The Separation

I am certainly no stock pundit, but in the last four months, I have been monitoring the public markets more regularly than I have in the past. I think I am searching for signs of life or maybe just direction. In this newly isolated world, the rhythm of the trading, albeit chaotic recently, has provided an odd sense of comfort and connection to the world. While we consider herd immunity for our species, we should consider the herd instincts of the stock markets.

On February 19, the S&P 500 closed at 3386.15. One month later, on March 23, it closed at 2237.40 for a decline of 33%. The 11-year bull market was coming to an end with a resounding thud. Virtually every stock was down in a significant recalibration of the value of our entire economy. Of course, some were hammered worse than others (e.g. the hospitality sector), but everything was lower. Then, the S&P closed on April 23 at 2797.80, an increase of 25% from the low four weeks earlier. I don’t think we are yet onto a bull market run, but there is some discernment underway – a kind of separation – within the herd.

The market (whoever they are) is beginning to back certain stocks that are perceived to be doing well in this new “work-from-home” (WFH) environment. Consider everyone’s favorite of the moment – Zoom. On February 19, Zoom closed at 103 and it is now trading at 170+. Zoom is not alone, and there are others that are lagging and likely to do well as the economy hopefully roars back. However, the market is now making choices based on expectations of what that market will look like and the consensus is that it is likely to be different than the one we started with in January. Will we return to the levels of energy usage we had in 2019? Will consumer behaviors adjust to less frequent travel? What will be the general level of capital availability in the next 24 months?

It is a good reminder to those of us that have spent careers in Private Equity and Venture Capital that markets can change and we should adapt our thinking to that. The bull market of the last decade fueled some amazing success stories and unicorns. Were these all solid, fundamentally sound business models that will endure? Or were they momentum plays that needed a sloppy, overly liquid market to support growth without regard to timing of profitability. What can we expect out of the next ten years?

In choosing managers for the next cycle, limited partners would be wise to develop their own thesis for the future environment and apply those expectations to their manager choices. Review current portfolios for potential performance into this new cycle. Assess the need for additional capital and the expected path to sustainable profits. Apply a certain rigor to the evaluation of your existing relationships to determine if their business model is appropriate for what is coming; determine if they can adapt. 

It may be time to more fully embrace some of the emerging managers that are creating new models and building for the future. There is an understandable loyalty to managers who have performed well for two, three or even four fund cycles, but they may not be poised to manage the future environment. There is likely going to be a separation between the markets in which they thrived and those in which we find ourselves. Similarly, there is separation in the thesis and focus between many of the emerging managers and the incumbents that have been active for 10, 20 or even 30 years or more.

The managers of the future will bring credible skills to the table beyond that of an excellent deal flow network, access to unicorns or expertise in financial engineering. Managers must be skilled at identifying large-scale opportunities in an unsettled market combined with an ability to lead, manage and create value. Many of the managers will possess unique skills that are now applied in ways previously undervalued. Many of their targets will be emerging businesses that can bring transparency and resilience to mission critical operations within larger enterprises. Some will develop new ways to reach and deliver compelling offerings to consumers. Managers of PE/VC funds must be skilled at managing supply chains and paths to market; they will need to create new approaches to accelerating market and customer traction. There will be significant disruption throughout markets as businesses seek to ensure availability of parts and products from more reliable sources. Product quality may again be in vogue, instead of simply the lowest price. “Just-in-time” inventory, may give way to “just-in-case” inventory.

Regardless of your views of the “new” economy and consumer behaviors, the landscape is likely to be different and will demand adjustments. Certainly, some value will be created through investments at now lower valuations, but not every company will have a lower value simply because multiples have been reduced – some will deserve lower valuations that may not improve. Relying on those who produced results in the past may work, but it will be imperative to assess their suitability for your view of the future. A fresh look at those managers who are dedicated to building profitable, resilient businesses in the new era could help to separate your returns from the crowd.