Circle of Competence Issue #72

QUOTE OF THE WEEK

"Even so, the most striking characteristic of China’s presence on the Global 500 remains the overwhelming—and growing—dominance of state-owned firms. A calculation by Hong Kong’s South China Morning Post found that, if firms from Hong Kong and Taiwan are excluded, state-owned enterprises account for 80% of the revenue generated by Chinese companies on the 2019 list, up from 76% last year." - Alan Murray, Fortune

FOOD FOR THOUGHT

Howard Marks' new memo "On The Other Hand" (Howard Marks)

Two quotes from Howard Marks' latest memo jumped out at me, especially the second one (emphasis mine) which leads into some thoughts on Adam Neumann and WeWork.

"Low rates reduce the discount factor used in calculating the net present value of future cash flows. Thus, all else being equal, there’s a direct connection between declining interest rates and rising asset prices. (I consider this to have been the dominant feature of the world of finance over the last ten years.)"

"Low rates on savings and fixed-income investments drive investors to accept increased risk in order to pursue decent returns in a low-return world. This increased risk tolerance makes the financial markets more accommodating, increasing the availability of financing for ventures that otherwise might find capital in short supply."

Hence the public market appetite for high growth (yet high negative free cash flow) IPOs as of late...

WeWork's CEO, Adam Neumann (Intelligencer)

Adam Neumann is cashing out $700M prior to IPO (WSJ)

The bullish case for WeWork (Odd Lots)

I may end up eating crow for this, but I'm OK with that because it is a part of the learning process i.e. risk being wrong. I simply can't understand the massive multi-billion dollar valuation (on-paper) assigned to essentially a real estate leasing company that *used* to be capital-light when it was *only* subleasing office buildings on a short term basis but then *pivoted* into actually *owning* the buildings. Isn't it morphing into an actual real estate company? They trade for far lower multiples than WeWork. Community adjusted EBITDA? Hmm. The CEO owns buildings that are being leased back to the company? Fishy. The CEO is cashing out almost three quarters of a billion dollars prior to the IPO? Huge red flag. Competitors are beginning to emerge in other markets? The bells are tolling.

I've been thinking a lot lately about exactly what Marks wrote above: when the cost of capital is low for a long time, it is tempting for investors to allocate capital to ventures and companies that otherwise could not attract capital if the cost of capital was higher. WeWork may end up justifying its sky-high valuation, but it also may be a massive shift of capital from investors to Adam Neumann's pockets.

Of course, I'm not saying that WeWork won't be a profitable company one day. Of course, I'm not predicting WeWork will fail. All I am saying is that I find it very hard to justify the company's curret valuation given its business model and financials. If you have any thoughts as to why this company will either succeed or fail, I'd love to hear how you came to the conclusion.

WRITTEN WORD

TOP READ: The psychology of prediction (Morgan Housel)

The trust crisis (Harvard Business Review)

How Duolingo built a $700M business through its adaptive-learning application (Forbes)

How the maker of the world's bestselling drug keeps prices sky-high (Fortune)

The promise and price of cellular therapies (The New Yorker)

SPOKEN WORD

TOP LISTEN: The bullish case for WeWork (Odd Lots)

William Poundstone discusses The Doomsday Calculation on life beyond earth, the end of human life, and more (Science Salon)

Andre Bourbonnais on Blackrock's new permanent equity vehicle (Capital Allocators)

How quantitative investing evolves with Eric Sorensen (Invest like the Best)