Weekly Thoughts: Thiel 2.0, Sellability and Bond Liquidity
Here are three things that caught our eye this week:
We continue to closely follow the lectures for Stanford’s Online course “How to Start a Start-Up”. Last week, Peter Thiel delivered a lecture to the class and we were particularly interested in his comments regarding competition. He noted,
“There is always this question about competition as a form of validation, where we go for things that lots of other people are going for. It’s not that there is wisdom of crowds, it’s not that lots of people trying to do something is the best proof of that being valuable. I think it’s when lots of people are trying to do something, that is often proof of insanity. There are twenty thousand people a year who move to Los Angeles to become movie stars, about twenty of them make it. I think the Olympics are a little bit better because you have, you can sort of figure out pretty quickly whether you’re good or not, so there’s little less of a deadweight loss to society…There is always the question: does the tournament make sense as you keep going?
Competition does make you better at whatever it is that you’re competing at because when you’re competing you’re comparing yourself with the people around you. I’m figuring out how to beat the people next to me, how do I do somewhat better than whatever it is they’re doing and you will get better at that. I’m not questioning that, I’m not denying that, but there often comes this tremendous price that you stop asking some bigger questions about what’s truly important and truly valuable. And so I would say, don’t always go through the tiny little door that everyone’s trying to rush through, maybe go around the corner and go through the vast gate that nobody is taking.“
For us, in an age where the word start-up is synonymous with creating a new mobile app, the small business opportunities we have been pursuing represent exactly the type of “vast gate” Thiel is describing. Over the past several months we have found great businesses that successfully deliver in-demand products or services to the marketplace while managing to capture attractive portions of the value they provide. We believe continuing on the value proposition these companies have built is an overlooked opportunity and our pursuit of it can deliver significant long term returns.
Our research has also uncovered some useful analytical tools that can help quantitatively define the extent of the opportunity in the small business space. This week for instance, we stumbled across an interesting data source, called “The Sellability Tracker”, which is a comprehensive study of the liquidity and health of private businesses. The company behind it conducts a quarterly survey of 12,000 worldwide businesses with $1- $20 million of annual revenues.
The survey offers interesting insights into what drives small business ‘sellability’, and in turn, purchase multiples. For instance, the key factors that drive purchase multiples are: Size, growth, industry, scalability, recurring revenue, age of owner and desire to own the business for the long term. While these factors might be somewhat intuitive to business-minded people, what is particularly valuable is that the survey provides quantitative data that shows how the various factors impact purchase multiples (see table below).
While we will certainly take time to outline various aspects in future reports, of particular interest to us this quarter was quantitative insight into how size of business impacts purchase multiples:
Annual Pre-tax Profit and Offer Multiple
Under $1 million: 2.87
$1 – $3 million: 3.60
$3 – $10 million: 4.46
$10-$20 million: 5.08
This data confirms our thesis that a size premium exists in the world of small business valuation in part due to the presence of larger private equity buyers, where scale is necessary to make the allocation of institutional capital worthwhile. Consequently, we believe smaller companies are more interesting but ultimately size isn’t everything, and we continue to rely on the other factors listed above to identify the truly ideal opportunities.
Given the volatility in the public markets this week, we spent some time reading about the lack of liquidity in the market and the potential impact this could have on the price discovery mechanism. We focus this week on corporate bonds though we may discuss other asset classes in subsequent weeks. Over the last several years institutional investors have drastically increased their position as the largest holders of corporate and foreign bonds, with a large portion of that share coming from banks (who have been forced to reduce positions as a result of Dodd Frank regulations).
This is problematic because these two players have distinctly different roles to play in the market. Historically, in a downturn, wall street trading desks could use their inventory to serve as a liquidity providing counter-trend buffer (i.e. if you have $10mm in bonds to sell, a wall street bank might mark down the price but it would buy your bonds). Today, in the same situation, if a mutual fund is holding all the inventory, they are likely to be selling along with everyone else in the name of risk management. This pro-cyclical behavior results in prolonged periods of market calm punctuated by extremely outsized jumps in volatility, i.e. fatter tails.
From our perspective, the trend toward high valuations coupled with excessive pro-cyclicality is worrying and confirms our view that small private businesses offer compelling value relative to public market alternatives at this stage in the cycle.
Have a great week,
Your Chenmark Capital Team