Knowing What We Don’t Know

The following commentary was adapted from De Novo Capital LLC’s letter to investors:

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

This quote is attributed to Mark Twain, although like many Twain quotes it is apocryphal as there is no evidence he said or wrote it.  Nonetheless, this quote has been a guidepost for my own investing philosophy.  As I have discussed often in these letters, I do not like to make predictions.  De Novo Capital sticks to a long-term strategy that can hold up regardless of the path of the markets.  The range of possible outcomes is always wide, and while fortunes can be made placing speculative bets, they can more easily be lost.

The past year convincingly illustrates that “what you know for sure that just ain’t so” can get you into trouble.  As it became clear the pandemic would force the shutdown of much of the world economy and stocks were crashing, it would have been easy to “know for sure” that a depression was coming and stocks would reflect it.  And while stocks dropped significantly beginning in late February, they began their rebound in late March.

In the summer, stocks soared while lockdowns and layoffs continued in many sectors of the economy.  It would be easy to “know for sure” that the disconnect between stocks and the economy would be resolved with stocks plunging lower. Selling at this time would have been a mistake, causing an investor to miss out on much of the year’s gains.

In a year where stocks performed strongly in the face of so much economic and political uncertainty, a little humility went a long way.  Investors are best served admitting what they don’t know and avoiding knowing things “for sure,” especially when the range of possible outcomes is very wide. 

I will admit the surge in stocks this year caught me off guard and at times the disconnect between stocks and the economic fundamentals made holding stocks quite uncomfortable.  However, knowing that I may not be seeing the full picture, I did my best to look past the news of the day and focus on long-term outcomes.  While we did sell some stocks that were put at increased risk due to the economic turmoil, we shifted our funds into others that were better positioned to weather the crisis.  The key was to admit that we did not know what was going to happen and not to get too nervous, either at the bottom when things looked bleak or later when stocks rose in the face of a continuing crisis.

Going forward, the lesson to be careful of what we “know for sure” will be one to keep in mind.  As we turn to 2021, the headlines are still largely dismal, although with rays of hope as coronavirus vaccinations proceed.  Yet the market rally seems to have shaken investors out of the view that the market must decline to match current conditions, and instead a different and opposite view may be taking hold – that the market will continue to rally regardless of current conditions.  This may be fueling a speculative frenzy.

Presently, the strongest returns from stocks are coming from the most speculative companies that, while growing rapidly, are not yet profitable.  Robinhood, a trading app offering free trades to retail investors, is seeing explosive growth, adding an estimated 6 million accounts in 2020.  Bitcoin recently touched $40,000.  IPOs are hot again. 

One of the most troublesome developments is the increasing popularity of the SPAC.  A SPAC is a Special Purpose Acquisition Company and essentially functions as an alternative way to take a company public.  SPACs have been around for some time, but their popularity is booming.  SPAC sponsors raise money by issuing shares and have a period of time (typically 24 months) in which to find another company to buy with the capital.  Once the target is found and deal agreed upon, the SPAC’s shareholders vote to approve or reject the deal.  If the deal is approved, the company is merged into the SPAC and immediately becomes publicly traded.

If this sounds like a way to avoid the scrutiny that comes with the IPO process, well, that’s because it is.  In late 2019, I wrote that WeWork’s failed IPO was a sign of a healthy market because a company with a weak business model and poor corporate governance was ultimately rejected by public market investors.  Specifically, I wrote, “[T]hat investors are capable of tapping the brakes and showing skepticism demonstrates that they are still giving at least some consideration to business value…. [T]his is not the kind of market euphoria that marks the top of a bubble waiting to pop.”

What we see today is quite different.  With SPACs, sponsors are incentivized to make a deal to earn their fees, which may lead them to cut corners in due diligence.  Investors seem fine with this development as long as stock prices go up once the acquired company trades.  The result is many highly speculative companies are now going public via SPAC, such as electric vehicle company Nikola.

Nikola was acquired by a SPAC in June for $3.3 billion even though in the first three quarters of 2020, Nikola recorded $95,000 in revenue (no, that is not a typo).  In November, Nikola founder Trevor Milton resigned amid allegations that he deceived investors about the company’s technology.  Among other things, Nikola produced a video in which an electric truck was rolled down an incline to make it look as if the company had developed a working prototype.  The company defended itself by saying, “Nikola never stated its truck was driving under its own propulsion in the video.”  A company this speculative – and dodgy – should not be trading on the public markets at a $9 billion valuation, yet here we are.

As I was finishing this letter, it was reported that WeWork is in talks to possibly combine with a SPAC.  Clearly, we have come full circle.

This is just the tip of the iceberg of the wild things happening in the markets.  This month has seen the amazing saga of retail traders organizing via Reddit to push the stock of GameStop, the struggling video game retailer, up as much as 1700% in 2021, crushing short sellers and putting a multi-billion-dollar hedge fund on the brink of collapse.  The saga is ongoing, as trading restrictions imposed by brokerages caused the stock to plunge over 40% before rebounding significantly today.  What comes next is anyone’s guess.

If history is any guide, things could get even crazier.  Books will be written about this period.

Things have changed fast.  After believing the world was ending just last March, investors are now looking to get rich quick by bidding up the most speculative companies.  It would be easy to look at the current markets and cry “Bubble!”  It would be easy to “know for sure” that it will burst, sending markets crashing.  This view can get you into trouble.  While these speculative trades will unwind eventually, calling market tops can be incredibly challenging, and you need to know not only when to get out, but when to get back in.

Instead, much like in 2020, 2021 will be a time to embrace uncertainty, exercise caution, and stick to the long-term strategy.  We may sell some stocks if they are bid too high, but we will not be too quick to do so simply because other parts of the market look frothy.  And we will of course avoid the bubble stocks.  Our primary goal will the same: buy great companies and hold them for a long time.