Blurred Lines
A few years ago, Hendrik Bessembinder, a finance professor at Arizona State, conducted a study of stock market returns over the past century that yielded interesting results. In his study of approximately 26,000 companies, which also accounted for companies that either went out of business or were acquired, Bessembinder found that approximately 60% of stocks underperformed Treasury bills, even after considering dividends. While approximately 40% of stocks demonstrated relative outperformance, much of this outperformance went to offsetting the underperformance of the laggard 60%. Just 2% of companies were responsible for more than 90% of the aggregate wealth creation of the stock market relative to Treasury bills.
Of course, the impact here is skewed heavily to huge long-term winners given the results were measured by market capitalization. Nvidia’s run to a $4 trillion dollar market value would have a significantly larger impact on an updated version of this study than a mid- or small-capitalization company growing tenfold over a multi-year period. With approximately 40% of stocks outperforming Treasury bills, there remain plenty of winners to choose from, though probably not as many as some would assume. Also, the stocks that move the needle on overall stock market wealth creation eventually tend to break through to become a significant right tail outlier.
I believe Bessembinder’s study might provide a useful framework for understanding some of the current market behavior. I suspect there has been a shift toward an even more intense search in public markets for the next company that is an extreme positive outlier. If we assume that the majority of overall stock market wealth creation is driven by just a small handful of stocks, a collective strategy that indicates an increased desire to invest in huge potential long-term winners is understandable, even if the implementation of such a strategy at the individual level is almost certainly to be accompanied by nerve-testing volatility.
This shift nudges the public markets incrementally closer to what we have historically seen in private equity, and more specifically venture capital. Generally, the venture capital model is to invest in a portfolio of risky start-up companies with high potential upside. Most of these companies will end up failing while some generate a reasonable return and a few become huge winners. The expectation is that the few extreme winners far more than make up for the failures, ultimately generating an attractive overall portfolio return.
Public investors scrambling into the presumed biggest winners have been met by more traditional investors pointing to extreme valuation amongst the high-potential companies. With the Magnificent Seven a convenient reference point, some investors likely feel emboldened to disregard traditional valuation metrics for stocks with great promise. After all, at some point in the past each of the Mag Seven companies traded at a multiple that at least some would consider ridiculous. How’d that work out? Well, clearly, or they wouldn’t be in the Mag Seven today.
This context helps to better understand enthusiasm for companies viewed as potential long-term category winners such as Palantir Technologies, which currently trades at over 85x forward revenue and nearly 250x forward earnings. Cobble together a portfolio of companies with a similar profile using the venture capital framework and maybe it works out. I don’t have a lot of interest in trying that, but it certainly seems that some do, and who knows, it might work out for them.
In recent years we have seen a blurring of lines between the public and private markets. There are a growing number of “crossover” investors who invest across both public and private markets. As further evidence of this convergence, JPMorgan recently expanded its sell-side research coverage to include private firms. This shift is somewhat necessitated by the increased number of companies that have remained private longer than we have historically seen. Many of these companies have grown to such size and importance in shaping the outlook of a multitude of industries that the decision to add research coverage makes complete sense, even if investors cannot buy or sell equity in these companies today.
OpenAI’s recent valuation of $300 billion underscores the importance of the privately held company. Elon Musk’s SpaceX was valued at $350 billion last year, which would currently put it among the 25 largest companies in the S&P 500. OpenAI competitor Anthropic has reportedly recently been approached by investors seeking to invest at a valuation of over $100 billion, up from an investment round valuing it at $61.5 billion in March. To throw in one more example, privately-owned fintech provider Stripe was recently valued at $91.5 billion. While the rapidly increasing valuations for some of these private companies have been eye-opening, these valuations do not seem completely beyond justification, especially given the enthusiasm for AI. Recent funding rounds do not by any means exhaust the demand to invest in many of the largest privately held companies. For example, there have been publicly traded vehicles offering stakes in a variety of high-profile private companies that have traded at significant premiums to their underlying values despite some debate over whether the stakes even represented valid ownership of those private companies.
The trend toward companies staying private longer has been enabled by the mitigation of some of the drivers that historically would have prompted a move into the public markets. The availability of large incremental funding rounds, aided in part by the growth of crossover investors, has certainly played a role. Avenues for employees to obtain liquidity for their private shares have also increased. Progress does not always occur in a straight line, and perhaps this trend towards staying private takes a step or two back toward what we have seen historically, but I suspect the general trend will continue.
This would have implications for Bessembinder’s findings going forward, as a greater portion of wealth creation would occur in private markets. As many of the enormous potential long-term winners remain private for longer, it limits the public supply of potentially game-changing companies. This drives incremental demand for the publicly traded companies that fit this description. Pointing to the Magnificent Seven as examples and a reason high multiples don’t matter incorporates a very healthy dose of survivorship bias. The investment cemetery is littered with companies that investors once believed were game changers. As always, the key to success in investing is to get it right, which is easier said than done.
James M. Skubik, CFA®