Dissecting Our Mission Statement
Surveying the emerging growth universe. Perhaps less captivating than the Starship Enterprise’s famously split infinitive of ‘to boldly go where no man has gone before’…., but catchy nevertheless. This second issue of Confluence outlines our strategy and the market landscape.
To survey is to look at or consider the whole of something carefully. It also means to examine something and measure it, usually in order to map it. Although we don’t plan to do formal surveys, our work involves gathering information about a lot of different companies and markets, and learning about the opinions or behavior of the various participants.
Still, any intelligence we collect along the way can only add real value within the context of reliable corporate, market and industry data and widely-accepted trends. All of this serves the primary objective for Confluence, which is to explore the investment research process for emerging growth companies.
Sizing Up EGCs
What exactly is an emerging growth company? The answer usually comes down to perception and lack of any clear definition. Too often the term is used simply to describe fledgling microcaps, and that’s wrong. We think the SEC provides a good yardstick with revenue as a marker.
An emerging growth company as defined by the SEC has annual revenues of less than $1.07 billion in its latest fiscal year. This encompasses the small and microcap tiers and numerous additional companies – especially in the most technology-driven industries – with market capitalizations up to $5 billion and higher.
According to the SEC, a company continues to be an emerging growth company for the first five fiscal years after it completes an IPO, unless 1) its total annual gross revenues are $1.07 billion or more; 2) it has issued more than $1 billion in non-convertible debt in the past three years, or 3) it becomes a ‘large accelerated filer’ when the issuer has a public float of $700 million or more on a specified date.
If a company qualifies as an emerging growth company, the SEC says it can choose to include less extensive narrative disclosure than required of other reporting companies, particularly in the description of executive compensation. Consider this a red flag because any company that fails to disclose this info undoubtedly hiding additional things investor should know about.
Other loopholes for emerging growth companies include allowing audited financial statements for only two fiscal years (versus three for other reporting companies), and no requirement for an auditor attestation of internal control over financial reporting under Sarbanes-Oxley. Again, these warning signs typically only appear in, yes, fledgling microcaps.
A look at Google Trends offers another view of the EGC landscape. A five-year comparison of Google search trends for the terms ‘emerging growth’, ‘small caps’ and ‘tech stocks’ indicates that emerging growth ranks third. No surprise here. Indeed, we chose ‘emerging growth’ not for its branding power, but believe it most accurately describes the type of companies and industries in our scope.
What’s interesting in this chart is the explosiveness of tech stocks from the start of the pandemic in early 2020, followed by a steep decline in recent months. While this reflects a tempering of animal spirits, trading activity suggests their momentum still holds an edge over their smaller brethren.
Stock Market Parallels
Applying reasonably good proxies for tech stocks, small caps and emerging growth stocks fills out the storylines. Here’s the breakdown:
Nasdaq 100 Index, the 100 largest, most actively traded U.S companies listed on the Nasdaq, is heavily weighted in information technology (48%), with Apple (13.4%), Microsoft (10.8%) and Amazon (10.7%) accounting for more than a third of the entire index.
Russell 2000 Growth Index covers small U.S. public companies whose earnings are expected to grow at an above-average rate relative to the market. Healthcare (30%) and information technology (21%) companies account for half of the nearly 1,200 holdings.
Russell Microcap Index consists of the smallest 1,000 securities in the small-cap Russell 2000 Index, plus the next 1,000 smallest eligible securities by market cap. Healthcare (29%) and technology (9.4%) are the two biggest industries for an index with a median market cap of $272 million.
A five-year chart comparing this trio illustrates a few things we’d like to highlight. The first is the initial hit from Covid-19 and subsequent recovery; the second is the activity since January 2021.
In the six months leading to the start of the pandemic the three indices tracked each other very closely. Upon first impact from Covid, small and microcap stocks declined far more sharply than large tech stocks. However, the Nov. 2020 U.S. Election jolted smaller stocks in anticipation of domestic spending programs, which have a larger effect on these businesses. This group surged ahead of the Nasdaq 100 into the new year.
Since Q2 2021, the biggest tech stocks regained leadership. And as the third quarter approaches, consolidation in small and microcap stocks is playing out.
Brother Can You Spare a Paradigm?
We have already defined the largest set of emerging companies based on a simple metric (revenue), but Confluence is focused on a subset of this group: companies developing of new technologies and innovative solutions to address technological, medical, social, environmental and economic challenges.
Isolating this group from the full set of emerging growth companies, we find that a large majority are profit-challenged. Analyzing these small and microcap firms as if they were mid or large cap companies with established histories and years of profitable operations is crazy. Yet that’s what so much of the equity research covering this segment is essentially doing even today.
[In next week’s issue, we’ll begin to look at the third stream research process, which emphasizes innovation, intangibles, user experience, and narratives.]
From a wider perspective, we explore the evolution of technology ecosystems. Since technological advances steer the course of economic development and progress, we’re interested in the dramatic shifts occurring in three areas, and their effects on the ECG ecosystem. Persistent technological, economic and social forces are accelerating decentralization and fragmentation of aggregated industries, notably in healthcare, finance and energy.
Models of Emerging Growth
Most prominent is the hair-raising trajectory and reach of new digital technologies (e.g., artificial intelligence/machine learning) and the upper layers of the stacks where platforms and apps operate.
In the biotech and medical tech sectors, the evolution of personalized medicine and digitalization of healthcare are opening myriad opportunities for a broader cross-section of EGCs.
Then there’s climate change and the urgency to deal with its consequences, which will augur a new regulatory environment with the rollout of additional incentives for innovative clean energy solutions.
Anyone identifying these trends as ‘paradigm shifts’ can easily be accused of over-hype. But this matters little today since paradigm shifts, like bull markets, can never be confirmed until long after their fact.
Thomas Kuhn, author of “The Structure of Scientific Revolutions” (1962), introduced the concept of paradigm shift to characterize a scientific revolution that stands apart from the normal activity of science.
Kuhn held that a revolution is a destructive as well as a creative act. Paradigm shifts arise when the dominant paradigm under which normal science operates is rendered incompatible with new phenomena, facilitating the adoption of a new theory or paradigm.
His theories have been adapted by W. Brian Arthur, a leading technologist and one of the pioneers of complexity theory, who has applied them to technology.
In his book “The Nature of Technology” Arthur points out that because science and technology are purposed systems (the purpose of a system is a property of the whole and not in any of the components; they follow the same logic) the whole of a technology and all of its parts develop simultaneously in parallel.
“Technology evolves by combining existing technologies to yield further technologies and by using existing technologies to harness effects that become technologies,” according to Arthur.
However we characterize the rapid evolutionary changes in motion today, emerging growth companies are situated in a time and place for tremendous opportunities. Our primary aim is evaluating the ability of individual companies to execute in the face of complex technological, economic and market challenges.
News & Trends
Entrepreneurial Revolution Heats Up
Tim O’Reilly writes that climate change “will become the epicenter of the next entrepreneurial revolution”. In an opinion piece for Wired, he suggests that the businesses and applications built on the internet and Silicon Valley’s resources will be eclipsed by opportunities in climate tech.
O’Reilly is founder and CEO of O’Reilly Media and the author of “WTF? What’s the Future and Why It’s Up to Us,” a book I highly recommend.
He points to a recent PwC report showing that climate tech investment increased from $418 million per year in 2013 to $16.3 billion in 2019, growing at five times the venture capital market rate over the last seven years.
It wasn’t always like this. Venture capitalists had lost about half of the $25 billion they invested in the clean-tech sector between 2006 and 2011, leading them to divert investment to developers of apps, software and artificial intelligence that could grow quickly without large amounts of capital.
In a Harvard Business Review article from May 2017, the authors quote a Brookings report from that year. They said VC money had not been reaching many promising technologies, especially the riskiest ones, often with the heaviest financial demands, that are urgently required to address climate change.
The HBR authors surmised: “Perhaps that’s because VCs got distracted by the siren song of social media companies, especially after Facebook’s incredibly successful 2012 IPO. Perhaps it’s because the U.S. never put a price on carbon. Perhaps it’s because the shale boom hurt the outlook for clean energy.”
A few years later it’s a whole different story. China’s success in scaling up solar power, as well as similar cost reductions in wind energy and batteries for electric cars, have laid the groundwork for a new wave of investment in clean energy start-ups, or ‘clean tech 2.0’.
Dozens of companies developing everything from battery storage to low-carbon concrete have listed on US stock exchanges over the past year via mergers with SPACs, raising billions of dollars. All told, however, listed companies set to benefit from a transition away from fossil fuels are worth a collective $6 trillion, according to Bank of America.
That big investment figure is noteworthy, but equally noteworthy is how investors are approaching the sector. Climate Tech VC reports that:
“A decade ago, almost the entirety of investor interest in cleantech was electricity- (solar, wind), transport- (biofuels) or efficiency-related (a suite of software applications and software-as-a-service business models). Today? More venture firms are interested in food than anything else, by a wide margin. Next in investor interest is mobility, which, given that it includes everything from scooters to aviation, is a far broader category than transport fuel. The consumer sector, which was relatively minor a decade ago, is third.”
Irrespective of where investments are going, climate and corporate performance will be increasingly linked. Already, more than 90% of S&P 500 companies have sustainability reports on their website. Efforts to fight climate change and transition to a green and circular economy will mean at least $4 trillion to $5 trillion in annual global investments, financed mostly by the private sector.
A huge restructuring of the global economy is happening.
Act of Discovery
Poetry in Motion
It’s football season and the New York teams are off to a collective 0-4 record. We have to marvel at the fortitude of fans who watch full games.
The average professional football game lasts 3 hours and 12 minutes, but if you count the time when the ball was actually played, the action lasted only 11 minutes. That’s a remarkable fact and a tribute to the NFL’s public relations and marketing prowess.
Business is certainly brisk for the league. Approximately 800 brands collectively spent $6.2 billion on advertising during NFL telecasts during the 2020-21 season, an increase of 17% over the 2019-20 season, according to iSpot.tv.
In 1960, pro football was the fourth most popular spectator sport after baseball, college football and boxing. But over the next decade, it rocketed to first place in polls, television ratings and revenue. NFL Films, begun in 1962, helped propel it. Sports Illustrated called the enterprise “perhaps the most effective propaganda organ in the history of corporate America.”
Ed Sabel founded NFL Films, but Steve Sabol – the producer, writer, director and cameraman – created the images and sounds. Their work was a brilliant collision of football and art. Overlaying the film was stirring orchestral music composed by Sam Spence and the ringing narration of John Facenda, whose voice "turned every game into Waterloo and every player into an epic hero," Richard Cohen once wrote in The Atlantic. Facenda was also known as “The Voice of God.”
Check out ‘NFL Films: More Than a Game (1970)’ on YouTube and visit this NFL Films playlist on Spotify if you want to relive the era when the New York Jets were the toast of the town.
Let’s go Jets!
See you next week, and thank you for your support.
Josh
Disclaimer
The content provided in this newsletter is intended to be used for informational purposes only. It is important to do your own analysis before making any investment based on your own personal circumstances. You should take independent financial advice from a professional in connection with, or independently research and verify, any information that you find on our Website and wish to rely upon, whether for the purpose of making an investment decision or otherwise.