May 22, 2019
A Double-Edged Sword
Please read important disclosures HERE.
May 22, 2019
Please read important disclosures HERE.
At a business conference a couple of years ago, the speaker got things going with a joke, as is often the case at such events. “If Amazon is going into your line of business,” she said, “then you should sell now. And if Amazon is not going into your line of business, then your business is stupid, so you should sell now.” It got a big laugh at first, but the room quieted down quickly. For many of the business owners in that room, Amazon is the veritable boogeyman of contemporary capitalism, a hungry caterpillar actually led — as if in a bad James Bond film — by a twisted genius with an unsettling visage and a cackling laugh. But the joke could just as easily have been in the name of any of a handful of other massively successful technology companies that steamroller competitors and are collectively called the FAANGs: Facebook, Apple, Amazon, Netflix, and Google. Let’s add Microsoft to this mix and take measure.
Going back to the beginning of 2018, a hypothetical portfolio that owned only these six companies would have generated a rate of return of approximately 35%. An alternative hypothetical portfolio, a global equity benchmark with more than 1,600 of the world’s biggest companies — but none of the FAANGs or Microsoft — would have generated a rate of return very close to zero.
Source: John Authers, Bloomberg, May 1, 2019.
While the dichotomy seems remarkable, there is in fact nothing new or unusual about this concentration of stock market gains. Indeed, one reason index funds so often beat actively managed funds is that index funds reliably own all of the tiny proportion of companies that power broader market gains. What is distinctive is that until recently the temporarily dominant companies came from many different industries. Today the companies marching across the landscape are all, at heart, technology companies. And there doesn’t appear to be anything reassuringly impermanent about, say, Google’s dominant market share.
We rely daily on the products and services these companies provide. We delight in their low prices or, as in the case of Facebook and Google, the fact that they are seemingly free. (Pity about your data.) But there is accompanying dread. Anyone with a college student struggling in multivariable calculus might regard these companies as both “Transformers” and “Terminators,” shape-shifting and prowling menaces imperiling once secure lines of employment. Though there are surely multiple layers to the argument, the newfound interest in universal basic income is at some level recognition that lots of citizens are at risk of having nothing to contribute in the new economy. The title of economist Tyler Cowen’s 2013 book says it best: Average Is Over.
Can I Give You a Lyft?
In light of the accumulating power of those few companies that promise not just the opportunity to compete but in fact to disrupt, it’s not surprising that many of the most exciting Silicon Valley-fed companies are lining up to go public over the course of the next year. Several have done so already, including rideshare company Lyft, which went public in late March. The details of that initial public offering (IPO) betray a long line of investors eager and optimistic to the point of indiscriminate.
A ride in a Lyft vehicle is typically a lot cheaper than taking a taxi and also a bit cheaper than taking an Uber. Its glorious smartphone interface notwithstanding, Lyft sells an undifferentiated service for what is usually the lowest price, and so it is not especially surprising that the company loses a lot of money. Be that as it may, Lyft’s IPO generated a frenzy of investor demand and shares were priced at the high end of the expected valuation range. No matter how anyone may see the future, $24 billion is a big valuation to put atop a company that may very well never earn a dime.
Wouldn’t it still be a great deal for investors, though, if some company swooped in and offered Lyft shareholders a 25% premium for the company? Interestingly, probably not. This is because Lyft’s dual-class ownership structure all but insures that its co-founders will continue to control the company even if substantial majorities of shareholders want to take it in a different direction. The company won’t be sold at any price if the founders prefer to keep their jobs.
Dual-class structures provide a company’s earliest owners the opportunity to make their own shares more powerful than everybody else’s. In the case of Lyft, founders Logan Green and John Zimmer own about 5% of the company but control 49% of voting shares. Such structures secure stable leadership and may make a lot of sense if you can’t even imagine, say, Facebook ramping up without Mark Zuckerberg. But because the best companies know they have especially eager buyers in the current economic and investment environment, many are pushing for ever more self-aggrandizement. This was true of the recent Levi Strauss IPO, in which the founder’s descendants codified a disparate voting power similar to what is seen at Lyft, but the trend is particularly common today in the technology space. For example, dual-class structures are used by Google, Facebook, and Dropbox. At recently IPO’d Snap, the public shareholders have no voting rights whatsoever.
According to a mostly approving Harvard Business Review paper, a dual-class structure offers immunity against proxy contests and “could be optimal if it enables founder-managers to ignore pressure from the capital markets and avoid myopic actions such as cutting research and development and delaying corporate restructurings.”1 This argument may sound familiar to readers of the New York Times, in which weekly columnist Thomas Friedman regularly extolls the advantages of being governed not by unwashed voters with volatile opinions but, rather, by the wise and long-term focused civil servants of the Chinese Communist Party.
For their part, economists most often regard market prices as information that may be useful for managers and investors alike. And it’s not just economists who argue that America’s justifiably envied stock markets are built in large part upon a distinctive edifice of long-term potential and the fair treatment of investors. Unsurprisingly, such voices maintain that shareholder rights should never be truncated by founders who, in the language of the Lyft IPO filing, “may have interests that differ from yours.” 2
Lyft shares now trade at a value well below the IPO price. This would seem to support the conclusions of a recent Harvard Law School Forum on Corporate Governance and Financial Regulation, at which it was concluded that Lyft’s IPO structure is “expected to decrease the economic value of Lyft’s low-voting shares.”3
In fact, the data on the performance of companies with more than one share class is inconclusive given that issuance of multiple share classes with differing voting rights is a mostly recent phenomenon. In 2017, 25% of IPOs had dual-class shares, up from just 1% in 2005.4 Not so long ago, the Facebook IPO was perceived as a mini-disaster, too, with shares falling almost 50% in just a few months after the IPO. But it’s not likely anyone who bought Facebook at any time in 2012 (and resisted the temptation to sell as losses mounted) regrets it today.
It’s now been almost 17 years since the NASDAQ Composite declined 78%. (Remember that?!) For good reason, no one envisions that happening again. And given the recently outstanding returns of the best technology stocks, it’s unimaginable that an investor might think, “I own Google and Facebook, but I’m hesitant to buy Airbnb because those shares provide less voting power than the founders enjoy.” Still, perceptions about the fairest way to run a railroad can change quickly as a result of lived experience. Subsequent to the 1888 election of Benjamin Harrison, the candidate who won the most votes won every presidential election for over 100 years — and only dull, pedantic people talked about the electoral college.
1. Vijay Govindarajan, Shivaram Rajgopal, Anup Srivastava, and Luminita Enache, “Should Dual-Class Shares Be Banned,” Harvard Business Review, December 3, 2018. https://hbr.org/2018/12/should-dual-class-shares-be-banned
2. U.S. Securities and Exchange Commission, “Form S-1 Registration Statement,” March 1, 2019. https://www.sec.gov/Archives/edgar/data/1759509/000119312519059849/d633517ds1.htm
3. Lucian Bebchuk and Kobi Kastiel, “The Perils of Lyft’s Dual-Class Structure,” Harvard Law School, April 3, 2019. https://corpgov.law.harvard.edu/2019/04/03/the-perils-of-lyfts-dual-class-structure/
4. Scott Kupor, “Limit, Don’t Ban, Dual-Class Share Structures,” February 25, 2019. https://a16z.com/2019/02/25/dual-class-shares-indexes-long-term-innovation/