more. The market watchers were out toying (as liquidity and portfolios can sometimes make one do) with metrics and configurations like these were a kind of tender. That was a while ago, though not so long, before the focus shifted as it has to the assumptions, the assumptions, the assumptions…

(Which can’t be emphasized enough.)

It’s possible to look past certain things, approximate results, or get swept up in the excitement when the funds flow, the IPOs are pricing, and the economy is trending in an upward sloping line. When the economy can be defined and its component pieces somewhat understood, visions may be influenced by keeping up, and the attention to assumptions – their elements, causality, and dynamics – can sometimes trail the outcome, so to speak.

When the mood changes from gain to survival, the focus on assumptions picks up steam. It’s natural that this should happen: for market watchers who now have to look more closely as portfolio positions start to correlate and the liquidity gets questioned, and for the chiefs who might get by without it, learning to depend only on the enterprise that is forever being reinvented.

(This is a welcome thing at every level, I believe.)

The current case is an extreme, perhaps, (I am reminded of a wise investor who once cautioned against thinking of anything as extreme, for it can always be extremer), and the circumstances are unfortunate to say the least. But if there is a silver lining in it all – as there is with the popularizing and advancements of biotech, its methods and innovations – there may be one as well in financial planning and analysis.

The talk of a swoosh shaped economic recovery…

What’s a swoosh anyway? Is it sharp, flat, long, short, wavy?

… and related top-down theorizing and crystal-ball hypnotics…

WSJ

… might start to shift to a bottom-up approach that’s based on direct experience in the individual case, shaping value drivers and metrics that will hopefully get shared for scrutiny, making both the enterprise and markets more efficient and the economy more robust, in the future that is always arriving.

Perception, timing and efficiency

Perception and timing are forever interlinked in market valuations, which can drive and are driven by liquidity. Circularly this comes back again to timing and perception. That which cannot be escaped.

Perception: A seller of an asset, for example, might feel its value to be 2x +1, where x is some operating or financial metric, the multiple implies its future growth potential, and there is an added premium because the asset is perceived as scarce and special. The buyer disagrees and would pay x, best and final.

Timing: For a variety of reasons, the noted seller argues that it’s justified to accelerate value realization. The buyer does not see it the same way (or maybe can’t) and would defer that value transfer, or, if possible and better still, eliminate it altogether. The buyer would rather wait for proof of how it all plays out, the seller wants to lock it in.

In this way of seeing things, the asset’s liquidity will increase with the narrowing of timing and perception gaps. And liquidity itself may facilitate that narrowing. When money and resources are abundant, for the buyer or seller, either way, and when the choice of assets is diverse, there is a greater chance than not that some deal will clear the market. Conversely, when liquidity is thin, the gaps are much more difficult to bridge, and assets are more difficult to value in the absence of transaction evidence – which may circularly lead to illiquidity, as alluded.

That second case is referred to as market inefficiency by some, implying that the first case is efficient. What is or isn’t so, however, may more correctly be assessed by individual objective. When buyers and sellers all perfectly agree on timing and perception, there is no value realization opportunity for either side, though by conventional accounts that is a perfectly efficient market.

It’s good to disagree, it’s good for markets to be analytically (as opposed to operationally) inefficient. Timing and perception gaps drive risk, which leads to opportunity. The risk is in this case a healthy variety. The absence of a gap, by the same token, may lead to a collective shocks in unison, which is a different kind of risk entirely.

Alternative asset classes, which tend to be less liquid, are an interesting case.

WSJ

The formation of a thesis

It’s interesting to follow trains of thought among the medical authorities around this time. The progress that is made in tiny analytic steps, the statistical and probabilistic assessments, the hesitant conclusions subject to further testing and interpretation, all this in many ways resembles the formation of an investment thesis.

And the endpoint is more or less the same: a recommended course of action towards a desired outcome, predicated on the isolation and mitigation of risks that are identified along the way, balanced against tradeoffs and potential benefits that hopefully result.

Particularly as the subject matter is one of multivariate complex systems – organs that may react and interact in varying ways, groups of bodies that may do the same, externalities that skew outcomes, individual and group psychology, always a wildcard – the resemblance to economies and markets could not be more pronounced.

CBS News

As large economic managers and their counterparts in medicine consider their next steps and large directions, which in the current case also interrelate, we smaller ones may seek to do the same. That is to say, we’re all investors, even if not in financial assets, with positions that require monitoring and reconsideration at all times. Especially in turbulence.

Business strategy and execution, career planning and education, expenditures and downside protection, such things make up our non-financial portfolios (but so much boils down to finance at least indirectly, truth be told) which aren’t always liquid. A thesis helps.

A thesis helps to set a course, to watch for variances or fine-tune, as will likely be required. In many cases, the thesis will be one to modify outright as circumstances outright change. Under the guise of a business plan, a job, a degree, a stock purchase, and etc., there is consciously or unconsciously a thesis in any case; thinking this through formally, if you will, is probably not a waste of time and energy these days, as the givens and assumptions are said to be changing.