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The Build: I’m a Cash Flow Dinosaur
Two years ago, I sent an email to a handful of successful fund managers to start a dialog about investment philosophy. Some of these guys have names you’d recognize. Most ran billions of dollars.
Call me a dinosaur, but the premise of the email was that great investments are dictated by business performance, specifically the generation of future cash flows. Any investment predicated on anything other than future cash flows is speculation, not investment.
I was hoping to connect with these managers because I was seeing “investor” behavior as both a VC and public investor that seemed far from investing. If you invest on the idea that a multiple is too cheap or that some other company might buy it or that some other VC is going to mark you up, that’s speculation. I wanted to know if I was missing something. Was I just a dinosaur?
No response. They’re busy. They run way more money than me. Most of them probably didn’t even read it. It may not be the game they were playing anyway.
Two years later, cash flows seem to be in vogue again. I’m sharing the email here because I think it’s relevant for all of us to consider as we think about deploying capital in a bear market.
I’ve been considering three dichotomies in investing:
Investing vs speculation
Public vs private
Growth vs value
Investing vs Speculating. Via Buffet (paraphrasing): if you’re an investor, you look at what an asset is going to do. If you’re a speculator, you look at what the price is going to do. Investing vs speculation is the most fundamental distinction to make in developing an investment philosophy. It is easy to think you are investing when you are actually speculating but hard to think you are speculating when you are actually investing.
Investing is necessarily a long-term activity. It cannot be done over a short period. To benefit from the accumulation of cash flows generated by some asset, an investor must hold it over an extended period. Speculation is usually shorter term by necessity because it’s easier to predict price movements over shorter time periods than longer ones given fewer potential variables; however, holding period is a false indicator when considering investing vs speculating. If an asset holder’s ultimate intention is to have someone else pay more for the asset at a future time, irrespective of the actual cash flow generation of the asset, it would be an act of speculation rather than an investment.
There are few truly great investments because few businesses can be found at fair valuations that will eventually generate extraordinary cash flows. On the other hand, there are many great speculations for those with good timing and an above average ability to understand what others will be willing to pay for certain types of assets in the future. Therefore, even money managers that want to be investors may be forced to act as speculators because there are more far more frequent opportunities found in the latter category, and LPs expect managers to deploy capital allocated to them over a reasonable time horizon.
Public vs Private. Public vs private could be written liquid vs illiquid. In public markets, it’s easy to build positions in assets and easy to convert positions to cash. Liquidity welcomes speculation, which creates volatility in the pricing of assets. Volatility in pricing can be viewed as a negative measure of the incremental risk in holding liquid assets, but volatility also creates temporary opportunities for investors to acquire assets at attractive prices. Having a truly long-term perspective as an investor is one way to counteract the risk of volatility. Changes in prices don’t hurt investors with a long-term horizon
In private markets, it’s harder to gain access to the best assets and harder to convert positions into cash. Illiquidity creates the appearance of more stable asset prices and less risk. The combination of more stable asset prices and a forced holding period can fool speculators that hold illiquid, private assets into thinking that they are investors. This may be part of the reason for the attraction to private equity as an asset class for both LPs and managers. Both need to speculate because they need to deploy, and speculation in private assets feels more like investing than speculation in public assets.
Growth vs Value. “Growth” and “value” are different paths to the same ultimate end for an investor: ownership interest in an asset that will generate substantial cash flows over some period in the future. Growth investing assumes that new customer adoption creates cash flows that don’t currently exist and haven’t existed in the past. Growth investors pay for an asset based on an expectation that future cash flows will develop. Value investors depend on prior track records of existing customer adoption and cash flows generated from those existing customers. Value investors pay for an asset based on an expectation that current cash flows will continue into the future.
Good growth investments will almost always look expensive in the moment because they must price in cash flows that don’t currently exist. Good value investments should almost always look inexpensive in the moment since some established trend of cash flows must be expected to persist into the future. The challenge for growth investors to find investments that look expensive but are actually cheap. The challenge for value investors to avoid investments that look cheap but are actually expensive.
Bringing speculation into the picture, it’s easier to speculate on growth than value because growth is more abstract while value is more tangible. The more abstract an asset’s potential, the wider the range of potential outcomes and perspectives in the market about the asset. The more tangible an asset’s potential, the narrower the range of potential outcomes and perspectives in the market about the asset.
Adding illiquidity to growth creates another layer of abstraction, making it easier to speculate with the offsetting feel of investing from the inability to readily sell. Adding illiquidity to value forces more tangibility as investors rely on cash flows to pay back the investment.
Observations. There’s nothing wrong with speculation. It’s only a problem when a manager doesn’t realize he or she is speculating. Speculators that think they are investors act like investors, which enforces ineffective constraints in how they view their holdings. Speculators acting like investors will likely hold on to assets too long because of a false belief that they are “in it for the long haul.” Those misguided speculators would be better served to realize they are in it for a better price.
Specific to tech/growth investors, we would all be well served to define whether we’re investing or speculating. We may do the former for certain holdings, and the latter for other holdings. Given expectations from our LPs, it’s likely many of us will need to do some of both given the expectation of performance and a limited set of opportunities to only invest for the long term.
Notes and Quotes
Eric Newcomer did a tour of Silicon Valley to get perspectives from VCs, tech execs, and founders. The whole piece is worth reading. Here are two things I noted.
Bloated Tech Staff
A lot is said about easy capital access in boom times. The obvious lesson from the 2021 boom is that money trickles down to employees in tech companies where the asset base is intangible vs tangible. Tech is about creating IP. Engineers, product managers, marketers, salespeople — they all benefitted greatly from the now bust bubble.
“There’s a sense that there have been many software engineers who have been overpromoted in the bull cycle and that this downturn could force some coders to reset their expectations about their appropriate rank and pay.”
This comes after Flexport CEO Ryan Petersen questioned software engineer pay relative to running a profitable business:
I think the race for talent greatly impacted the ability of many tech companies to generate a profit. If you look at enough income statements, you ask yourself enough times, “Why does this business need this many people?” to see that over hiring was de rigueur in tech. It’s sad when people lose jobs, but it’s also a necessary healing process to fix the unsustainability of losing money in a world where money is tighter.
It's going to take time for these expectations to right size for tech workers. Investors need to be patient too. Expect to see a lot more from me on valuing growth assets in the coming weeks. Maybe to little surprise, the challenge of valuing growth assets was a key theme throughout Newcomer’s conversations.
What’s it Worth?
“Startup founders think prospective employees want assurances that their company is really worth what the company says it is. Good private unicorns are in a bit of a bind. Prospective employees are now automatically giving their equity offers a mental haircut based on the market downturn. So good companies have an incentive to reaffirm their valuations with funding rounds during the downturn — even if it otherwise might be smarter to keep their valuations artificially low so as to maintain room to grow should conditions worsen. (I wish employees would get better at assessing companies based on fundamentals, rather than the last tick fundraising round. Employees are basically begging founders to maximize for valuation, which then minimizes employee upside.)”
A startup is not immune from the first law of The Deload: Assets are always worth the sum of future cash flows in the long run. A simple concept that is so abstract that super smart startup founders and employees miss. It’s abstract because in most cases, equity owners never literally see any of that free cash flow. It gets reinvested back into the business or used to buy other companies or maybe to buyback stock. But residual cash in a business belongs to the equity holders nonetheless.
This past decade plus of easy money has impaired us from valuing companies on a cash flow basis because of the amount of money chasing anything and everything. No one would ever win a venture deal valuing a company on reasonable future cash flow expectations, nor would an employee get excited working for a company valued as such. All participants in the system are complicit, and now it’s time to reset.
One uncomfortable idea for the 2022 era until the next boom — we better get used to thinking about cash flows instead of revenues, and we should get used to lower, more realistic valuations as a result. It’s a hell of a lot harder to find a company really worth $10 billion when you’re considering future cash flows than when you’re considering rapid growth of unprofitable revenue.
Thanks for reading, and see you next week.
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Excellent. Thank you.
Many thanks for sharing Doug, a great summary, totally agree with your observations .. Cash flow should always be the primary measure of success .. I run global strategies that are more growth focused, however the number one factor still relate to cashflow measures .. I've seen very complicated quant models presented in different quant/CFA forums, long run success still boils down to is there more $$$ coming than going out from principal business activity