Tag Archives: Finance

What was the best 10-year period to invest in the S&P 500?

I’m doing a small project right now looking at whether stop losses are actually useful in investing. When FTX blew up, it was noted that the traders there didn’t believe in stop losses, for which they were ridiculed on social media. Of course, do stop losses actually help? Or are they more likely to kick you out of a volatile-but-profitable investment than save you from an unprofitable one? Well I can’t answer that yet, but I can answer a different question.

To start my project, I downloaded 30ish years of S&P 500 data starting September 1990 and asked a quick question: what 10-year period gave the best return if you had invested in the S&P? Once I get the baseline return down, I can add in things like stop-losses and momentum strategies to see if a savvy investor could have improved their return with simple rules. Anyway, here’s the data:

I make a small program to estimate the return if you have bought $10,000 of S&P 500 stocks and simply held them for 10 years, selling them at the end of the 10th year. From this we can see that 1990 would have by far been the best years to start as you would have been able to sell at the peak of the Dotcom Bubble. Just a couple of years later however and you would have sold into the Dotcom Crash instead, drastically lowering your returns. The worst years for a 10-year buy-and-hold were 1998-2000 as you would have sold into the teeth of the Financial Crisis. These are only years where your 10-year return would have been negative. Then we can see 2008-2009 themselves as some of the best years to start investing, since you would have bought right at the bottom and ridden strong returns into 2018-2019.

I hope to update the program soon to see if momentum strategies beat buy-and-hold, but for now this gives a good picture of the historical returns for the S&P 500. The average 10-year-return was 100%, but with an 80% standard deviation. The absolute worst return would have been to start investing March 30th 1999, you would have bought into the Dotcom Bubble and sold into the Financial Crisis with a net return of -48%. The best 10-year-return was to start October 11, 1990, which would have had you buy very low and sell near the tippy top of the Dotcom Bubble for a 510% return. There are some wild swings with the buy-and-hold strategy, but the average is still very positive, we’ll see later if stop-losses can beat that.

Send troops to the Fed?

Pardon me for wading into Twitter Drama, but Rohan Grey is a remarkably unserious “intellectual” and I couldn’t help myself.

Before I start, let me share a tiny story from “Zen and the Art of Motorcycle Maintenance.” This book was a thoroughly unenjoyable read for teenaged me, but it has one anecdote that still sticks with me. If memory serves, there is a university that is being threatened with losing its accreditation due to repeated failures and the students are naturally protesting as this would make their degrees worthless. One student talks to the narrator and claims that the University in fact can’t lose its accreditation, because if someone tried to take it “the Governor would send the national guard to protect us!”

I shouldn’t have to spell out the ridiculousness, but I want to hit word count so I will. Accreditation isn’t held in a vault, it isn’t something you can protect with guns and soldiers. Accreditation is the trust that other institutions have in you, and while some of it is legally codified most of its power is in the uncodified trust that a society is built on. You can’t protect accreditation with and soldiers any more than you can protect trust or friendship.

And so it was with bewilderment that I read an Assistant Law Professor on Twitter making the same mistakes as the nameless student from a book. Rohan Grey wants to do an end-run around the debt ceiling by having the Treasury mint a one trillion dollar platinum coin and deposit it in the Federal Reserve. This coin would then pay for the USA’s financial obligations without the need to borrow money. A big (and usually ignored) problem is that the Fed would have to accept the coin, and as Josh Barro writes, the Fed has expressed the opinion that this chicanery is illegal and undermines Fed independence. (Read Barro’s article, it goes into great detail as to why this idea probably wouldn’t work). Undeterred, Grey thinks the Fed’s opinion doesn’t matter, and that if they refuse to accept the coin then Biden should send troops to the Federal Reserve and force them to accept it.

Grey’s mistake is thinking that guns can be used to enforce trust. The Federal Reserve has the trust of the markets, and its power to move markets is based on that trust as much as anything else. The Federal Reserve trades bonds and sets rates, but those bonds and rates have value because people trust the Fed to keep its word, Jerome Powell’s speeches about the Fed’s plans have as much or more power as any action taken by the Fed. Now imagine a scenario where troops are instructed to besiege and occupy the Federal Reserve, where Powell is held at gunpoint and forced to accept a one trillion dollar deposit from the Treasury which he and the Fed have gone on record as saying is illegal. Trust in the Fed would be shattered, nothing Powell says or does matters anymore because the troops (and by extension the President) are running the show. Investors would flee from US government bonds, causing yields (and thus America’s cost of borrowing) to skyrocket, because America’s currency will have been debased against the will of its central banks, and will now be at the whims of the President.

And you may say “that’s fine, I like Biden as President” but do you like DeSantis? Do you trust that DeSantis wouldn’t be willing to send his own troops to force his will on the Fed? Would you buy a 10-year government bond if there’s a chance that DeSantis or Trump will be controlling it 2 years? And furthermore, Powell’s remarks on inflation will become worthless. Maybe Biden doesn’t like the rate rising that Powell needs to do, or maybe when the election comes he wants to juice the economy. So what’s to stop him from leaning over and reminding Powell who’s boss? What’s to stop Trump or DeSantis from doing the same? People like Grey once griped that Trump’s complaining caused the Fed to pause rate rises in 2019 (ignoring of course that inflation went under the Fed’s 2% target, which should cause them to pause rate hikes all on its own). Now Grey wants to make the Fed wholly subsumed by the President, so Trump would be able to do whatever he wanted.

Once you’ve sent troops to the Fed, you can’t unring that bell. Investors invest in American Dollars and American bonds in large part because they trust the Federal Reserve to do its duty with regards to the currency. Shattering that trust with soldiers would shatter investor confidence in the American economy as a whole. You’d have a trillion shiny dollars, but they wouldn’t be worth a pence.

Beam Therapeutics: what’s so special about prime editing?

Beam Therapeutics is another biotech company often mentioned in the same vein as Ginkgo Bioworks, Amyris, and Twist Bioscience, and since I’ve blogged about all three of those I might as well blog about Beam. Unlike Ginkgo and Twist, Beam isn’t a shovel salesman in a gold rush, they’re actually trying to create drugs and sell them, in this case they’re trying to break into or perhaps even create the cutting edge industry of medical genetics, changing people’s genes for the better. I’ll briefly discuss the science of their technology, but I feel like the science surrounding their technology deserves the most focus.

Beam has a novel form of CRISPR/Cas gene editing called prime editing. In both normal CRISPR/Cas and prime editing, genetic information is inserted into a living organism by way of novel DNA, guide-nucleotides and a DNA cutting enzyme. The guide-nucleotides direct the information to the specific part of the genome where it is needed, the DNA cutting enzyme excises a specific segment of host DNA, and hopefully DNA repair mechanisms allow the novel DNA to be inserted in its place. These techniques always rely in part of the host’s own DNA repair mechanisms, you have to cut DNA to insert novel DNA and that cut must then be stitched back up. Most CRISPR/Cas systems create double-stranded breaks while prime editing creates just single stranded breaks, and this greatly eases the burden of the host DNA repair mechanisms allowing inserts to go in smoothly and with far less likelihood of catastrophic effects. Double stranded breaks can introduce mutations, cancers, or cause a cell to commit cell-suicide to save the rest of the body from its own mutations and cancers. Because Beam is using prime editing, their DNA editing should have less off-target effects and far less chances to go wrong.

So the upside for Beam is that they’re doing gene editing in what could be the safest, most effective way possible. The downside is that gene editing itself is still just half the battle.

When I look at a lot of gene editing companies, I quickly find all kinds of data on the safety of their edits, the amount of DNA they can insert or delete, and impressive diagrams about how their editing molecules work. I rarely see much info about delivery systems, and that’s because delivering an edit is still somewhat of an Achilles’s heel of this technology. In a lab setting you can grow any cell you want in any conditions you want, so delivering the editing machinery (the DNA, the guide-nucleotides, the enzymes) is child’s play. But actual humans are not so easy, our cells are not readily accessible and our body has a number of defense mechanisms that have evolved to keep things out and that includes gene editors. To give you an idea of what these defenses are like, biology has its own gene editors in the form of retroviruses which insert their DNA into organisms like us in order to force our body to produce more viral progeny, a process which often kills the host. Retroviruses package their edit machinery in a protein capsid which sometimes sits inside a lipid (aka fatty) envelope, and so the human body has a lot of tools to recognize foreign capsids and envelopes and destroy them on sight. These same processes can be used to recognize and destroy a lot of the delivery systems that could otherwise be harnessed for gene editing.

Some companies side-step delivery entirely, if it’s hard to bring gene editing to cells why not just bring the cells to gene editing. This was the approach Vertex Pharmaceuticals used in its sickle cell anemia drug, blood stems cells were extracted from patients and edited in a test tube, before being reinserted into the patients in order to grow, divide, and start producing non-sickled red blood cells. This approach works great if you’re working on blood-based illnesses, since blood cells and blood stem cells are by far the easiest to extract and reinsert into the human body. But for other illnesses you need a delivery method which, like a virus, is able to enter the organism and change its cells’ DNA from within.

So if Beam Therapeutics wants to deliver a genetic payload using their prime editing technology, they’re going to need a delivery system which obeys the following rules

  • It must be able to evade the immune system and any other systems which would degrade it before it finds its target cells
  • It must be able to be targeted towards certain cells so that it doesn’t have off target effects
  • It must be able to enter targeted cells and deliver its genetic package

So let’s look at the options.

Viruses have already been mentioned, and they can be engineered in such a way as to deliver a genetic package without causing any disease. However as mentioned they are quickly recognized and dispatched by the immune system whenever their are found, their protein shells being easy targets for our bodies’ adaptive immune system. Normal viruses get around this by reproducing enough to outcompete the immune system that is targeting them, but we don’t want to infect patients we just want to cure them, so using viruses that reproduce is off the table for gene editing.

A variety of purely lipid-based structures exist which can ferry a genetic package through the body. Our cell membranes are made of phospholipids, and phospholipids will naturally form compartments whenever they are immersed in water. Phospholipids also have the propensity to fuse with each other, allowing their internal compartments to be shared and anything inside them to move from one to the other. Packaging a gene editor inside phospholipids would be less likely to trigger the immune system, and they can be created in such a way that they target a particular cell type to deliver their genetic package. However random phospholipids can be easily degraded by the body, limiting how long they can circulate to find their target cell. Furthermore their propensity to fuse is both a blessing and a curse, allowing them to easily deliver their genetic package to targets but also making them just as likely to deliver it to any random cell they bump into instead. This means a lot of off-target delivery and the possibility for plenty of off-target effects

At the other end of the scale are nanoparticles made of metals or other compounds. Many methods exist to attach drugs to the outside of a nanoparticle and target that nanoparticle to a cell, however this in turn leaves the drug free to be interacted with and targeted by the immune system. For many drugs this is fine, but prime editing uses foreign proteins, DNA and free nucleotides and the body is downright paranoid about finding those things hanging around since that usually means the body has either a cancer or an infection. To that end, the body destroys them on site and triggers an immune response, which would severely curtain any use of nanoparticles to deliver a genetic package. Nanoparticles can also be designed hollow to allow for the prime editing machinery to fit snugly inside them, but this can lead to the machinery just falling out of the nanoparticle in transit and being destroyed anyway. You might say “well not a hollow sphere that fully surrounds the machinery so it can’t fall out?” But it does need to get out eventually if it wants to edit the cell, and if it’s encased in a solid sphere of metal it can’t do that. Enzymes to breach the metal would be cool but are impractical in this case.

Between these two extremes we have a number of structures made of lipids, proteins, polymers or metals, and they all struggle with one of these points. They can’t encase the machinery, or they can’t easily deliver the machinery, or they trigger an immune response, or they degrade easily, or they often cause off-target delivery. Delivery to the target is Step 0 of both prime editing and gene editing in general, and for the most part this step is still unsolved. I’ve visited several seminars where viral packages for delivering CRISPR/Cas systems were discussed, and while these seem some of the most promising vectors for gene editing they still have the problem of triggering the body’s immune system and being destroyed by it. The seminars I’ve watched all discussed mitigating that problem, but none could sidestep it entirely.

I do believe that Beam therapeutics has technology that works, their prime editing is clearly a thing of beauty. Beam is currently working on treatments for sickle cell anemia, as is Vertex Pharmaceutical, and as are most gene editing companies because it’s a blood-based disease that is amenable to bringing the cells to the gene editing machinery instead of having to go vice versa. But for anything where you can’t bring the cells to the editing, Beam isn’t quite master of it’s own fate because for prime editing to reach the cells of the body it will need to be delivered in some way and currently that’s an unsolved problem. Even a system that works to deliver some packages won’t necessarily work for all of them as size and immunity considerations change with the specific nature of the genetic package you’re delivering. I would also be worried about Beam’s cash burn, they are essentially pre-revenue and will need to do a lot of research before any of their drugs get to market or can be sold to a bigger player. I think they can survive for a long while by selling stock since their price has held up a lot better than other biotechs I’ve blogged about, but that’s good for them and not for a shareholder. As long as interest rates keep going up, I’ll treat pre-revenue companies with a wary eye.

People buy stocks instead of ETFs because their values are different

I enjoy talking stocks, and whenever you hang around on the finance parts of the internet, you’ll inevitably run into the following sentiment:

Why are you even buying individual stocks? You should just buy a broad-market ETF. You’ll never beat the market so ETFs are the best and most reliable way to grow your money.

Bogleheads et al

I’ve written about the Efficient Market Hypothesis before and about the difficulties of stock picking. I understand and to an extent agree with the arguments that people in general cannot beat the market reliably over any significant length of time. Any good runs are transitory, purely luck based, and eventually fall back to earth (see $ARKK 2016-2021 and then 2021-today). But that isn’t the primary value most stick pickers are going for, they’re going for potential return not expected return.

When you buy a broad market ETF, what is your expected return? Well the ETF tracks the whole market and the market goes up 5-10% every year, so that’s the return you can expect. Some years you’re down 20% (like 2021), some years you’re up 30% (like 2019), but on average you get a 5-10% yearly return that will slowly grow your money. Slowly is the key word: investing in the stock market probably won’t make you rich, for the average American it won’t even make you a millionaire over the course of your entirely life, but it will give you a small leg up in the long run with very little risk to yourself.

So what’s the expected return for stock picking instead? Well, definitely less than 5-10%. The efficient market hypothesis and significant amounts of experimental data show that stock pickers broadly lose to the market over any significant timescale. They might be up 100% one year but are equally likely to lose it all the next. But the key here is that the expected return is not everyone’s return. The expected return is just the average of everyone’s return, and while on average people lose to the market there are always a lucky few that beat the market and some of them win big. There is at least one person out there who went all in on Tesla stock in 2013, sold in 2021 when Musk started acting weird, and made a truly life changing amount of money, and everyone who stock picks hopes to be like that person. Is it likely? Of course not, but it’s possible and that’s what keeps people going.

This may sound illogical to a bogglehead, and they may scoff and say the stock picker is no different that the casino gambler, but let’s try another example. What is the expected return of starting a small restaurant? Well, it takes a lot of capital investment to start a restaurant and 80% of them fail within the first 5 years of operation, so it’s safe to say that the expected return of a restaurants is actually negative. On average a person starting a restaurant will end up losing money, so are an restauranteurs as illogical as stock pickers? I’d argue no, the expected return isn’t as important to them as the potential return. A restaurant is an opportunity to make a life-changing amount of money, and while it’s clearly very uncommon, it happens often enough to continue enticing people to try it. The bogglehead could just as easily state that it’s more efficient for restauranteurs to not open up restaurants at all and they should instead invest in broad market ETFs, but if no one ever took risks like that then we’d never have new businesses at all.

Big gains require big risk, and I’d argue being content with your lot and investing like a bogglehead is no more “logical” than going all in on smart but high-risk plays, it’s simply a questions of values.

Amazon and PE

Conventional business indicators such as the price-earnings ratio, the price-to-book ratio, and discounted cash flows belong in the Bronze Age – so say the new economists. But if the old metrics don’t capture the potential of today’s fast-growth companies, some new formulas can.

PERManent Upside, WIRED Staff, February 2000

I think about the above quote a lot these day. At about the absolute peak of the dotcom bubble, there were writers and (supposedly) economists claiming that the foundation of the stock market had changed, and that what appeared to be overvalued tech stocks driven by computer-illiterate investors FOMO-ing into anything with a website were in fact some of the greatest stocks to own since sliced bread. PE, PB, DCF were useless in evaluating these stocks, they stood on their own through a new metric created just for them, PERM. No one knows, cares, or remembers what PERM stood for (you can read the linked article if you really want to), but it was supposed to prove that earnings weren’t important and that high PE stocks were still good deals. I think about this a lot because this is the same argument many have used on me regarding Amazon.

Amazon had a bad 2022, over the year it’s stock price cratered around 50% and it lost 1 trillion dollars in market cap. The old adage that “Amazon’s PE doesn’t matter” has seemed less and less true as it’s PE has gotten closer and closer to “normal.” Sure it’s still well above value stocks, even well above most tech stocks, but it’s not to far off from Walmart these days which would have been unthinkable just a few years ago. It may be that economic gravity is catching up to Amazon, and if so I’d like to share my theory as to why. Full disclosure, I did buy 10 shares of Amazon right after their latest stock split and have held them ever since. I’m down rather a lot on the investment and if what I’m about to say is accurate I’m soon to be down even more, so you can consider that data point as a hedge against my thesis and read on.

The conventional theory for why Amazon’s PE never mattered was that it invested almost every dollar of profit back into the business. By re-investing their profits rather than claiming them as earnings, Amazon avoided a lot of corporate taxes. And if Amazon’s reinvestments were wise, then the stockholders gained value tax-free rather than through taxable dividends. There’s also an argument that Amazon’s reinvestments were more efficient even outside of tax implications. Every dollar Amazon reinvested could create so much growth that it was better for an investor to let Amazon keep their money and grow than for an investor to demand Amazon hand money back to shareholders. When you look at what Amazon was investing in: cloud computing, content delivery, and an every increasing share of online shopping; this certainly seems to have been the case for the last decade or so, an investor gained more value by parking their money with Amazon than they would have parking their money with a company that handed earnings back to investors.

But perhaps something has changed, and changed drastically enough that Amazon’s PE lows won’t be temporary. Amazon’s revenue and earnings continue to grow year after year, but if its stock price continues to sink it’s PE may eventually reach downright normal levels. If that is the case then I think the reason why would be clear: investors no longer believe that a dollar re-invested by Amazon is worth quite so much more as it used to be. Amazon may be approaching the limits of its momentous growth, and may now start evolving into a “mature” company like Microsoft and Apple before it. In those cases a moderately high PE is still justified, I mean these are trillion-dollar tech companies, but they can’t be expected to continue their meteoric growth and so PEs in the 100s are no longer sensible. Amazon is famous for how much it re-invests, but the dollar amount of investment is less important that the future dollars that investment generates. In the past, Amazon’s future returns of ever re-invested dollar were great enough to justify a sky-high PE but that won’t last forever. Many companies that aren’t valued like Amazon re-invest a lot of their profits, the Red Queen Hypothesis makes as much sense in biology as it does in Economics “you have to run as fast as you can just to stand still.” Companies which re-invest a lot to maintain their dominance don’t necessarily get a premium over those that hand money back to shareholders but maintain dominance. And if Amazon reinvests a greater percent of its earnings vs Apple or Microsoft but doesn’t grow significantly faster than them, then it’s stock price shouldn’t command a premium either.

I think it’s possible that Amazon is indeed maturing into a company that will be valued by it’s PE just like all the other tech companies. That doesn’t mean it’s time to dump the stock, the revenue and earnings continue to grow and will probably catch up to the PE, or at least that’s just as likely as the PE falling to meet the revenue. Regardless of the mechanics, economic gravity will eventually catch up to Amazon just like it caught up to Tech stocks of the 2000s. Nothing is ever truly new.

“Market Capitulation” is a circular argument

Will the market recover in the new year? Or do we still have a ways to go? Bears online have been going on and on about “capitulation” as in “nothing will change until we finally have capitulation.” Capitulation in normal terms means surrender, so in financial terms it means the point where investors finally give up holding and sell their shares at a loss. According to Investopedia capitulation is also the point where the investment hits its bottom. Prima facia this is a circular argument, “we won’t hit the bottom until we’ve reached the bottom” is another way to phrase it. But even dumber, this is a backwards looking argument that cannot be used for predictions. Over the year of 2022, $SPY (a popular ETF that tracks the performance of the S&P 500) hit it’s 52 week low in November at 348$ per share (it currently trades at 382$). Who’s to say that that wasn’t the capitulation, and it won’t go below that? When the S&P500 hit 666 in 2009, that was the bottom of the bear market, yet many people still didn’t believe it, expecting that there was still more pain to endure. It wasn’t until a while later that we realized no, that really was the bottom, there’s no more “capitulation” after that. So I don’t put any stock in people talking about “market capitulation.”

Short post today: green hydrogen isn’t always

“Green” hydrogen power has become something of a minor meme industry. Hydrogen power (or “fuel cells”) is used to burn elemental hydrogen with elemental oxygen producing only water as a waste product. This industry has long been the fantasy of those who want to reduce our reliance on fossil fuels and prevent the accumulation of carbon in our atmosphere, the problem is that the most economical way of producing elemental hydrogen does neither. Hydrogen is usually produced from natural gas, but “green hydrogen,” could theoretically be created by splitting water into hydrogen and oxygen. Recently I read a story of a company seeking out tax breaks to produce green hydrogen from water, but the company isn’t interested in installing solar or wind power and using that for their purposes, they want to simply buy power from the grid and use it directly. The problem is that most of America’s grid isn’t actually powered by green power but by fossil fuels. This so called “green hydrogen” would simply use the electricity from fossil fuels to produce hydrogen, with no analysis done as to whether this would produce more or less greenhouse gases than producing hydrogen from natural gas instead. In this case then, green hydrogen may not be so green.

The stock market doesn’t care about your cost basis

When someone is down 50% or more in a stock, they’ll often take to social media to complain and casually ask “what should I do next”? No one wants to sell for a loss, people almost act like it’s admitting failure. And people’s perceptions are often colored by the price at which they bought the stock. “Oh I bought 10 shares at 100$ and now they’re each worth 50$, when can I expect to break even again?” I can’t predict the market but I can say one thing: the price you paid for the stock DOES NOT MATTER. It doesn’t matter if you’re up or down, you should look at any stock you own and as yourself “do I think this stock will perform as well or better than the market in the near future?” A lot of people get stuck in a mental narrative, they start to think trends will either continue indefinitely or definitely reverse soon, depending on what would make them feel better. But a stock that is way down could still be overvalued just like a stock that is way up. A few months ago Carvana ($CVNA) stock was down 50% year to date. What did it do after that? It dropped another 50%, and another 50% from there, and just for good measure another 50% from there. Dropping 50% 4 times in a row meant it had lost about 94% of its starting value from January 1st. And Carvana still had a ways to go as it’s currently down 98%. If you had bought $CVNA on January 1st, then by April 1st you would have seen it lose 50% of it’s value. Your friend may have been tempted to think “it can’t go much lower, can it?” and bought the dip while you held your shares. You would then see your shares go on to lose 98% of their value while your friend’s shares lost 97% of their value. Your friend lost relatively less than you did, but still lost nearly everything.

Your cost basis on a stock is only relevant for tax purposes, it should have no bearing on your investment decisions. The only thing you should care about is the current price and the expected future price.

From a shareholder’s perspective, losses from stock compensation are still loses

Yesterday I talked about the economics of Ginkgo Bioworks’ ($DNA) synthetic biology business. In that post, I mentioned that Ginkgo had a loss of 650,000,000 dollars in the third quarter of 2022, against an expected annual revenue of just 500,000,000 dollars for the full year of 2022. What I didn’t mention was that a lot of that revenue was stock-based compensation, and I’m sure the $DNA boosters would be furious at me for not saying so.

When some companies release their earnings reports, they’ll focus on the “non-GAAP” number instead of the GAAP. GAAP stands for “generally accepted accounting practices” and so a non-GAAP number is obtained by using non-generally accepted accounting aka “funny math.” For our purposes today, note that GAAP considers stock based compensation as an expense, just like wages, and all expenses must be tallied up to obtain the profit or loss for the company as a whole. But for some folks this isn’t ideal, after all stock isn’t “cash,” you can’t go bankrupt by running out of it, so why should the company have to count it as an expense? For that reason, a common non-GAAP trick is to simply remove the stock based compensation to make the numbers look better. This isn’t breaking any laws, you have to make the GAAP numbers available for anyone who wants them but nothing precludes you from focusing on the non-GAAP numbers in your press release and earnings call. Lying is illegal, but optimism isn’t. This is important for $DNA as most of their expenses in Q3 were from stock based compensation: they lost 650,000,000 dollars in GAAP earnings, but only 100,000,000 dollars when stock based compensation is removed.

For a Ginkgo booster that 100,000,000 number is the only important one. Who cares about stock? They have 1.2 billion in cash and are losing 100 million a quarter, so they can keep doing this for 12 quarters (3 years) with no problems whatsoever, and by that point they’ll be profitable so cash-on-hand doesn’t matter, right? But for an investor the stock is still very important because without a dividend the value of your stock going up is the only way you’ll make money on a company. When 500,000,000 dollars worth of stock are given to the C-suite and senior execs, that dilutes how much of the company you own with your few shares of stock. Assuming the company’s total value stays the same, you now own a smaller slice of the same size pie so the total value of your slice has gone down. Even if the folks don’t sells their stock (and trust me, they always do), the threat of that sale will also have downward pressure on the stock price as skittish investors sell off so as not to become bagholders for the C-suite. That 500,000,000 dollars still represents a loss of value to the investors and should be treated as such.

There are a lot of ways a company can pay for things, and they all have their pros and cons. A company can sell stock, or hand over stock in exchange for something, a company can use the cash it has or it can take out loans and use those instead. Then a company can do a lot of different things with the revenue that comes in, it back buy back stock (or hand out a dividend, functionally the same) pay off its loans, or let the cash pile up for use later. There are many different reasons for a company to do any of these but they all involve the movement of value to different places. A company with a wildly overvalued stock price could benefit from selling share because the cash is worth more than the (transient) value of the stock. A company in a high interest rate environment could benefit from paying down its loans more than from sitting on cash, etc etc. But stock is a thing of value, it’s a source of money that the company controls, and handing that value over to the C-suite dilutes its value for every other investor. That’s why I only like to talk about the GAAP numbers for companies.

Ginkgo Bioworks: the economics of genetic engineering

Yesterday I discussed the science of genetic engineering, or at least its application to synthetic biology. Today I’d like to discuss how Ginkgo Bioworks is trying to monetize genetic engineering and gain all the value of its total addressable market.

To recap, genetic engineering is used for the production of biological molecules. If you have a drug for curing a disease you’ll need to produce mass quantities of it to both get through clinical trials and sell to patients down the road. In modern cases, that drug will usually be produced in specially made genetically modified organisms, and then purified out of those organisms using a specific purification pathway. The end result is a pure drug, which is something that the FDA demands and patients really want as it cuts down on variability and potential side effects. This is the business that Ginkgo Bioworks wants to get into, they want to be the ones producing those genetically modified organisms and validated those purification pathways. The organism and the pathway then become akin to intellectual property (IP) for the production pathway of that drug. So say you’re a company that own a drug but has no ability to produce it at scale, Ginkgo will develop a production pathway and charge you the lowest possible price for doing so (making zero profit themselves). They do this because their IP specifies a revenue sharing agreement whereby they get a cut should you manage to sell your drug in the future. This system is what gave Ginkgo such a ridiculous valuation based on TAM, if they can be the lowest-cost provider of drug production pathways, then every single company will want to contract with them, and so they’ll get revenue from every single drug on the market.

The problem is… that’s not how it seems to have worked. First, Ginkgo wants to drive down the cost of producing these production pathways, but they’re competing with companies that already work at economies of scale far greater than them. Let’s start with just the first step of the producing a production pathway: you had to get DNA for your drug and insert it into an organism. There are already many companies that will do this job for you if you’re willing to pay up. Those companies include heavy hitters like Genescript (market cap of more than 3x what Ginkgo was at its peak) and Thermo Fisher (the 600lb gorilla of this sector). These companies have driven down the cost of DNA, genetically modified organisms, and other tools to the point that Ginkgo doesn’t seem much like competition. Now Thermo Fisher And Genescript to my knowledge won’t make an entire pathway for you, but they will you a large part of the pathway for dirt cheap and then sell you the tools to finish it up yourself. But that still means that for many of the steps, Ginkgo is competing with companies that are far larger than it which are better able to deploy economies of scale than it. So Ginkgo might not even be offering you the best price possible when you compare with using some of the big boys instead. And remember they need to be offering the best price possible as they don’t even make money by selling you this process, instead they need to entice you to sign the deal where they get a portion of your future revenue.

Then there’s the fact that their business model relies on successes but self-selects for failures. It’s important to start by remembering that most drugs which go through clinical trials will fail to make any money whatsoever. Ginkgo’s business model is to produce a drug production pathway and sell it for zero profit and bank on the revenue sharing portion to make them money, but they of course understand that most of these revenue sharing agreements won’t make any revenue. But then what type of drug discovery company will even take such an agreement? A large drug company (Johnson and Johnson, Pfizer) already has the in-house tools produce a drug production pathway, they have little reason to enter a revenue sharing agreement especially when Ginkgo’s cost might compare unfavorably with just buying stuff from Thermo Fisher and doing the rest themselves. A small drug company is exactly the type Ginkgo needs to go after, but what type of small drug company? A small company that has lots of money and a product they are very certain is a hit also will be dissuaded by the revenue-sharing agreement, why fork over so much future revenue unnecessarily? On the other hand a small drug company will less money, or a drug company that has a product it isn’t sure of, those would be the kind of customers who would willingly bet on Ginkgo, but they are also the customers who will be least likely to succeed at bringing their drug through clinical trials. If they have no money they could easily go bust before they make it, and if they’re unsure of their drug then it probably means their scientists know it’s a long shot. So Ginkgo’s business model is forcing it to self-select and take on the customers who are least likely to make it a lot of money through the revenue sharing agreement.

And that’s important because the revenue sharing is supposed to be how the company will grow larger, and until it grows larger it can never compete with the big boys on economies of scale, therefor never address it’s total addressable market because there will always be big companies for whom it’s cheaper not to even work with Ginkgo. This is a chicken and egg problem, they need to grow large to reach economies of scale and drive down the cost of their services, and they need to drive down the cost of their services to make it more enticing to sign those revenue sharing agreements, but as long as their services are still higher they’re stuck in a holding pattern. It’s important to note that at this point that Ginkgo had a loss-from-operations of about 650,000,000 dollars in Q3 2022 alone. They are expected to have total 2022 Revenue of around 500,000,000 dollars. They lost more in a single quarter then their expected year-long revenue and that trend shows no sign of changing. Their cash on hand at the end of all this was 1.3 billion dollars, and with plenty of stock to sell and loans to take out, they can continue this business for a while yet. I’ll talk more in a future post about their burn rate and their losses, but it’s important to note that this is where the company is: growing but not necessarily at at rate that will let it achieve lift-off. It needs find some way to make its revenue-sharing business model work, either by driving down their costs so much that other companies have to use their services or by somehow enticing more winners instead of losers to use their services. The only part of the firm that is close to break-even is the “biosecurity” arm a COVID-monitering and diagnostic service that will likely fade as the salience of COVID continues to fade. Perhaps they can pivot to new avenues of biosecurity, flu monitoring? Either way this work is much lower margin than the synthetic biology revolution that was supposed to propel their TAM, and stock price, into the stratosphere.