When the Music Stops (Sarah Guo)

Sarah Guo on what happens to private-company valuations and investor behavior when rates rise.

Why it was kept

The passages Kyle kept on downward marks, investor psychology as rates rise, and tenured technology investors who had never seen a downturn.

As Kyle captured it

• when the music stops by Sarah Guo
  • What drives exaggerated, downward market cycles? Some trigger leads a few investors to conclude that pricing is irrational, and they begin to sell. The movement is reinforced by investor psychology.
  • Your average investor becomes more driven by fear-of-missing-out than by greed, which further accelerates selling.
  • As interest rates go up, asset prices come down, and especially high-growth equities prices. In theory, a public company stock is valued as the sum of all their discounted future cash flows, where the discount rate applied to those future cash flows is some risk free-rate plus a “risk premium” that reflects the risk of that asset. A big hike in the risk-free interest rate significantly decreases the value of a growth stage company, where the lion’s share of the value is cash flows in the distant future.
  • For years, many tenured technology investors would say that solid, relatively fast-growing software companies, public or private, should be valued at 6-8X forward revenues. As the market’s understanding of software companies has matured, increasing numbers of investors capitulated to higher and higher prices.
  • An early-stage firm whose public holdings fall 25% in value and whose portfolio falls from an 8X to a 6X multiple-of-money is a feeling a lot less pressure than a crossover firm whose public stocks are underwater and whose private holdings will go public at a price well below their cost basis. The cardinal sin in the hedge fund world is losing people money.
  • It is often said that it is “hard to overpay for the best companies.” That’s true — but my hunch is that the cause of some stress now if investors doubt that they’ve truly chosen the best companies, and they’ve potentially bought into too broad a sweep at a local pricing maxima for the power law to work in their favor.
  • The less tethered your valuation is to your traction, the further the ground you need to cover with execution before you meet the market again. The public markets are the final arbiter on price, and dislocations from the public markets can only be temporary.
  • Predicting whether this is a brief correction, or if winter is coming, is a fool’s errand. The best leaders will build a muscle of adaptability and a culture of long-term orientation, and be transparent with their teams about the uncertainties in the environment.
  • “I like burgers, and when burgers are on sale, I eat more burgers.” Warren Buffet
  • If I liked burgers at $100, I’ll eat more at $25.