Innovation is stronger than ever, innovation stocks are not
January 23, 2023
Chief Investment Officer (CIO) at BluOr Bank
“We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next 10.” — Bill Gates
On December 5th, scientists at the Lawrence Livermore National Laboratory in California produced nuclear fusion – recreating the force behind power of our sun and every star in the galaxy. Elemental power unleashed, albeit on the smallest of scales.
Less than a week before that, OpenAI released their most recent large language model chatbot – ChatGPT - which the New York Times hailed as “the best artificial intelligence chatbot ever released to the general public.” It can answer complicated questions, generate poems and write essays in the style of renowned writers. In so doing, it has confirmed the prospect of computer code as synthesizer and artful manipulator of known human knowledge, thereby mimicking another powerful elemental force: mythmaking.
Earlier this year generative AI prototypes such as Stable Diffusion and DALL-E 2 showed how text based commands could generate fantastical images from text based commands, opening new frontiers to human creativity. Combinations of words creating images that speak thousands more – visual nuclear fission.
At the same time, shareholders of what have come to be deemed ‘innovation stocks’ have also experienced two powerful forces of the physical world and the human condition: gravity and hubris.
Let us take for example the world’s most renowned ‘innovation’ fund, Cathy Wood’s ARK Innovation ETF (ARKK US). As of the close of trading on December 27th, the ARK Innovation Fund was down 69% in 2022 and now has a return of -19% over the past five years.
Despite crushing losses, back in September Wood tweeted “Innovation solves problems, and the world is facing many more problems today than two years ago. Innovation is key to real growth!”
Do not go gentle into that good night, Cathy! Or as Dylan Thomas might paraphrase you according to ChatGPT:
"Innovation, a beacon bright, Solves problems with all its might. The world, a stage of endless woes, Is plagued with troubles it behooves to close. And so we must embrace the key To true and lasting growth, you see. Innovation, fierce and bold, Unlocks the door to stories yet untold."
(ChatGPT promt: write “Innovation solves problems, and the world is facing many more problems today than two years ago. Innovation is key to real growth!” in the style of Dylan Thomas)
The ARK Innovation Fund is not the only innovation fund that has been hit hard. Many of the best performing funds of the past several years were focused on innovation stocks.
One reason why it would be naïve to expect a significant bounce in innovation stock share prices is due to the current interest rate environment. Any investment that is dependent on a long time horizon is deemed to be a long-duration asset and is thus negatively impacted by higher discount (interest) rates. And this year’s record pace of rate increases has crippled the most ambitious future cash flow assumptions that had previously been used to justify ridiculous overvaluations.
Faced with collapsing valuations and no real profits in sight many ‘innovation fund’ investments are now focused on cutting costs.
Dear fellow investors, please be wary of such narrative shifts. Companies that were hailed as having the possibility of being beautiful forever lose their magic when they go from strident gods and goddesses with high metabolisms to having to count calories, or what’s worse, not making it by face control at clubs where they used to be gilded VIPs.
Speaking of counting calories, Vladimir Lenin once said that “Every society is three meals away from chaos”. Unfortunately innovation fund portfolio managers are learning that their funds can be three quarters of losses away from massive redemptions.
Cathy Wood’s ARK Innovation ETF’s assets under management (AUM) peaked in February 2021 at $28 billion. Investors can buy and sell her ETF shares every day and a combination of investment losses and redemptions have reduced the fund’s AUM to $6 billion – a contraction of 81% from its highs. However, there are many hedge funds that hold similar positions in public companies that will see redemptions coming hard and fast that have quarterly liquidity (investors can only buy or sell once every three months). Many will unfortunately find that their long-term investors are not really very long-term after all.
And let us not forget about private companies and venture capital.
Venture capital funds typically value their holdings based on their last round of financing.
A stark warning sign to venture capital investors about the pending valuation apocalypse was when Klarna - the Swedish ‘Buy Now Pay Later’ company that was considered to be one of Europe’s most successful ‘unicorns’ - did a financing round this summer that cut its valuation from $46 billion to less that $7 billion. They will not be the only ones.
The Venture Capital landscape has changed dramatically. According to investment data company Preqin new VC deals fell 42 per cent in the first 11 months of this year to $286bn – the biggest drop since 2009.
What’s more, according to the Financial Times “company founders have entered into debt-focused deals such as bridge loans, structured equity, convertible notes, participating bonds and generous liquidation preferences. These moves are designed to avoid a dreaded “down round” —accepting funding at a far lower valuation than a company had previously secured.”
As any investor that does not believe that milk and honey are a permanent fixture of any asset class and has been through a proper investment cycle very well knows, any attempt to delay or obfuscate the inevitable will only ultimately only because more pain. The coming valuation collapse is not something to be ‘bridged’. Just as importantly, venture capital and private equity funds revalue far less often than those holding public securities – which tends to give investors a false sense of them being less risky, since we have come accustomed to tying volatility to risk. It will be interesting to see how a lack of public scrutiny and mark-to-market pricing leads to massive sticker shock when private company holdings begin to be revalued and VCs cannot garner the same investor interest in IPO exits as they could before. In the previous cycle Venture Capitalists were been rock stars and made a lot money for their investors and themselves. Do not be surprised if there is a rush for the exits over the next year or so (at least…) as redemptions lead to sales which lead to lower valuations, which lead to more redemptions, and so on and so on.
Technology used to be considered a ‘moat’ for successful companies, but technology is developing so quickly that many companies will be rendered obsolete before their ‘castle’ can be built. If yesterday’s world changing start up became a unicorn in three years, the company that will disrupt them will do so in even less time. This is very problematic for the long-term discounted cash flow models at the root of their massive valuations. Higher interest rates that reduce the present value of future earnings will actually be the least of their problems.
The era of bountiful VC money and lofty valuations is over, but true innovators will be just fine. They will find a way to get capital. It just won’t be anywhere near as easy as it was before. And from these challenges a new generation of innovative entrepreneurs will emerge that will enlist the power of the natural world and human ingenuity to build new and phenomenal businesses. The most important innovations do not happen overnight. Neither does investment success.
The Latvian version of this article originally appeared in the January 2023 issue of Forbes Latvia.
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