What is a Bubble? – My response to Ben Evans slide deck

Benedict Evans at Andreessen Horrowitz published a slide deck yesterday outlining his analysis showing that there is no ‘Bubble’ in tech. I read through the whole thing several times, and I could not escape the feeling that I did not agree with his reasoning.

First, let me point out that this deck is an amazing piece of work. By my count, Evans combined 13 separate data sources. The fact that he was then able to pull new insights out of that is awe-inspiring for data nerds like myself. No Python script could replicate this. It is a work of True Craft.

So it took me a while to understand why I did not agree with it. Evans sent me a PDF copy of the deck, and I went through and tried to relabel the headlines on each slide to see if I could craft a different narrative with the same facts. That was fun, but then I realized I had a more fundamental issue.

Evans is answering a lot of questions with his slides, but the main question is Are we in a Tech Bubble? A refrain that he and his colleagues must hear every day. As I discussed in a post a few weeks ago, I certainly do not have an answer to that question. Some things seem very bubbly, some things not so much. But before we answer that question, we need to make some things clear. What do we mean by Bubble?

A good definition I hear in the public markets goes something like:

“A Bubble is an investment in which no reasonable argument can be made that the fundamentals of the asset could ever pay back the investment.”

So by that definition, Amazon with its nearly infinite PE multiple is not a Bubble, because I can make a reasonable argument that they could flip a switch on any of their businesses and become immensely profitable instantly. (In fact, I have made that argument in regards to AWS. And disclosure I own 100 shares of AMZN.) At the same time, the 17th century Dutch Tulip Mania was a Bubble because no one could reasonably argue that any tulip bulb would live long enough to pay back its price at the peak.

So today, the question “Are we in a Tech Bubble?” becomes “Would a reasonable person invest in a private tech company today?”, and perhaps more to the point “Would a reasonable person invest in a venture capital fund today?”.

And this is where I start to diverge with Evans. I am not saying he is wrong, only that on the subject of external validation of valuation I am not convinced by his data. Much of his work sits inside the closed loop of venture investing. I think his analysis of the division of returns among various funding stages is very fascinating. Great work, but it does not answer the broader question. Venture valuation methods are very different than public market valuations. Maybe I am biased because of my work history, but I am a big believer in the long-term efficiency of public markets. So to prove to me that we are not in a Bubble, I need to see some connection between private and public valuations.

Now Evans does touch on this in his deck, looking at Tech investing in relation to the US GDP and to public market metrics. In particular, he compares PE multiples of the S&P IT Index to 1990’s levels, and indeed we are well below those. I think there are two things wrong with this approach. First, a quibble. That particular index is market-cap weighted, which means that Apple is a huge component, and Apple’s valuation is just outright confusing to everyone. I do not want to go too far down this rabbit hole, but put simply, tech stock multiples are higher than it appears in the data. Second, and more important, all of Evans’ data shows that current conditions are much lower than the late 1990’s peak, BUT current levels are in second place to that numbers. We are nowhere near the extremes of the last Bubble, but that does not mean we are not in a Bubble. It could just be that we are in a Bubble with a different shape.

When it comes right down to it, I actually agree with Evans’ basic point. Conditions are different now, companies are more profitable, venture investments are much less risky. But I wanted to write this after I saw a lot of people on Twitter and the blogosphere collectively breathe a sigh of relief on reading Evans’ analysis. As much as current conditions look good, that does not mean we should lower our guard. Evans proves that we do not need to become Prophets of Gloom today, but I think it is important to remember that conditions change very quickly. And they will change.

3 responses to “What is a Bubble? – My response to Ben Evans slide deck

  1. After viewing the presentation I found it mildly interesting but not incredibly telling. I think the comparisons which involve GDP, inflation and P/E multiples are not helpful. GDP and inflation are prone to government goal seeking such as the all new doubly seasonally adjusted data, hedonic adjustments and various basket changes that distort reality, so long time comparisons are inaccurate. P/E measured via non-GAAP for stock options and other one time measures continues to get more creative in my opinion making earnings look better. One thing is for sure that the private market is extracting all the value and this trend has been clear for some time. And yes it is cheaper than ever to start-up, also not new. But we need to look at a much bigger picture of which VC and tech investing is just a piece of the global economy. Even though I used to be a tech guy in the industry and a tech investment analyst at a fund, I have spent most of my time over the past year looking at the dark world of (modern) central banking (QE), money markets and shadow banking and the huge amounts of debt creation (deleveraging is largely a myth btw unless defaults count) and the insane notional amount of derivatives exceeding $710 trillion notional with $461.3 trillion in interest rate swaps (BIS May 2014). While there are experts who understand the various pieces there are few who understand the modern global financial plumbing and how it works as a whole (and I am not one of them). However, what happens when things break down in the system? (Note: We could have asked Dick Fuld for an answer, but apparently Lehman wasn’t bankrupt after all). Maybe it will be rising rates (paging Dr. Yellen), FX due to currency wars (Kon’nichiwa) perhaps a default in Greece (Opa!) or insolvency in other state entities (Think State Street that great street). My point here is that 0% interest rates and QE have caused large imbalances and nearly every asset class is highly correlated. VC investing has been one way to get nice returns in a low interest rate (cost of capital) environment. Going forward it is tough to make money on new deployments in just about any asset class. The real question as Mark Cuban noted is how to exit private VC investments? When things turn down it won’t be easy bubble or not because liquidity might be an issue. As long as there is no leverage or demands for capital calls on the investor base, limited partners can use all the beautiful cash flow from operations that portfolio companies provide to pay handsome dividends (for the profitable ones with revenues and I hear Snapchat is working on it), but I don’t think many of the investors will have the flexibility to hold their investments. Anyway, I’m not a VC expert.

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