First Quarter 2017 Commentaries

“Bull market climbs a wall of worries.” It was no exception for the first quarter of 2017. Despite record valuation, waves of political populism around the world and US Federal Reserve tightening interest rate, S&P 500 rose a strong 6.07%.

The big IPO for the first quarter was a social media darling of the teens known for its ephemeral messages. In a relatively quiet quarter for market volatility, SNAP Inc saw more than its share of excitement. The shares were priced at $17 on March 2nd and zoomed skyward 44% on its first day of trading, reminiscent of the more nascent but wider days of internet stock trading circa 2000. Yet only two days later, it dawned on investors that an ad driven business model whose target audiences are famous for their fickleness and limited purchasing power may in fact be a risky proposition, especially considering its super premium valuation. In successive trading sessions, it sold off nearly 30%. Finally, the underwriters of those shares who by the way normally commend 7% commission on IPO proceeds came to the rescue. “Who cares about its current business model?” so they say, “just throw it money and it will expand beyond its current trappings.” It worked for Amazon; it worked for Facebook; it worked for Netflix. Why not SNAP? The shares then moved up again, although at a much slower pace.

Unnoticed amid the fanfare is the structure of SNAP Inc. The newly minted shares, however dear they may be, carry no voting rights whatsoever. The two founders of the company controls 90% of the voting right, while its early venture investors own a class of shares that conveys only one tenth of such rights compared to the founders’ shares. The story is not much different at other prominent firms like Google and Facebook. When Google went public, the two founders held 33% of the company’s shares and 38% of the voting rights. For any secondary offering, it now sells a non-voting share so that the founders stake will not be diluted. At Facebook, its initial public offering resulted in Mr. Zuckerberg controlling 58% of votes while owning 28% of the company.

While academic studies have shown no discernable differences between companies with single ownership structures versus multiple share classes, it is certainly reasonable for Silicon Valley executives to argue that in an extremely competitive and winner take all high-tech world, the guidance of visionary founders without meddlesome shareholders can make the difference between success and failure. However, the existence of such structures represents the waning bargaining power of shareholders against management. Once upon a time, bankers desperate to lend required no documents of income for a mortgage and bond buyers desperate for income required little covenant from issuers of junk bonds. Experience shows that desperation doesn’t end well. Bull market climbs because it overcomes a wall of worry, but ends on the back of complacency. The casual acceptance of shares with no voting rights attached is yet another sign of complacency.

We invest in stocks because companies that our shares represent create value over the long term. This is why we want to be involved in the market even when stock valuations seem high. However, given the increasingly irrational behavior in the market place, we also want to exercise caution. For 2017, we will likely maintain our strategy of high cash balance, strategic hedging and more active stock trading and selection.

Dong Hao Zhang
President & Chief Investment Officer