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Illiquidity And Bubbles In Private Share Markets: Testing Mark Cuban’s Thesis!

It looks like Alibaba is investing $200 million in Snapchat, translating (at least according to deal watchers) into a value of $15 billion for Snapchat,  a mind-boggling number for a company that has been struggling to find ways to convert its popularity with some users (like my daughter) into revenues. While we can debate whether extrapolating from a small VC investment to a total value for a company make sense, there are two trends that are incontestable. The first is that estimated values have been climbing at exponential rates for companies like Uber, Airbnb and Snapchat. In venture capital lingo, the number of unicorns is climbing to the point where the name (which suggests unique or unusual) no longer fits. The second is that these companies seem to be in no hurry to go public, leaving the trading in the private sharemarket space. These rising valuations in private markets led Mark Cuban to declare last week that this “tech bubble” was worse (and will end much more badly) than the last one (with dot-com stocks). In the article, Cuban makes four assertions: (1) There is a tech bubble; (2) A large portion of the tech bubble is in the private share market which is less liquid than the public markets; (3) The bubble will be larger and burst more violently because of the absence of liquidity; and (4) This bubble is worse than the dot-com bubble, though it not clear on what dimension and from whose perspective. In his trademark fashion, Cuban ends his article with a provocative questions,  “If stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it ?” I like Mark Cuban but I think that he is wrong on all four counts.

This is not a tech bubble

In my last post, I took issue with the widespread view that the rise in stock prices from the depths of 2008 has been largely due to tech companies using a simple statistic: the proportion of overall equity market capitalization in the United States coming from tech stocks. Unlike the 1990s, when tech companies climbed from single digits in 1990 to almost 30% of the overall market capitalization by the end of 1999, tech stocks collectively have stayed at about 20% of the overall market.

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Tech stocks in S&P 500

There are other indicators that also support the argument that this is not a tech bubble, since a bubble occurs when market prices disconnect from fundamentals. Unlike the 1990s, the market capitalization of technology companies in 2014 is backed up by operating numbers that are commensurate with value. In the figure below, I compare tech companies to non-tech companies on market values (enterprise and equity) as well as on operating statistics such as revenues, EBITDAR&D, EBITDA, operating income and net income, across the entire US market (not just the S&P 500):

[drizzle]

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Tech vs Non-tech companies in US market (Source: Cap IQ)

One measure of whether a sector is in a bubble is if it accounts for a much larger share of overall market value than it delivers in revenues, earnings and cash flows. In February 2015, tech companies account for about 13.84% of overall enterprise value and 19.94% of market capitalization and they hold their own on almost every operating metric. While tech companies generate only 11% of overall revenues, they account for 19.99% of EBITDA+R&D, 17.93% of operating income and 16.46% of EBITDA, all much higher than tech’s 13.84% share of enterprise value, and 18.65% of net income, close to the 19.94% of overall market capitalization. On the cash flow measure, tech firms account for almost 29% of all cash flows (dividends and buybacks) returned to investors, much higher than their share of market capitalization. To provide a contrast, in 1999, at the peak of the dot-com bubble, tech firms accounted for 30% of overall market capitalization but delivered less than 10% of net income and dividends & buybacks. That was a bubble!

Note, though, that this is not an argument against a market bubble but one specifically against a collective tech bubble. If you believe that there is a bubble (and there are reasonable people who do), it is either a market-wide bubble or one in a specific segment of the tech sector, say baby tech or young tech. In my earlier post, I broke tech companies by age and noted that young tech companies are richly priced. If Cuban’s assertion is that young tech companies are being over priced, relative to fundamentals and potential earnings/cash flows, it is a more defensible one. Even on that front, the question remains whether this over pricing is a tech phenomenon or a young company phenomenon.

Illiquidity is a continuum 

Cuban’s second point is that this bubble, unlike the one in the nineties, is developing in private share markets, where venture capitalists, institutional investors and private wealth funds buy stakes of private businesses and that these private share markets are less liquid than publicly traded companies. While the notion that public markets are more liquid than private ones is widely held and generally true, illiquidity is a continuum and not all private markets are illiquid and not all publicly traded stocks are liquid.

The private share market has made strides in the last decade in terms of liquidity. NASDAQ’s private market allows wealthy investors to buy and sell positions in privately held businesses and there are other ventures like SecondMarket and Sharespost that allow for some liquidity in these markets. To those who would argue that this liquidity is skin deep and will disappear in the face of a market meltdown, you are probably right, but then again, what makes you believe that public markets are any different? While it is true that some of the big names in technology have high trading volume and deep liquidity, many of the smaller technology companies often have two strikes against them when it comes to liquidity:

  1. Low Float: The proportion of the shares in these companies that are traded is only a small proportion of the overall shares in the company. Just to illustrate, only 10.5% of the shares in Box, the latest technology listing, are traded in the market and small swings in mood in this market can translate into big price changes. Looking across all stocks in the market, the notion that young tech companies tend to have lower floats is backed up by the data:
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Source: S&P Capital IQ (February 2015 data)
  1. Here today, forgotten tomorrow: The young tech space is crowded, and holding investor attention is difficult. Consequently, while many young tech companies go public to high trading volume, that volume drops off in the weeks following as new entrants draw attention to themselves, as evidenced by the trading activity on Box: