Things are about to get real and I’m not talking about Leaving Certs, A-Levels or the Orange Toddler being fitted for a matching jumpsuit. Who knew a Trump legal defence against the criminal possession of US nuclear secrets would be “it’s mine” ? Too surreal for you? Well, Adam Neumann might just say “hold my beer”. The implosion of Adam’s WeWork from a $47 billion IPO wannabe to a zombie office portfolio of just over $3 billion will be no surprise to readers of our articles back in 2019. However, what is truly staggering is that the WeWork founder has just managed to persuade the legendary venture capital player, a16z, to write its largest ever funding cheque ($350 million) for his latest real estate adventure, Flow.
A penny for the thoughts of Softbank’s Masayoshi Son, or possibly $10 billion which is the approximate amount he has already ploughed into WeWork and “Our mission to elevate the world’s consciousness”. Just not investor consciousness. Too late now but one suspects Son wishes he had been conscious that WeWork was losing an astonishing 84 cents for every dollar of sales at the time of its first IPO attempt. This might be a rather extreme illustration of the collision between revenue hopes and investment returns reality but start-up founders should be prepared for increased scrutiny of margin progress(profitability trajectory).
Revenues are, of course, critical but tales from the funding coalface are pointing to a much greater focus on cash burn. And, there is a further complication. We can’t avoid inflation these days but in the world of investment there is a double impact. First, investee companies must deal with potentially higher costs in their operations. The second factor is a financial reality which has been shrinking in impact for forty years. Until now. In a low inflation world of sub-2% we were less conscious of the exact returns being promised in an investment prospect. In an inflationary world that could be an expensive mistake. Allow us to explain.
Goldman Sachs were happy to report that the companies in the major US stock index, the S&P 500, grew their earnings/profits by an average of 9% in Q2 this year compared to the same period a year ago. Whoop whoop. But what was the REAL profit growth? In the financial world you will occasionally read metrics such as “real GDP growth”, “real yield”, “real returns” etc. This differentiates these numbers from their “nominal” siblings which take the headline number and make no adjustment for inflation. No biggie in a low inflation world, but now we should be paying attention. Back to the S&P 500, profit growth and the current US inflation rate are each trucking along at a similar 9% rate. REAL profit growth calculated by subtracting the inflation rate would suggest actual progress is closer to zero. The same applies to reported headline rates of revenue growth.
Companies in the UK’s blue chip index, the FTSE 100, might post revenue growth of 10% but if inflation is running at over 10%(as recorded this week) then this metric in real terms looks far less heroic, possibly more Tory. Another way of looking at this is to expect most companies to be growing their revenues at least as much as prices are rising in the wider economy. This inflation phenomenon is adding an extra hurdle to operational performance and perhaps hiding some real world problems. Arguably, there are other significant financial documents requiring more scrutiny…
- Investment reports will document historic returns/losses and give guidance to future returns. So, in 2022 in REAL terms, if your stock portfolio is down 10% that involves a real negative return closer to 20% ie your purchasing power has decreased by more than just the nominal value of the share prices.
- Fundraising documents will feature revenue growth and returns projections. A 15% revenue growth rate might look respectable in nominal terms but if inflation is 10% then a 5% real growth rate is less exciting. Clearly, this will impact returns expectations(and valuations!) for investors too.
- Pension plans will typically have an average returns target to be achieved over time albeit not necessarily the same percentage gain each year. Many plans for those closer to retirement might be conservatively managed and have annual returns targets of say 5%. If inflation persists at 4% for a few years after 2022, and one factors in management fees of 1%, then it is entirely possible that your pension plan is making no progress in purchasing power terms for your retirement.
The above examples should not lead to instant panic. Inflation may have already peaked so the longer term story might not change too much. However, be wary of promoters or financial advisors hiding behind inflationary tailwinds. Bluntly speaking, 10% growth in revenues or returns in 2022 could be in real terms closer to zero progress. However, let us end on a more positive note and again it involves some mathematical reality which the financial commentariat is in danger of missing amid the cost of living horror headlines.
In our “Ten Little Rays of Macro Sunshine” we mentioned month-on-month US inflation peaking in June and possibly going negative in August. Before everyone questions the reality or sanity of that statement predicated on a recent supermarket visit we need to understand a key inflationary truth. Prices do NOT need to decline for inflation rates to fall. The mathematics are very clear. If prices in aggregate were to stay at these elevated levels for the next 2 years the inflation rate would NOT be the current 9-10%, or 5%, or even the ECB or Fed targets of 2%. The inflation rate would be ZERO percent. The numbers do count but don’t ask Adam. Ask Masayoshi Son – Softbank just lost $23.4 billion in Q2. Forget return on your capital, how about return of your capital!
