Is Another Bubble About To Burst In 2021?
Last month, Barron’s splashed the eye-catching headline “IPO FRENZY” on its cover, following the massive runups in first day trading for Airbnb, DoorDash, C3 and other hot IPOs. The story wasted no time bringing up the dreaded b-word — as in bubble — as a chilling reprise of another cover story Barron’s ran twenty years ago that many investment analysts believe was the spark igniting the dot-com crash. We now have the benefit of hindsight to assess whether we’re in another stock market bubble. So let’s take brief walk down memory lane to see what’s changed, what hasn’t and what to expect in 2021.
The Dot-Com Bubble — 2000
Heading into the new millennium, amidst widespread euphoria — if yet limited understanding — of the promise and perils of ecommerce, venture capital poured into dot-com startups — many pre-revenue, and with unproven or non-existent business plans. In 1999 and 2000, total VC funding in the US spiked 366% over the prior two year period.
Public markets also experienced unprecedented activity during this period, with 630 tech venture IPO listings in 1999–2000, a 220% increase over the prior two years. The new publicly traded companies were younger, smaller and considerably less profitable than their predecessors.
The rise and fall of Pets.com exemplifies the foibles of the dot-com bubble economy. Pets.com launched in February 1999, backed by major VCs and Amazon, who collectively invested $110 million in the venture. Less than a year after launch, Pets.com filed its S-1 IPO prospectus, revealing that the company had lost $61 million on sales of only $5.7 million in 1999. It didn’t help that the company’s cost of goods sold was $13.4 million, meaning that Pets.com was losing 57 cents on every sales dollar, even before accounting for large administrative and marketing expenses. Nonetheless, Pets.com successfully IPO’d in February 2000, raising $82.5 million. The new capital didn’t last long. Pets.com ceased operations and declared bankruptcy on November 9, 2000, just 268 days after its ill-fated IPO.
Pets.com was one of hundreds of over-hyped, underperforming tech IPOs in the dot-com boom era. The NASDAQ stock price index soared into the new millennium peaking at 5,049 on March 10, 2000, more than double its level just one year earlier. No one factor triggered the ensuing market collapse beyond a steadily growing recognition that countless tech ventures were operating with no credible business plans for short-term survival, let alone long-term success.
On March 20, 2000, Barron’s splashed a picture of a pile of cash ablaze on its magazine cover under the headline: “BURNING FAST.” The issue featured a study of more than 200 Internet firms, many of which Barron’s predicted would shortly “go up in flames.” The market agreed, and tech stocks went into free-fall. One by one, the weakest dot-coms began underperforming the market, first in a trickle, and then at a frighteningly accelerating rate. Within a month of its peak, the NASDAQ price index plunged 34%, wiping out nearly $1 trillion in market value. The decline continued through October 2002, by which time the NASDAQ stock index had declined 78%, torching $5 trillion in investor equity. It would take fifteen years before NASDAQ would again reach its March 2000 peak. In the interim, private and public capital markets retreated from the irrationally exuberant investment levels of the dot-com bubble era, surely a sign that we would never fall prey to such misguided behavior again. Or would we?
Blitzscaling Mania — 2018–2019
Another next epoch of irrational exuberance emerged in mid-2017 when Softbank’s Vision Fund completed its record-breaking $100 billion fundraising effort. In a world awash in capital from sovereign wealth funds, deep-pocketed Asian investors, and other highly endowed institutions, VC’s increasingly adopted the philosophy of “blitzscale investing,” under the belief that a venture’s access to unprecedented amounts of capital conveyed winner-take-all competitive advantage.
In 2018 and 2019, the average annual value of VC dealmaking in the US jumped 72% over the relatively stable prior three years, driven largely by a spike in number of mega-rounds of $100 million or more, which increased 2.5X between the two periods.
These blitzscale investments were driven more by VCs’ urgency to deploy capital than by real business needs or the underlying strengths of venture business models. For example, when US dog-walking service Wag sought to raise a $75 million D-round from a syndicate of US VCs, the Softbank Vision Fund swept in with a preemptive investment of $300 million, quadrupling money-losing Wag’s market valuation from just 9 months earlier. It wasn’t clear then or now that a dog-walking service warranted an investment or valuation on this scale. Nor so when coworking office space startup WeWork secured over $10 billion in sole source Softbank funding between 2017 and 2019 at progressively higher valuations. But as Uber’s CEO, Dara Khosrowshahi (who himself secured a $9 billion capital infusion from Softbank) noted at the time, “Rather than having their capital cannon facing me, I’d rather have their capital cannon behind me.”
Under the right conditions, blitzscale investments can be a game-changer, but only if the recipient’s underlying business model is highly differentiated, scalable, defensible, and enjoys inherently high operating margins that only get better with increasing scale and network effects. But few ventures actually exhibit these characteristics, and the consequences of investing too much, too soon in unproven businesses can be catastrophic, as it often compels ventures to rapidly replicate their flawed business model on a global scale. These are exactly the tail-wagging-the-dog circumstances that led to the collapse of WeWork’s planned IPO, Uber and Lyft’s down-round IPO’s and to the sizable private market devaluations in Softbank’s mega-investments in Oyo (budget hotels), Fair (car leasing), Wag, and other misguided blitzscale investments.
Unlike the dot-com crash at the turn of the millennium which was fueled by irrational exuberance in both private and public markets , the excesses of the 2018/2019 VC blitzscale binge was moderated by investment discipline in public markets. In fact not one of the unicorn ventures that went public in 2019 traded above their last private valuation or IPO listing price by year end. Surely, stock market investors had been chastened by irrational VC exuberance. Or had they?
IPO Frenzy — 2020
On March 5, 2020, Sequoia Capital warned its portfolio companies to rein in spending and reexamine their business fundamentals, as future financing was likely to become challenging. As the depths of the Covid pandemic became apparent last spring, few expected 2020 to become a banner year for private and public market investment. But by any measure, that’s exactly what happened. To begin with, VC investments came roaring back in the second half of the year, followed by IPO’s, and a special class of speculative investment called Special Purpose Acquisition Company (SPAC).
VC investments in the US reached an all-time high of over $150 billion in 2020, once again paced by a record-setting number of mega-rounds in excess of $100 million. IPO proceeds surged 69% in 2020 to over $78 billion, the second highest yearly level ever. But 2020’s biggest investment gains came in arguably the most speculative of all venture investments: SPACs.
A SPAC is an alternative to a traditional IPO where an investment firm raises funds through a public offering with the intent to acquire an unspecified private venture within eighteen months. At the time a SPAC goes public, individual investors have no idea what the SPAC will buy or at what price; they’re simply investing in a blank-check acquisition. While SPAC’s have been around for decades, activity this year has been off the charts. In 2020, 243 SPACs started trading on US exchanges, raising over $81 billion (more than IPOs), a remarkable six-fold increase over SPACs in 2019, which itself was a record year. The biggest SPAC in 2020 was launched by hedge fund manager Bill Ackman, who raised $4 billion in July. Although Ackman has yet to find a suitable company to acquire, his blank-check SPAC had already appreciated 25% by year end.
Recent IPO activity underscores why Barron’s raised the spectre of a bubble in their December 14th cover story. Food delivery business DoorDash went public on December 9th, selling 33 million shares to institutional investors at $102 each, raising $3.4 billion at an implied opening market value of $38 billion. During first-day trading, DoorDash’s share price closed at $189.50, a first-day trading pop of 86%. This gave the company a market value over $60 billion, a remarkable 3.8X runup over the company’s last private valuation just six months earlier .
On the same day as DoorDash’s IPO, artificial intelligence startup C3 also went public, raising $651 million, and hitting first-day trading highs 174% over its opening price. The next day, Airbnb IPO’d, raising $3.7 billion and enjoying a first-day trading pop of 113%, briefly valuing the company at over $100 billion.
Throughout 2020, IPO’s manifested signs of frothiness, eerily reminiscent of the runup to the dot-com crash in 2000. For starters, the first-day pop of all IPO stocks this year was 48.1%, higher than the 45.8% level recorded in 2000, and at least twice as high as any other year in the interim. Amongst technology companies, the 2020 IPO listing price-to-sales ratio was 13.4, the first double-digit measure recorded since 2000. For context, the price-to-sales ratio for S&P 500 stocks is currently around 2.6. And finally, in a reprise of the growth-trumps-profit playbook of the dot-com crash era, only 19% of tech IPO’s this year were profitable before going public, even though the current median age of IPO companies is 9 years old, three years more mature than the tech IPO’s of 2000.
What To Expect in 2021
If investors should have learned anything from the dot-com bubble at the turn of the century, and the more recent VC blitzscaling binge, it’s that money per se does not bestow competitive advantage and that business models really matter. And yet, as we head into 2021 riding the wave of an incredibly buoyant past year in private and public capital markets, it appears investors have once again stumbled into unsustainably exuberant behavior.
To be sure, today’s business environment is vastly different now than at the dawn of the Internet. The current ubiquity of broadband access, mobile technologies, AI, open source tools, and cloud computing has led to explosive growth in the size of addressable markets, while dramatically lowering the costs of launching and operating new ventures. Moreover, market conditions have also become more conducive to winner-take-all outcomes, most visibly evident in the emergence of four companies that currently enjoy market caps well over $1 trillion. It is perhaps this siren song of seemingly unbounded upside potential that has now attracted so much investment in search of becoming the next Apple, Amazon, Google or Microsoft.
But for all the progress in today’s technology, market, and competitive environment, two interrelated lessons from the past remain unchanged. The first is investing too much, too soon in unproven business models only heightens the risk that the race for global domination will turn into a race to disappointment, or worse. As a case in point, for all of the over-hyped, over-capitalized victims of the dot-com crash, some of the most successful companies today started out during the dot-com crash era, and succeeded on the strength of their superior business models, rather than the amount of venture capital they raised. To wit, the total VC funding raised by Amazon ($108 million), Google ($36 million) and Salesforce ($64 million) prior to their IPOs would barely register today as a single mega-round investment.
A second enduring lesson learned is the importance of individual company business models in determining which enterprises are, or are not well positioned for long-term profitable growth and attractive investor returns. Too often, broad investor sentiment fuels momentum market movements that lead to under-investing in high potential performers during bear markets, and over-investing in dogs during periods of investor exuberance. We’ve seen examples of both in just the past few years.
Peloton had the misfortune of going public in September 2019, just ten days after WeWork postponed (and subsequently withdrew) its IPO, amidst growing investor concerns with high-valued, high-growth, money-losing ventures. Despite the fact that Peloton was performing better than Apple, Tesla, or Netflix on product and subscription gross profit margins, on customer-satisfaction ratings, and on customer-retention rates, its IPO was disappointing. Shares of Peloton opened 6.9% below the company’s IPO listing price of $29 and tumbled 11% by the end of first-day trading, marking the third-worst debut for a large-cap IPO in more than a decade. Peloton’s IPO was a victim of guilt by association, and bad timing. But with steadily improving performance in ensuing months, and the tailwind of a buoyant 2020 stock market, Peloton closed the year 2020 trading at over $160 per share.
In contrast, DoorDash enjoyed a remarkably successful public offering in a buoyant 2020 IPO market, despite problematic business model weaknesses that have plagued on-demand, last-mile delivery ventures for decades: low productivity, high costs of customer acquisition (for diners and restaurants), low economies of scale, low stakeholder satisfaction and loyalty, intense competition, undifferentiated service, low barriers to entry, and of course, chronic losses. Belying its rosy IPO prospectus, Doordash and its equally challenged competitors have been failing for years to create sufficient value to adequately reward all stakeholders — consumers, couriers, restaurants, and company shareholders — forcing the company to play one off against another, in what has become a long-running pursuit of profitless growth. Even the spectre of post-pandemic demand declines and growing threats of costly government regulation didn’t to deter the market appetite for DoorDash’s public debut. As a sign of buyer’s remorse, DoorDash’s share price declined by 25% in just the two weeks between its IPO and the end of the year.
History suggests we’re likely to experience a correction in 2021, as investor exuberance at the close of 2020 confronts the reality of justifying lofty valuations with proven business results in the coming year. Let’s hope that the painful lessons learned from the past stick this time around.
