Beating “Efficient Markets”

I touched upon my dislike for the Efficient Market Hypothesis (EMH) in an earlier post, but thought I’d bring it up in a little more depth here.

The EMH is a framework for thinking about the stock market that is taught in many undergraduate and MBA programs.  Basically, the theory states that all information that is publicly available is reflected in a stock’s price.  So, when a company announces a new partnership, the stock pops at that moment and perfectly reflects the expected value of this new partnership.  The information made available to the public is now supposedly reflected in the price.

But, the reality is that not all information is readily available (even if it is public).  And, many times you have to dig.  That may mean calling on people in your network who have specific knowledge you’re after, reading obscure blogs, or reaching out to someone who is in the know.  We do this a lot at Bessemer to try to better understand industries and companies we are interested in.

I’m bringing this up as a result of my experiences in our ongoing efforts to find a new analyst to start this summer.  We’ve interviewed a lot of candidates, and many of them have made me realize how lucky I was to have gotten this job in the first place (there are a lot of smart people out there!).  But, the few that that have stuck out obviously did their homework to understand the job, the recruiting process, and woven these knowledge points into their interviews.  They’ve read a few blogs written by our professionals (especially the posts about the analyst recruiting process, which exist), researched our portfolio, and have asked friends in VC what it’s like.

The 5% of candidates who have done this work have stood out – and in my mind they have gone beyond what is public knowledge of our firm and what we do, in order to give them an edge.

More generally, this type of digging seems to be what separates people who are pretty good at something from the people who are the best.  When I talk to friends working at some of the most successful hedge funds, I ask how they can make money on a consistent basis when so many people fail.  The answer is almost always that they spend extra time figuring out what exactly is going on in a market, and going off the beaten path to solidify their investment thesis.  They are rewarded quite quickly through higher returns and a bigger pay check.

But, I think this sort of methodology applies to many facets of life beyond investing: everything from sports to building a business (MyCityWay for example is a company that is leveraging publicly available info to build a cool mobile app – apparently few others building this type of app had came across these data sets).  And, I can remember back in my wrestling days breaking down tapes of Russian wrestlers to try to learn techniques that my opponents hadn’t seen before and wouldn’t know how to defend.

These sorts of data are quite valuable, but even more so is the mentality of digging in order to get an edge.  I just hope I can keep that mindset and try to find new ways of getting those advantages as life goes on because I truly feel those small advantages add up in a big way over time…

Quick Thoughts On Travel Zoo (TZOO)

If I’m not mistaken, in a few hours Travel Zoo (TZOO) will announce earnings for Q4.  This stock has been hyped due to it’s expansion into daily deals and has gone up 300% of so since the summer.  And, as the Yipit guys pointed out, the deals segment is now valued at around $400 mm.

As a disclaimer, I own a small amount of Travel Zoo which I bought a few months back.

Quickly, many of these daily deal sites have been valued at around 3x the run rate net revenues (the amount of cash that actually goes to the company in a month – i.e Groupon charges you $50 for a coupon, but only takes 40% of that for themselves with the rest going to the merchant.  That 40% is the net revenue).  You can check out the Spreets/Yahoo acquisition as a comp.  The numbers haven’t all been posted, but you can do some easy calculations to back into a run rate net revenues number and figure that they were bought for around 3x.  By the way, run rate here is simply taking last month’s revenues and multiplying by 12 (annualizing the number).

So, do we think that TZOO is doing 450 mm / 3 = 150 mm in run rate net revenues?  This would imply 150/12/.4 = 31.25 mm in monthly revenues for January.  The math is net revenues/months in a year/the amount of net revenue that TZOO collects as cash to them.  This would seem like a lot, especially considering they just launched 6 months ago.  However, the company also has a 20 mm member email list, access to capital markets (which potentially means they should trade at a premium to 3x gross profit due to better liquidity than a smaller, private company), and a proven management team.

All that aside, I’m more interested in knowing what the market thinks will happen, which will be evident by the change in the stock after the data is actually released.  What if they are doing 10 mm in monthly revenues and that is enough to see the stock rise 15%?  Does that mean people are just being irrational?  Time will tell…

Note: As stated above, I have a small amount of personal money invested in TZOO stock at the time of writing this post.

Partial Liquidity in Response to Changes in the Capital Gains Tax Code

Many of the larger companies that I speak to are contemplating partial liquidity in 2010 before any potential changes to the capital gains tax code take effect.

The WSJ did a small article on this in last week’s Weekend Edition and I thought I’d run some numbers to see what makes sense when contemplating this decision (dividend taxes could more than double and it looks like long term capital gains will increase 33%).

The attached excel model (see the link below) should provide a working tool to customize this analysis to your own company.  Basically the decision comes down to taking money that is guaranteed and guaranteed to be taxed at a lower rate OR, letting it ride, continuing to grow the business, and keeping a greater equity stake for a larger liquidity event (M&A or IPO) down the line.

Obviously, if your business has Twitteresque growth, you should hang onto the equity for dear life!  But, especially given the relative stability of today’s markets and the relatively strong multiples deals are getting done at, it is worth exploring taking some “chips off the table” this Fall while still keeping a sizeable equity stake in your business to participate in the upside of an IPO or M&A exit.

Another scenario we’ve run into is non-operating partners who have large equity stakes and who may want to take money off the table now.  Especially in the case where these types of companies do not have a strong venture partner, it can make sense to allow those people to cash out, at least partially, in order to bring in a financial partner to help continue the growth of the business.

Below is the output of an NPV analysis on a very profitable and quickly growing business.  As you can see, taking some money off the table now makes sense given the assumptions of the model.  I highly suggest downloading and playing with the excel (see link below) to customize it to your business.

Some notes: I’ve basically assumed in scenario 1 that you sell 20% of your equity, continue to grow the business and then IPO in year 4 (2014).  In scenario 2, you keep all the equity, and IPO in 2014.  The cash flows in each scenario are discounted in order to take into account time value of money and also the probability of the business hitting a rough patch and not being able to deliver on projections.  In the excel, you may also want to take into account that partial liquidity/growth capital now could lead to the acceleration of your business if you find the right venture partner, and thus scenario 1 would become even more compelling.  Enjoy!

Cap Gain Taxes Analysis [Excel]