What's Fueling the Bay Area's Housing Bubble (w/ Vincent Deluard)
VINCENT DELUARD: Vincent Deluard. I'm the global macro strategies for INTL FCStone, which is a global financial service firm, working with securities team, advising institutional investors on asset allocation, sector selection and so forth. I'm based out of the Bay Area where I live for the past 10 years. I think it's the entire model of the Bay Area economy of rising asset prices, very high wages, most of that being stock based, and very high real estate prices. It was somewhat of a virtuous cycle for most of the past 10 years and with the recent slaughtering of the unicorn, I think we are at the beginning of a massive unraveling of this model. WeWork is like the-- WeWork is not San Francisco It is the tip of the iceberg. You see the big public ones that catch everyone's attention but the way Silicon Valley works is almost like a pyramid scheme in a way where every valuation is based off someone else's evaluation. If one needs to take a ride down, then the entire chain needs to work its way down. Then a lot of this wealth is on paper and it's very hard to use traditional discounted cash flow models for companies that don't have cash flow or have cash flows that are very negative for as far as the eye can see. You really have to price them off other deals. Most of the bubble that we've seen, contrary to what happened in the late '90s in the private market, but that being said, the IPO remained the endgame. It's just been longer and longer. You had all these Peter Pan companies that have been from the private investors for 5, 10 years. When you started, you only had series A, B, maybe C, now, people are F, and all these companies now, basically the road to publicly listing is now closed, and the laud investors that could bring them the liquidity, typically division fund are just not doing so well. A lot of them use leverage. I think we are just at the beginning of this unraveling and I don't see a happy ending to this. That is an excellent question. Probably it was one bridge too far. The big IPOs were priced to aggressively and the excesses have just been-- WeWork is a poster child of really the end of a cycle, if you will. I think initially, if we get a first stage of the unicorn massacre this summer, it somewhat made sense because we had these steeper yield curves and high yields now. I think it was actually WeWork as one. It was probably the biggest shark crime as one finding was there was no Y axis. It was a chart of one and I think what it was meant to represent was the expected cash flow of WeWork and then it was very negative for, I don't know three, four years and then it just shot to the sky. Like I said, no unit, no guarantee, no nothing. The point is, if you have a capital profile like that, which is what most unicorn think they will have, the best configuration for you is an inverted yield curve because you discount your losses at a higher rate, and then your profit which come later is at a lower rate. If you take a net present value approach, this is the yield curve that will maximize your net present value. When you have a yield curve steepening in which is what we had early in September, not just for this dynamic upside down. That was somewhat logical, but then something strange happened in the past, I would say three, four weeks, is that we've seen the long bond rally, we've seen flattening, if not inversion of the yield curves, and yet the unicorn massacre kept going. In a way, that reminded me of what happened in '06, '07 with the real estate market. There was this famous school by Ben Bernanke. I think it was in his Chicago speech, I think the subprime problems will be contained. That was not such an unreasonable thought at the time because at that time, you could-- well, I think the Fed just hiked 20 times in a row. Yeah, we cut probably get a couple times and it will be fine. But then the surprise was that as the Fed cut, subprime trouble kept getting worse, not better, and that's because it was not-- it was just the math didn't work. These guys were not going to pay, so even if you cut it to zero or below, it would seem unaffordable. I think that's probably what's happening now with some of these unicorns is people are realizing that negative cash flow at a negative discount rate are still negative present value. I would expect San Francisco to be the epicenter of this and maybe we'll get into this later but partly because of the role played by equity based compensation. I think that's the missing link and that's the leverage that take something that should be a welcome valuation correction. You had this bubble, it's somewhat of a healthy thing that it corrects but that will translate that at least within the regional economy. Past that, lack of profit is not just a unicorn who started the phenomenon. If you look at the Russell 2000, about a third of Russell 2000 companies do not make profit actually. I counted. There was about 18% of the companies that lost money in 15 of the past 16 quarters. That's a significant number then they're not just tech startup or biotech companies. Again, we have tax rates at the lowest they've been since the end of the war, we had the unemployment rate of the lowest it's been for, again, the end of the war, interest rates at about a 5000-year low and still, you have a third of the market that cannot turn a profit in under these circumstances. At the same time, you've seen these explosion in debt per share, three, four x on the Russell 2000 since 2011. You have all the ingredients for a major correction. Absolutely. To me, this is one of the most fascinating stat that really doesn't get talked enough is the amount of dilution and stock-based compensation that has been paid out. Part of the reason it doesn't get discussed as much is you should get big tech, there's usually a buyback to offset that. You don't really see that in the number, like you have to dig through. Oh, why are they spending all this money on buybacks, but the share count is flat rolling. Then you realize, oh, that's because they pay so much, or they comp stock-based. I think if you look at like a mid-level data scientist at Google probably makes 401k, I would think, and I would say half of that is going to be stock-based camp. Same would be true at Amazon or other places. Now, when the stock price goes up, that is wonderful. As you mentioned, these expenses were much faster than any of what its revenue, what its earnings, cash flow, so I made these amusing calculation that if we kept going at the current pace, so I built this index of Bay Area based companies, I found that they paid 18 billion, now, 18 billion in one quarter in stock-based compensation. 18 billion is a significant number. It would be I would say about 1% of French GDP for a matter of just in one quarter in maybe four zip codes being paid out. Again, keep in mind that the absorbing capacity of the Bay Area in terms of our real estate assets is quite limited so you see this wall of money that just falls. Anyway-- and they kept that at this pace, it would take five years until we wish they would pay more in stock-based compensation than it would have earnings. If earnings kept growing at a healthy pace that they are and then stock-based compensation keeps skyrocketing as it is. Obviously, where the problem like you would need an infinite amount of growth to sustain these practices. You had the first cuts in the second half of last year, and then we've seen the case here rebound everywhere, but the three cities, San Francisco, Los Angeles and Washington D.C., which are coincidentally also the ones that have seen the highest appreciation. We may be at this point where rate cuts have lost their ability to make people solvent again and I wonder what will happen to the employees that were happy to take these very-- and it's a nice life. When you work at Google or Netflix and you're paid a lot of money but again, half of your compensation is in equity based options. If suddenly, this is not worth anything, well, you may ask for real money instead of options, and that will be a problem for all those companies that don't make any money. They just won't be able to do it and those who do, the companies who do make money, part of the appeal of big tech is high margins and high growth. Well, if suddenly your employee expense, which these are not like capital based industries, the biggest expense is their people, if that doubles, then the case where these high and resilient margins just goes away, the EPS growth drops, and then you could see this negative feedback cycle. You could also see it go through taxation. I think San Francisco gets about a third of its revenue from various housing and transaction related taxes. Basically, the virtuous cycle of the 2010s could be the vicious cycle of 2020s. One thing that struck me is if you look at a median millennial, he turned 20 in 2009, when the S&P 500 bottomed at 666 and then last summer, that same median millennial turned 30 just as the S&P 500 go through 3000. I like to put in these terms that this was in a way a millennial bull market and we get a bad rap as millennials will ruin everything, sex, beers, whatever boomers' grumpy about is being ruined by millennial but that's the one thing with it is this bull market. In a way it makes sense. The millennial is the greatest generation. It's not the boomers. You have more millennials than you have boomers, at least in the US. You have the greatest generation in American history going from an income of zero or even negative when you're 20. When you don't have any income, you'd have a bunch of expenses and that's it. Two, you're 30s when really this is a time when your earnings are too slow or even sometimes peaked, but during these 10 years, your income grows, I would say double digit every year. If you think about who were shopping on Amazon first? It was people in my generation who, my parents would have had an AOL or the French equivalent email account, I would have switched already to Gmail. Who was Facebook initially was for? Really millennial. You need to have a US university actually, [indiscernible] at the beginning email address to join. Netflix obviously has the boomers would-- a date would be a dinner and a movie and then for the millennial would be just watching Netflix together. These were millennial companies and they rode this enormous wave in this generational rise of income, and that's why growth seemed effortless for them. I think we're seeing the end of it. The best example would be Netflix where, for the first time in the most mature market for them, the US, you saw this subscriber decline and the need to raise prices. The best historical analogy to me would be the Nifty 50s. This was back in the late '60s, early '70s. This was the prior greatest generation, which is the boomers. Same story. The boomers were born starting just in the middle of the war, 1942, I think is the first year for the baby boomers. As the baby boomers started spending, you see these rise of consumer companies. At the time, it was Old Disney, Coca Cola, Gillette. They were touted as this one decision stock so it doesn't matter what the price is because they would always have the growth to support that. Then by the time you get to the mid-70s, well, it turns out that the boomers also had to pay houses, also had to raise children and the growth just-- it was like the air like when a plane hit the turbulence, just drops like that. That's certainly something we've seen with the-- if you look at the a composite of the sales growth of the Fang stocks, the gap with the rest of the market is at its lowest as it's ever been. I think part of the game then is going to be okay, are we able to appeal to this younger generation, Gen Z as I believe. I think some of the, certainly, if you think about, Facebook buying other social networks, they can probably do that, but that generation is much smaller. Just by sheer demographic effect, you'll see an adjustment in growth rates. It's been marvelous for someone like me. It's assisted living for the young professional. You literally have and I still, you will take many historians to explain why the world thought that was a good idea to take the savings of pensioners in Japan and Germany and use them to subsidize the consumption of yuppies in New York and San Francisco but that's effectively what a lot of these-- if you think maybe not the Fang because the Fang do have a profit generating ability, but if you think about the more consumer centric unicorns like well, it's not really a unicorn anymore, but something like a Blue Apron or Casper or even Uber or Lyft where effectively the product is being subsidized indefinitely in order to win market share. It is a subsidy. As a recipient of this subsidy, I'm obviously in favor of it, but I wonder whether the-- in some of these companies is we have the Peter Pan syndrome where they never grow up, they never pass this phase of, we're just building out like, WeWork is an example. We need to spend to $2 for every dollar we earned. If you remember from the internet bubble, the joke was a pet.com because that was the day of the Super Bowl ad and it was clingy. Basically the story was like I think they had a revenue of-- and the numbers were tiny compared to what we've seen today, but I'm gonna say 100 million, but I was not sure. Then they have comps at 160 million. Congratulation, you took something that was worth 1.6. You sold it for one. That's your business model. Well, [indiscernible] that and you get WeWork. Again, I would work off the '70s because in many ways, it's somewhat similar in terms of the least, the demographic aspect, and the biggest thing in the '70s was these companies didn't go under. A lot of them are still members of Dow Jones. The multiples went and again, the Nifty 50 is traded at 50, 60 times earnings, very similar to what you'll get for Netflix or Amazon today. As you rerate that growth, that multiple just needs to come down so you need to see a massive adjustment in valuation and then because of the [indiscernible], you need dependency for the Bay Area on stock-based compensation, which I don't think was as prevalent in the in the '70s. I think you could see a wider impact certainly on the local economy. Another added risk factor in the 2020s that was not present 1970s is high level of debt. You're racing this explosion of debt, debt per share in pretty much all across the board which will make companies much less resilient to this rerating of multiples. One experiment I made came from a frustration with traditional factor investing which as you know, hasn't really worked. Most multifactor ETFs really haven't worked. The only factor that has worked has been momentum and that reversed last summer. I've seen instead of like back testing things and calling them anomalies, maybe we should understand the term factor in a more literal manner. What makes value? Fundamentally, you can break down value, it either comes from capital, labor or everything else? There's nothing else. I build these portfolios. I form portfolios, typical factor based on decide which companies have the most market value per capital or sorry, the most capital per market value, the most labor per market value and then the most nothing per market value. All the way up until former accumulation period, buying a capital on the cheap or labor on the cheap was the best strategy. Again, that's basically the value anomaly, buy low or sell high. Then as you move towards the 2010, what you start seeing is intangible capital meaning to drive a return. Things like [indiscernible], like copyright, and that's consistent with the rise of big tech companies that really don't have that much capital, they have employees but still on adjusted but the market cap is very low so most of these is intangible. Then starting 2015, the best strategy is the one that used to be the worst strategy before which was buy the companies that have neither capital nor labor, nor even intangible capital, they have nothing. I think in in a way, you can call that a bubble and you can say, maybe it's because of passive indexing, because of the death of the value investor, because-- maybe all these things are true to some extent but I think, more fundamentally, it happened coincidentally with the rise of these negative yielding bonds, which is what 16 trillion today. I think what it says is like, when capital becomes free, owning stuff is not an advantage anymore. Having a big retail network is anybody can do that. Anybody who has access to borrowing can replicate this. What defines value then becomes the things you cannot replicate. It could be reputation, data on consumers, brand loyalty and so forth. I think that's this was capturing. It could also be just an illusion and the piece I mentioned was referring to, I call it the fire festival stock market. We're all living in this world where we tell stories to each other and as long as we all believe that fire festival is going to take place, everyone's happy, the influencers are happy, the organizers are happy, the musicians are happy. It's only when-- and I worry that we are getting at this fire festival moment with the collapse of the unicorns. The most interesting statistic is the one you brought up where you see the stock-based compensation growing four times faster than the market cap, which itself is growing three times faster than earnings. To be fastidious, I added a charge-- that's the beautiful thing about San Francisco is a clean street but you can trap boots in real time. They have a service called steet101.org where you can report any incident. Actually, you really don't need to be a great caller to do it and [indiscernible] that next to the stock-based comp, and you'll see this almost one to one correlation between stock-based compensation and reported incident involving human feces in industries of San Francisco. You also had the same thing with discovering needles. As you know, there's a huge homelessness crisis in San Francisco. The city doesn't quite-- well, I think they know how to address it, which is to build a house, really, they just don't want to. One of the solution is to just give them needles. I think at the current base, it's about 2 million needles a year have been discovered in the streets. Anyway, the reason I like to bring these two together, other than the shock value is to really speak to that, we started by saying there's something rotten in the state of California. I think it's something that you'll feel when you talk to people in the sense that this should be the best time, Silicon Valley should be the model for this brave new world. Everyone talks about these crises of capitalism, stagnant wages, rise of populism. The Bay Area should be this shining city on a hill with people living happy in suburban houses, driving Tesla and stuff. It's shocking when you talk to people, there is sense of pessimism, of self-rejection almost, they don't want their kids to be anywhere near iPads. There's this almost sense of guilt that this big tech is destroying society as we know. Politically, you cannot see that with Andrew Yang's [indiscernible] which everybody, all my friends love Andrew yang, and in a way he reminds me a little bit of when the Pope was building St. Peter in Rome, the church money so [indiscernible] sold Andrew Ross. Give the church your money and you'll earn a couple years in paradise and your sins will be forgotten. A few that the universal basic income and its enthusiastic embrace by not just big tech people but regular employees, like oh, my God, what have we done here? Hopefully, here's my $1,000 month indulgence to redeem my sense.