For Sale Signs Everywhere

July 3, 2022

The real estate world has been on fire for months now in the USA, and for years in Canada. The prices are crazy, the annual gains are inexplicable, and now it looks like the party may be coming to an end.

It’s still a bit early to tell, but there are insights that house prices are coming down, that deals are being cut by sellers. In Canada there are reports that buyers are walking away from their down payments to avoid buying houses that have dropped in value between the signing of a deal and the closing date. Of course these anecdotes don’t make up the entire market, but the realities of higher interest rates and reduced liquidity may be starting to sink in. There is little point in highlighting the many headlines here that bring this story to life as they are so common now, that every major newspaper has similar stories.

The really concerning aspect of this is that this is probably just the beginning of this sort of mess. The marginal buyer is not the problem here. The true craziness comes when the average buyer, who paid too much based on a low interest mortgage has to refinance at the current, much higher, rates. There is a good chance rates continue to rise in the coming months and years as risk gets priced back into the market. There is also a good chance this doesn’t end well.

There are a few cases in point. This space has highlighted the problems with Evergrande Group in China. They have been struggling through payment delays for a few months now and are now facing a further crunch. Another Chinese developer, Shimao missed repayment of $1 billion over the weekend. In Germany, The Adler Group, also mentioned here remains under careful watch after being accused of faulty book keeping among other things.

Overall, the problems are not going away and are arguably spreading. While markets in North America are ‘more robust’ than in some corners of the world, the weight of the market can still represent a systemic risk if there is a significant correction, and even a slowdown will cause dramatic changes in local economies.

The for sale signs are not just on assets like real estate. One of the headlines that caught my attention over the weekend is from the somewhat mystical world of private equity. Having spent a LOT of time analyzing non public companies and assessing valuations, I appreciate the magic that has been happening over the past few years as private company valuations scaled unbelievable and unsustainable heights.

One area that has enjoyed a lot of attention and success is the ‘DeFi’ area. Decentralized Finance. There is a big push by small companies to take over a lot of the business currently being transacted by larger financial players. Namely the big banks and credit card companies.

One of the ‘hot’ companies has been Klarna Bank AB (based in Sweden). One of the areas where Klarna has achieved some notoriety is in payments for purchases. If you can’t afford that $200 dress, then pay it over three payments for $70, etc.

Unfortunately many of these small organizations need to raise funds three, five, even ten times before they become profitable. A key objective is to raise funds at a higher valuation than the last time, and to make that happen, growth has to also be on an upward trajectory.

The real story here is that the last time Klarna raised funds, investors put their money in at a valuation of $45.6 billion. As they go out to raise funds again, stories suggest that the valuation has been affected by the pull of gravity. The new valuation is $6 billion if stories are to be believed. That is a decline of 85%. Talk about a for sale sign!

There is no attempt to assess the future of the business here, this is just another cautionary tale that valuations, particularly those set outside of liquid markets should not be trusted. The frenzy that defined pricing over the past two and a half years should not be used to value anything important, and there is a good chance that these dislocations will continue to appear as liquidity is drained out of the market.

On another, and similar note, a lot of people put a lot of work into tracking and monitoring the holdings of Cathie Wood’s ARK funds. During Covid, the valuation of her flagship fund exploded higher and everything Ms. Wood said reverberated with the newly flush investors that followed her moves like a rockstar.

The same valuation problems that afflict illiquid (private) markets oozed into the public markets with rock stars like Cathie Wood. Unfortunately, almost all of the magic is gone. At last look, just 24 of the 130 or so securities held in her portfolios are above their cost, and most of those only by a sliver. A cursory look at them suggests that her biggest wins are (1) Tesla and (2) a bunch of solid, old school businesses like Deere, Intuit, Lockheed Martin, Pfizer. You get the picture.

New investors still believe that valuations make sense for companies like Tesla because they are projecting continued growth of 50%. Unfortunately many new investors fail to realize that markets with 50% growth inspire competition. They also fail to realize that 50% growth makes small, agile companies big and unwieldy. Areas that inspire competition and cumbersome businesses quickly lose the shine and valuations return to normal. (Further examples here include cannabis companies like Aurora Cannabis and Canopy as the realities of their business are made evident.)

That’s not to say that new investors who want lots of innovation and fast growth will ALWAYS be disappointed, but it is guaranteed that they won’t ALWAYS be rewarded. History suggests that the rewards come about 20% of the time. Some simple ‘back of the napkin’ math suggests that over the long run a value of about 20% of the estimated full value of those innovative companies should be about right. The ARK ETF is now about 25% of it’s all time high ($41 now, $160 was the all time high), but about 65% of it’s pre-Covid valuation.

Guessing the future is hard but a worthy estimate of ARKK’s future value is $30 in the next few months. There are lots of investors who disagree of course. That happens in most markets, particularly liquid markets. The fund experienced inflows of almost $658 million in May. So far those new funds have not done so well however. The fund started May at $47, and since has gone as high as $53, as low as $35 and is now at $41. Investing requires patience, so let’s leave it there.

There continue to be a lot of moving pieces in trying to figure out the post Covid, post liquidity boom but most indications are that asset prices will decline as liquidity is removed. It is best not to make large bets too early unless you have a lot of liquidity and a really long time line. The key piece of evidence is that it takes a really long time to heal fragile markets and the suffering has just begun.

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