Start-Up Companies’ Not So Great Returns
Thursday, November 7, 2013
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 45.5%, up 0.5 points
  Neutral: 32.7%, down 0.8 points
  Bearish: 21.8%, up 0.3 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »




Today’s debut of Twitter (TWTR) as a public company adds to this year’s resurgent IPO market. As of the start of November, U.S.-listed initial public offerings totaled $49 billion (190 deals) year-to-date. Dealogic says this is the largest amount since 2007, when 230 IPOs worth $53 billion were completed during the same 10-month period.

In the background of the hot IPO market is movement by regulators to allow non-accredited individual investors to invest in start-up companies. Acting in response to the JOBS Act, the Securities and Exchange Commission (SEC) is seeking public comment on crowdfunding.

Given this activity, I thought now would be a good time to bring up the subject of venture capital fund performance. Venture capital firms are a type of private equity focused on new and emerging companies. Venture capital firms invest clients’ money in companies too new and too small to be publicly traded. Institutional and high net worth (“accredited”) investors use venture funds to access companies with bright prospects in the hope that some of the companies will either go public or be acquired at a large premium.

When I was a Chartered Financial Analyst candidate in the late 1990s, my study materials discussed the strong returns realized by venture capital firms. Performance was described as a “J” curve, with losses incurred as unsuccessful ventures went under and significantly larger gains realized as successful companies went public or were acquired at premium prices. At the time the texts were written, the information was correct. Since then, the returns have been disappointing.

In a study cited by the Financial Times, advisory firm Cambridge Associates says investors would have fared better holding index funds over the last 10 years than they would have fared by investing in venture capital funds. On what the firm considers an apples-to-apples basis, the small-cap Russell 2000 index beat venture capital firms by 2% on an annualized basis. Equally notable, the return advantage doesn’t favor venture capital until a 15-year period is looked at. It’s a notable distinction because the 15-year period includes the tech bubble of the late 1990s, while the 10-year period does not.

Cambridge Associates is not the only organization questioning the return advantage of venture capital, the Ewing Marion Kauffman Foundation is too. Last year, after analyzing the performance of its portfolio, the nonprofit determined the returns were not good. The foundation revealed, “The majority of funds—62 out of 100—failed to exceed returns available from the public markets, after fees and carry were paid.”

More importantly, the Kauffman Foundation was critical of the entire venture capital arena. The nonprofit opined, “The Limited Partner (LP) investment model is broken. Limited Partners—foundations, endowments, and state pension fund—invest too much capital in underperforming venture capital funds on frequently misaligned terms. Our research suggests that investors like us succumb time and again to narrative fallacies, a well-studied behavioral finance bias.”

There are exceptions to any study, and even the Kauffman Foundation admits to having some venture capital investments with superior returns. The problem is that these were the exceptions. The investors who profit the most from start-ups are able to invest money at a very early stage in the company’s history. But we don’t hear about all the failures where investors lost their entire investment.

The people running venture capital firms are very smart. Yet if they struggle to deliver good performance, it should make us individual investors skeptical of our ability to determine how much potential upside there is for a new company with an excessive valuation and a questionable business model. (Yes, I am referring to Twitter.) It should also raise questions about what type of profits can be realized from participating in crowdfunded investments once the SEC allows them.

New companies are exciting and the hype surrounding them can create short-term trading opportunities. However, there are many companies with a better weighting of risk and reward. Though such companies are less exciting, there is nothing boring about seeing your wealth grow.



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The Week Ahead

The U.S. markets will be open on Monday, but banks will be closed in observance of Veteran’s Day. (On behalf of everyone at AAII, thank you to those of you who have served in the military.)

The 2013 AAII Investor Conference will start on Friday in Orlando, Florida.

Just nine S&P 500 member companies are scheduled to report quarterly results, as earnings season transitions to retailers such as Macy’s (M), on Wednesday, and Kohl’s (KSS), on Thursday. The only Dow component scheduled to report earnings is Cisco Systems (CSCO), on Wednesday.

The first economic report of note will be October import and export prices, which will be released on Wednesday. Thursday will feature September international trade and third-quarter productivity. The November Empire State manufacturing survey and October industrial production and capacity utilization will be released on Friday.

Several Federal Reserve officials will make public appearances. Dallas president Richard Fisher and Minneapolis president Narayana Kocherlakota will speak on Tuesday. Chairman Ben Bernanke will speak on Wednesday. Philadelphia president Charles Plosser will speak on Thursday.

The Treasury Department will auction $3 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday.

November stock options will expire on Friday.

AAII Sentiment Survey

Individual investors continue to be optimistic about the short-term direction of stock prices, according to the latest AAII Sentiment Survey. Bullish sentiment is holding above 40%, while fewer than a quarter of respondents describe themselves as bearish.

Bullish sentiment, expectations that stock prices will rise over the next six months, edged up 0.5 percentage points to 45.5%. This is the fifth consecutive week optimism is above 40%, the longest such streak since January through February 2013. The historical average is 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, declined 0.8 percentage points to 32.7%. This is the third consecutive week neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, increased 0.3 percentage points to 21.8%. This is the fourth consecutive week and the seventh in the past nine weeks pessimism is below its historical average of 30.5%.

All three indicators remain within their typical historical ranges, though bearish sentiment remains at the low end of what we consider to be a normal reading. Individual investors continue to be encouraged by the market's upward momentum as well as earnings and economic growth. Tempering this optimism are concerns about the pace of economic growth, elevated stock valuations and the lack of a long-term fiscal solution.

This week’s special question asked AAII members how third-quarter earnings have influenced their third-quarter outlook for stock prices. Approximately 45% said the earnings reports had no influence, while 20% said they are now more optimistic and 15% said the results caused them to be more pessimistic. Some members said the quarterly results were as expected, some said they are more concerned with Washington politics and few described themselves as less optimistic than they previously were.
Here is a sampling of the responses:

  • “No influence. As all sectors didn’t fare as well as others, I will still pick stocks based on their individual merits.”
  • “Earnings tempered my bullishness somewhat, but I’m still bullish overall.”
  • “Earnings have been so-so, which makes me think there is no reason for the run up in stock prices.”
  • “More than earnings, Congress is the important issue—and I have no idea what they will do.”
  • “Somewhat favorably. The unpredictability of U.S. government policies tends to moderate my expectations.”

» Take the sentiment survey

AAII Asset Allocation Survey

October Asset Allocation Survey results:
Stocks/Stock Funds:
    66.3%, up 1.8 points
Bonds/Bond Funds:
    16.9%, up 0.9 points
Cash:
    16.9%, down 2.7 points

Asset Allocation Survey details:
Stocks:
    30.6%, down 2.3 points
Stock Funds:
    35.6%, up 4.1 points
Bonds:
    3.3%, down 0.4 points
Bond Funds:
    13.5%, up 1.3 points

Take the survey »


Equity allocations reached a six-year high last month, according to the latest AAII Asset Allocation Survey. The increase occurred as cash allocations fell to their lowest level in five months.

Stock and stock fund allocations rose 1.8 percentage points to 66.3%. This is the largest allocation to equities since September 2007, when stock and stock fund allocations totaled 68.1%. October was the seventh consecutive month and the ninth out of the past 10 months with equity allocations above their historical average of 60%.

Bond and bond fund allocations rebounded by 0.9 percentage points to 16.9%. This is the second smallest allocation to fixed income since May 2009, trailing only last month’s figures. The rise brought bond and bond fund allocations back above their historical average of 16% for the 51st time in the past 52 months.

Cash allocation fell 2.7 percentage points to 16.9%. This is the smallest allocation to cash since May 2013 and the seventh month in the past 10 with an allocation reading below 20%. October was also the 23rd consecutive month with the cash allocation below its historical average of 24%.

The stock market’s rally is helping to boost the value of stocks and stock funds, as well as entice investors to either stick with equities or move money off of the sidelines into them. Optimism about the short-term direction of stock prices was higher than average throughout October, even though worries about the macro environment (slow economic growth, fiscal uncertainty, elevated stock valuations, etc.) continue to exist.

This month’s special question asked AAII members if they are overweighting or underweighting stocks relative to their age. Nearly 60% said they are overweighting stocks. The reasons given were mixed, though 15% of all respondents cited the current low interest rate environment and the possibility of poor bond returns in the future. Slightly more than 10% of respondents said they thought stocks simply provided more upside. Other respondents said they are overweighting stocks because they are not reliant on portfolio income, have pensions and other sources of retirement income, need portfolio growth because of their expected longevity or are trying to catch up on savings.

Approximately 13% of respondents thought their current allocations are appropriate, while slightly fewer than 15% said they are underweighted to stocks. Nearly half of those who are underweight stocks cited current equity valuations or Washington politics as the reason why.

Here is a sampling of the responses:

  • “Overweighting stocks because bonds are such a bad investment right now.”
  • “I’m overweighting stocks because of expected longevity.”
  • “I’m my 80s and don’t rely on my savings for current expenses. It’s all going to my kids.”
  • “At this point, we believe the current allocation to stocks (65%) suits our goals.”
  • “I’m underweighting stocks because of current valuations.”

» Take the Asset Allocation Survey