By SA Editor Mike Taylor, CFA :
Wait a second, are these coveralls on backwards?
I don't blame the general befuddlement that public has displayed at Facebook ( FB ) CEO Mark Zuckerberg's " Year of Travel " out of Silicon Valley and into the America of hardhats and Indian reservations. Reasonable reactions have included speculation about Zuckerberg's presidential aspirations (he denies them) and confusion about the surprisingly aggressive PR tactics surrounding the project. The inauthenticity and ham-handed symbolism have once again made Zuckerberg a handy satirical target . See, for example, the above photo.
The image is jarring for an obvious reason; it depicts a collision between American labor and American capital at a time where the two economic forces seem historically polarized. But juicy as it is, that irony does not fully explain the cynicism and resentment that has rejoined Zuckerberg's project. There's something deeper and more complex at work.
What's deeper and more complex than Zuckerberg's coverall usage is the confounding nature of the U.S. economy in 2017. And, whatever else the Facebook CEO's 2017 personal challenge is about, it is explicitly about the American economic condition. From his May commencement speech at Harvard University:
"As I've traveled around, I've sat with children in juvenile detention and opioid addicts, who told me their lives could have turned out differently if they just had something to do, an after-school program or somewhere to go," said Mr. Zuckerberg, who also received an honorary doctoral degree at the ceremony. "I've met factory workers who know their old jobs aren't coming back and are trying to find their place." ( The New York Times )
It sure would be handy to arrive at an explanation for the current U.S. economic puzzle. We enjoy record highs for publicly traded risk assets and seeming full employment. And yet: We just emerged from a presidential election cycle where economic anxiety was a key buzzword. Labor force participation looks grim. Employment prospects are worse for everyone than they were 10 years ago, as the relative value of a high school education continues to erode. Zuckberberg's interest in the problem is completely understandable.
The appeal of Douglas W. Jamison and Stephen R. Waite's Venture Investing In Science (Columbia UP) is its provision of just such an explanation. And, if the authors are even close to right, the implications for investors, as well as for the general public, are substantial.
In the forward, Mark Anderson asks, "What is the financial, economic, social, or even political difference between putting a dollar into Twitter versus the first cancer vaccine?" Acknowledging the short-term investment returns to social media and software investment, Anderson casts these decisions against a longer-term philosophy that embraces greater uncertainty but targets payouts that are orders of magnitude higher. Should venture capital dollars go to easily created social media apps that optimize consumption of baubles and necessities? Or should VC investment go to long-term, deep-science projects that may drive tremendous leaps forward in global economic well-being? Anderson's verdict is clear: "For investors with the intellect and patience to attain highest and best values for their money, long-term investing in deep science is the path to follow."
The argument proceeds from there. Because VC is the mechanism that transfers scientific advancement into economic productivity, it has also been the key driver of economic welfare in the U.S. From Newtonian mechanics through nuclear physics and the coding of the human genome, VC has produced much of the past century's astonishing advancement in our collective well-being.
This might come as a surprise; VC encompasses a small portion of present value capital allocation in the U.S. However, those decisions have an exponential impact over the decades that follow. For instance, the authors point out that 42% of public companies founded after 1974 were backed by VC, and that those companies account for 58% of all enterprise value, 63% of all market cap, and 38% of all employees. VC-backed firms contribute the overwhelming majority - 85% - of R&D expenditure among public companies. They also pay more taxes. Venture capitalists disproportionately shape today where tomorrow's blue-chip corporations will direct hundreds of billions of dollars.
Unfortunately, this engine of economic growth is malfunctioning, according to the authors. A "diversity breakdown" in VC has resulted in an over-concentration in software. VCs have shunned the dynamism of semiconductor manufacturing, quantum computing, EV manufacture, and biotech for app development, which "requires far less capital in the earliest stages, and market adoption can be gauged before significant investment is made in scaling and revenue growth."
Changes in the VC and investment banking industry over the past two decades have abetted this short-termism and risk-aversion, according to the authors. A-rounds have shrunk from the $5 million range to the $250,000 range. While internet startups can get off the ground at such low initial levels of investment, more capital-intensive projects such as biotechnology need larger injections at the outset. Then, at later stages of the VC investment cycle, "the sub-$50 million IPO," a critical exit mechanism, has dissipated. In public markets, the disappearance of the boutique investment bank and shrinking broker fees seized up liquidity in microcap investing and small cap sell-side research, keeping plausible opportunities off of investors' radars. Maybe it's time for Wall Street to re-engineer the bridge between clients and the Wild West of microcap IPOs.
I am not used to reading such a vigorous and confident argument in a book published by a university press. Authors Douglas Jamison and Stephen Waite have the luxury of advancing a straightforward and sensible-sounding argument: Investments are being misplaced at the highest leverage stage of American capitalism, stymying productivity enhancement and GDP growth. It is always handy to be able to describe the U.S. economy in a single sentence.
However, things are rarely that simple. The book draws heavily from academic and private research, but amid my excitement at its elegance, I couldn't help but pick up shades of Freakonomics or Malcolm Gladwell. The book is fun, but is it convincing? Tech startup culture is annoying, and Silicon Valley's bloated sense of self-importance makes it an easy target for economic scapegoating. The authors occasionally run the risk of allowing momentum rather than rigorous research to carry them forward, most notably when criticizing hedge funds and high frequency traders as contributors to VCs' overconcentration in software. So, let's explore some objections:
- The distinction between software and deep science may be a false one. Software innovation can facilitate discovery in deep science. Machine learning and artificial intelligence seem like clear facilitators of future scientific discovery in quantum mechanics and biotechnology. Just because some software projects are used to facilitate online applications now does not mean they can't be ported to other opportunities.
- The shorter term returns to software investment can be invested in other projects. Quick, high returns to lower-risk VC opportunities increase wealth, which should theoretically increase the asset base from which future deep science investment can be made. Jeff Bezos's and Elon Musk's enthusiasm to commercialize space exploration appears to be an example of software wealth diversifying into deep science.
- Is this a cyclical or structural shift? Wealth creation on novel technology platforms seems to come in waves. Once many of the opportunities are discovered and the easy money is made, it seems reasonable to expect a renewed enthusiasm for other areas of VC investment.
Even taking the above into account, Venture Investing In Science has some meaningful explanatory power for our current economic situation. And, although it reads mostly as a broad jeremiad against the current VC decision process, the book also has some important implications for investors' decisions:
- As microcap tech stocks have become more illiquid and banks have largely curtailed the practice of marketing these securities to investors, there may be opportunities amid the enormous risks in this space. Small allocations to science-driven startups could prove immensely rewarding, if an investor has capacity for extensive due diligence and tolerance for frequent total losses.
- There is a critical difference between an investment in radical technological innovation and an investment in a traditional business model that leverages recent technological achievements. Investors should have a clear idea of which type of investment they're making. Mistaking a traditional model for a revolutionary innovation can result in painful overestimations of future growth.
- While value investors make a compelling case against investing based on expectations for what the future holds, someone has to allocate capital to the high risk world of technological discovery. A well-constructed portfolio devoted to capitalizing on the commercialization of emergent technologies should reap substantial rewards. Don't overlook growth altogether.
Whatever his underlying ambitions, it's plausible that Mark Zuckerberg's trek through the rough terrain of the U.S. labor market is ultimately a journey of self-discovery. As the human embodiment of the past 20 years of Silicon Valley capital allocation decisions, Zuckerberg may eventually realize that he and his company have been key enablers of America's uneasy economic footing. In the foreword to Venture Investing In Science, Mark Anderson writes,
"Certainly more short-term money has come from the mix of privacy invasion and advertising income at Facebook, yet experts wonder whether such apps actually contribute to a slide in productivity."
In Chapter 4 , Jamison and Waite write,
"What we are seeing today is an entrepreneurial financing that is significantly concentrated and focused on software and what can be called 'creative commerce technologies' (e.g. media, entertainment, and financial services). As venture capital companies have turned to software-driven Internet and media deals, there has been a dearth of funding available for entrepreneurs seeking to foster the commercialization of innovations based in deep science. "
If we start from the commonly accepted premise that America has somehow lost its economic way, Zuckerberg and the rest of today's startup billionaires deserve some heavy scrutiny, and we should therefore be careful about looking to them for solutions. After all, Venture Investing In Science makes a compelling case that these titans have enriched themselves in the short term while leaving the really difficult economic challenges and opportunities for someone else to handle.
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