Tag Archives: Finance

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.

Ginkgo Bioworks: the science of genetic engineering

Last time I discussed Gingko Bioworks ($DNA) and how their absurd valuation over this past year was in part due to valuing them by their TAM (Total Addressable Market) on the assumption that they’d grow rapidly to meet it. Today I’d like to lay down exactly what Gingko does so that tomorrow I can discuss why I think they’ve been failing. Full disclosure: I’ll be writing this post assuming my audience is non-scientists, so if anything I write is obvious to you since you studied it yourself, feel free to skip ahead.

Gingko is in the industry of synthetic biology, which is just an application of genetic engineering. In synthetic biology, you manufacture biological things (proteins, cells, other molecules) in order to perform a specific job. The classic example of this is producing insulin for sale to diabetics. Prior to synthetic biology, insulin could only be procured from the living organisms that produced it, this was usually cows and pigs, who produce small amounts of it in their daily lives. Since the total amount of insulin you got from butchering a cow was tiny, the cost was astronomical. But insulin gets produced because it is coded for by a piece of DNA called a gene, and by cloning the gene for human insulin into a bacteria cell you can grow up huge colonies of those cells and extract the insulin from them instead. This revolutionized the development of insulin, and led to a steady reduction in prices to the point that today insulin can be purchased for just 25$ at Walmart. But how exactly does the cloning and gene editing work? And how does Ginkgo hope to make money off of it?

To start with we should understand the central dogma of Biology: DNA codes for RNA, RNA codes for proteins. If you give a cell a piece of DNA, it can make RNA based on that, and then make proteins based on that RNA. Since insulin is a small protein, producing it is relatively straight forward: insert a piece of DNA into the cell which codes for the RNA which codes for insulin, and in a relatively short amount of time the cell will use the DNA you gave it to produce the insulin you wanted. But of course first you have to get the DNA for insulin and put it into your cell, and these are no small problems!

So how do you put a piece of DNA into a cell and force the cell to make proteins off of it? Well to start with the DNA has to be readable and usable by the cell you’re going to put it into, for example if has to have the right kind of introns and exons or the cell won’t use it right. Most DNA contains both exons and introns, the exons are the parts that will actually code for a protein, the introns get removed through splicing and have their own special properties we’ll talk about some other day. The important part here is that bacteria do not participate in splicing and non-human eukaryotes (yeast cells, insect cells, non-human mammal cells) splice differently than humans do. If you want your DNA to actually code for insulin, you need to use only the exons and none of the introns and you also need to ensure the cell doesn’t try to splice away your exons anyway. Let’s also note that DNA won’t even be used by a cell if it doesn’t come with a promoter, a string of DNA at the beginning of a gene that tells the cell “please turn me into RNA.” Humans have different promoters in our genes than other organisms, so you’ll need to add a promoter that works for the cell type you’re using (bacteria, insect, yeast, mammalian). Then there’s the fact that DNA (really the RNA but let’s skip a step here) is read in 3-letter codes called codons. Each codon matches to a certain tRNA, and each tRNA comes with an amino acid attached. But not all tRNAs are created equal, some organism have more or less of a certain tRNA and so will create protein more or less efficiently if you give them certain codons. Codon optimization is another tool used for making sure your piece of DNA gets efficiently transcribed and translated into a protein by using the right codons in the right cells. All these factors (exons, promoters, codons) need to be altered so that your DNA can be used by the cell you are going to put it in.

OK, so you’ve altered your DNA a whole bunch so that it codes for insulin once it’s inside a cell. Now you just have to get it there. With bacteria the system is moderately simple, many bacteria have evolved mechanisms so that they will willingly pick up just about any piece of DNA they find when subjected to major stresses (heat, electrocution). So you zap some bacteria in a tube along with your DNA of interest and some of them will pick it up. Then if your DNA has a selection marker for antibiotic resistance and you grow them up on antibiotic plates, the ones that survive are the ones who picked up your DNA and can now be grown up to start making proteins. But that’s just bacteria, a lot of drugs would be better produced in higher-order eukaryotes because those organisms are more biochemically similar to us. Eukaryotes however have a nucleus that is a barrier to foreign DNA, so you have to be extra clever (sometimes using retroviruses or CRISPR) to get your DNA into a eukaryote and make them make your insulin. And that’s just for insulin, something we figured out decades ago! There’s always new proteins or modified versions of old proteins being tested as new drugs, and every single one of them goes through this process in order to be produced using synthetic biology.

Changing the sequence of DNA you’re using, removing the introns so it only has the exons, changing the promoter, optomizing the codons, getting the DNA into cells, all these are time consuming to do and validate. I won’t get into the specifics of how they’re done, but some low level researchers may work on just this in the lab for the entirety of their junior research career (before they get their own project). This is not a simple process, and is definitely an area where Ginkgo thinks they can make a splash. The problem is that they won’t be the first and only player, there are already a number of companies out there who will do this job for you. Academic labs generally don’t use those services because it’s too expensive, and private sector labs already have competitors to choose from besides Ginkgo Bioworks. There is definitely a market here, but it’s a competitive one.

But remember, this is still just about getting the cell to make a protein! We still then need to purify the protein out of those cells in order to sell it and use it! And this too is no small problem, the USA and other countries all have regulations requiring that drugs sold to consumers must meet certain standards of quality and purity, each batch must be identical so the drug will work the same way each time, and the drug must be at the highest possible purity so no contaminants can mask or alter its effect. So purifying the protein out of your cells is another problem that Ginkgo and other companies need to solve when they are doing synthetic biology. I’ll talk about purifying some other time but with how much I wrote above about just getting the right DNA into cells so that they can produce insulin, I hope you can appreciate that this is a long and involved process. This is the work that Ginkgo Bioworks wants to do, they want to do all this in exchange for money and take over the synthetic biology industry. But their business model is strange indeed, all this work (getting the right DNA, getting it into cells, producing protein, purifying protein) will be done in what they call the foundry and they want to run that part of the business at cost meaning it won’t run a profit and will sell its services for the lowest possible amount to remain breakeven. So how does Ginkgo expect to make a profit? Tune in next time where I explain the wonderful world of IP and revenue sharing, and how that is the part of their business that I think Ginkgo has failed at.

Ginkgo Bioworks: what is the point of Total Addressable Market (TAM)?

Ginkgo Bioworks ($DNA) is a stock that I’ve heard a hell of a lot about. The idea of “DNA as a programming language” is something a lot of stocks and hype-mongers trade on, because it promises the insane growth of the Tech industry but with whole new markets where you can get in on the bottom floor. What if you could invest in Apple, Amazon, and Google in the 90s? Well now you can by investing in $DNA and other biotechs like it. Their tech is supposed to be the future, and is supposed to make us all a lot of money (if we invest in it).

Part of the appeal of investing in “DNA as a programming language” comes down to the concept of “total addressable market” or TAM. TAM is a way to calculate the greatest possible revenue you could ever achieve, by bringing your product to every person on earth who wants it and charging them a fair price. Valuation based on TAM aren’t necessarily ridiculous, Facebook is used by just about 1 out of every 2 people on earth these days, so if you had gone back to 2008 you could have realized just how monstrous Facebook would become by looking at their TAM (and deciding Facebook and not MySpace would win the war). So investing based on TAM might have made you money if you’d thrown it at Facebook. Sure, these days Facebook only gets a few bucks in ad revenue per person, that’s still several billion every year. So bringing your product to every single person in this wonderful world of ours, all 8 billion people, is almost guaranteed to make you some money.

Ginkgo and DNA-based companies like it have some eye-watering TAMs because DNA and biotech is so fundamental to everything the world economy does. Agriculture? Modern crops are all engineered (yes, even your GMO-free crops are engineered, they just use different techniques to get around people’s prejudices). Health? Modern medicines are all engineered and grown in cell culture vats. Commodities? Biochemists are already working on using engineered proteins to create all sorts of industrial chemicals, or to clean up industrial waste, so that’s yet another avenue for biotech revenue. There are endless possibilities for using proteins and cells in industry, so there are endless amounts of money you could conceivably make bringing your product to these industries. But what Ginkgo brings isn’t any particular protein, or any particular cell, they supposedly bring a platform to create all proteins, and all cells at a lower cost than anyone else. Ginkgo wants to be a shovel salesman in the Biotech gold rush, and they think they can sell shovels to every company on earth. Whether you’re a Big Pharma company producing drugs, an AgriTech selling seeds to farmers, or even a mega-factory trying to comply with the EU’s industrial pollution directives, biotechnology can help you and Ginkgo can help biotechnology.

Here’s what Ginkgo says it does: say you want to make a drug and get FDA approval to sell it to sick people. Your drug needs to meet the highest standards of quality control, every batch needs to be identical to the others in all the right ways so that what the sick people get is the same every time. Any sort of variation can be deadly in these cases, and the FDA looks very disapprovingly at variation for this reason. But producing a drug at scale is hard and expensive, even at the relatively modest scale needed for phase 1-3 clinical trials. This is supposed to be where Ginkgo comes in. They’ll create a modified cell for you which makes the drug all on its own. They’ll produce a purification pathway that is easy to use and gets consistent results. Then you can grow up that yeast cell into massive colonies (easy enough, yeast eat anything) and harvest them to purify the drug they are producing (again, this should work).

The problem is this pipeline doesn’t necessary lead them to the TAM-style valuation that once sent their stock price skyrocketing. Most drug products start by being produced in an academic lab at ultra-small scale, and for these purposes making the cells and purification pathways yourself is actually the cheaper option vs paying a big company to do it for you. Once you have a cell and a purification that sort-of works, you publish it and it gets picked up by some massive biotech that wants to monetize it. Now this company isn’t starting from a base of nothing, the work that the academic lab already published will probably be a very strong base from which the company can make its own cells and purification pathway (with only minor tweaks to what the academic lab did). And because it’s so easy to do this, again it rarely makes sense for a big company to partner with Ginkgo to do these things, especially when it’s not just the cost but also Ginkgo’s business model you have to deal with. See, when Ginkgo does something for a Biotech company, they don’t just as for money upfront. Ginkgo writes contracts that say that if you use the cells and purification pathways they create, then they will get a certain percentage of your revenue or profit (negotiable, of course). This was sold as an unbeatable deal that would catapult Ginkgo to the stratosphere and help them reach the valuation predicted by their TAM, understanding why this deal is failing is key to understanding why Ginkgo is failing.

I’ll talk more about the specifics of Ginkgo’s deal and why I think they will never manage to address their theoretical TAM in another blog post. For now, reflect on the fact that $DNA is in the exclusive club of stocks that lost over 85% of their value in the last year, $CVNA is another. I think both businesses were predicated on a business model that was more science fiction than fact.

Small point: why is Ford stock such a bad deal?

In my first post on Cult of the Lamb, I offhandedly mentioned that it was retailing for the price of two shares of Ford ($F) stock, and that it was the better deal. This led to one friend asking me: “wait, why is Ford stock not a great deal?”

For the last 40-odd years Ford (and most American car companies) went through a mini-death spiral.  Profit margins shrank badly and caused them to lose a lot of value.  On top of it Ford is a “dividend king” stock, it pretty much always pays a hefty dividend which means investors like to hold it but you shouldn’t expect it to increase in value because money handed to the investors is money not being used to grow the company

Still, it’s true that Ford is down about 40% year to date while the broader stock market is down only 20% (Meta aka Facebook is down 60%, if you want to see what a disaster looks like).  Probably a lot of that is a combination of inflation (real wages are down 3.2% this year, and there was 0% real wage growth in 2021 due to inflation) and also the fact that EVs/plug in hybrids are the future and Ford barely does that.  Tesla is an all EV company and Toyota has become an all Hybrid company, both of them are expected to grow their revenue next year while Ford is expected to shrink.  Tesla was dummy overvalued in 2021 but it’s still a growing company and that counts for a lot.

So Ford as a company is worth less than it was in the 80s and it doesn’t have a plan to fix that.  It still pays a 4% dividend but so does a government bond these days and bonds are risk free.  If you buy Ford you’re hoping it goes up but you can’t really expect it to since revenue is shrinking.  You’re praying someone at the company figures this out and shakes things up.  If they could figure it out they might go somewhere.  Toyota produces 3x the amount of cars Ford does, but Ford produces 3x the amount that Tesla does.  5 years ago I remember thinking Tesla was a scam because Tesla produced less than 1/40 of the cars Ford did, but as I told you I was wrong in my bet against Musk (really I was in an echo chamber) because Tesla has grown and Ford has shrunk.  People buy Tesla stock expecting it to keep growing, people buy Ford stock hoping it stops shrinking.  Ultimately Ford’s history this century doesn’t make that seem like a good bet.

Always double guessing my stock choices

I don’t know if other folks do this, but every time I buy a stock I stop to double guess myself. If I see a stock that looks FANTASTIC, good P/E, good dividend, good growth, it may seem like a perfect buy. But I always stop and ask myself “if it’s such a great buy, why isn’t everyone else buying it, why hasn’t the price been pushed up?” Usually this leads me to double checking and realizing the reasons which I had not previously noticed. For instance, it was pointed out to me that Big Box retail stores are very highly valued right now, Walmart is selling at a higher P/E than Microsoft and Apple just for example. It seems that in the current economy, people are looking for the security of retails rather than the growth of Tech. But there’s no way Walmart is worth about 50 P/E, so it doesn’t make sense to buy it at this price point. Macy’s however ($M) is selling at just around 8 P/E. It’s a big box retailer with steady cash flow, doesn’t it look like a perfect buy? But why is it selling so low and Walmart is selling so high? I looked and Macy’s forward P/E isn’t so good, it’s expected to be around 10 or 12. So it looks like right now Macy’s is expected to be a shrinking company, and that’s why it’s being sold on discount. So now I have a better idea of exactly what bet I’m making, do I expect Macy’s P/E to go down that much or might they buck the trend and remain stable or grow? That will tell me whether I actually want to buy their stock or not.

In a market as efficient as the stock market, there are rarely any free 20$ bills on the sidewalk, you always have to wonder “if this move makes sense then why isn’t everyone doing it?” and that will make you realize the downsides of the bet you’re making.

Short post, just want to vent

I encourage anyone to read this tweet thread as it sums up perfectly my anger with how the FTX scandal is being covered. This is a news story about a crypto exchange doing what all crypto exchanges do, steal clients money to fuel their vices. And yet the framing in most stories you find will not be about how SBF stole client’s money, but about a “lack of controls” and “failures of governance” which are corporate-ese ways of downplaying SBF’s crimes and making him seem like just a CEO who couldn’t quite handle it. This cannot possibly be by accident, most journalists understand framing and most journalists on twitter are laser-focused on complaining about other people framing things in ways they don’t like. So why is the framing surrounding the FTX saga downplaying SBF’s crimes and normalizing his actions? Why are so many stories trying to focus attention on SBF allegedly raising new funds, instead of on the fact that he stole funds in the first place? Why is his opinions and personal life being written about with more detail than the lives he destroyed through theft? Go find some of SBF’s villains, it shouldn’t be hard. Write about them struggling to pay the bills because they lost it all in his exchange. Hopefully find some who have finally learned that all crypto is a scam, and write about how they had to lose their house in order to learn that lesson. Most of the journalists currently humanizing SBF and ignoring his victims would have screamed bloody murder if the same had been done to Bernie Madoff, so why the fuck are they doing it now.

Yes it’s OK that J Powell killed your puts

I’ve been trawling through old internet posts, and I found something interesting from March 2020. I won’t quote it directly but the gist was this:

I knew the market would crash due to Coronavirus, now that rat bastard J Powell comes in and pumps the market with free money, killing all my puts. What the fuck is this? Are you going to buy my puts from me now since they’re *distressed assets*?

As should be obvious this comes from the time when the Federal Reserve announced they would take every possible measure, including buying “distressed assets” in order to maintain liquidity in the market. Obviously anyone who was hoping a liquidity crisis would create a market crash was SOL, but for the good of the nation as a whole it’s better that our economy keeps chugging than a few disaster capitalists make it rich.

But it does raise a somewhat unfortunate truth: the Federal Reserve mostly buys up the assets of rich institutions that don’t need the help. The Fed buying someone’s underwater mortgage doesn’t actually help them, they’re still underwater and in debt, but it does help the bank that wrote the mortgage and is now facing a loss. The bank gets to offload the “distressed asset” (ie bad loan) and go use that money to make more money, while the mortgage owner just gets a new person they have to pay. It’s genuinely true that the Fed gives the greatest help to those already wealthy, and those of us not wealthy have to live with the consequences. Although all of us are helped in a way by the Fed maintaining liquidity in the economy, we aren’t helped to nearly the same extent as the banks that get to offload their bad decisions onto the government. I think it’s good that the Fed maintains liquidity, but I think there need to be more strings attached, demanding equity in exchange for liquidity would be a very fair trade in my book. And if banks don’t want the Government to own a percentage of them, then they can just refuse the free money.

Why is Sam Bankman-Fried being beatified?

The above paragraph is an utterly insane ending to what should otherwise be an OK NYT opinion piece on Sam Bankman-Fried (SBF). What’s insane to me is that SBF is getting media treatment like this which paints him as shockingly harmless despite the fact that he stole billions of dollars in other people’s money. Would Bernie Madoff have received this treatment? Would Jordan Belfort get this kind of treatment? Hell I don’t remember the NYT even treating legitimate investors like Mitt Romney this way. This SBF coverage is barely one step removed from beatification, covering up his sins and pushing his virtues to the fore in their stead. And the fact that he’s a thief and a crook? Well everyone makes mistakes, right?

Let’s get one thing straight, everyone does not make the kind of mistakes that steal billions of dollars from thousands to millions of people. Generations of money managers have not regularly stolen money from their clients. If you think they did, point to me how much was stolen by traditional money managers this year versus how much was stolen by SBF and pals. The financial institutions of most countries (barring the obvious kleptocracies) are watched closely by their governments to ensure compliance with the rules and regulations, and this means that theft is not the norm, when it happens it is newsworthy.

No, SBF is a once-in-a-generation crook and fraud. Someone who so brazenly stole from every one of his clients that his corporate governance was worse than Enron’s. He is not the kind of person who needs to be painted as a normal guy just like the rest of us who made a few mistakes, he is the kind of guy whose active and willful theft has left many many people much worse off.

What is utterly galling about this coverage is how transparent it is, how obvious it is that this is not the way the NYT usually covers people who profit off of other people’s misery. As someone who has sounded the alarm on crypto for a while now (privately first, and then publicly here on my blog) I’ve long been infuriated by reporters who cover cryptocurrency like it’s “just another tech beat,” as if a Ponzi scheme whose only value is evading taxes should get the same dispassionate tone as the latest smart phone. But now I’m finding a “paper of record” going so far as to whitewash the sins of crypto’s greatest thief (so far) and I have to wonder if they’re doing it on purpose or they’re just stupid?

Because the NYT has to know what this is feeding into, right? Trust in institutions is at an all time low, trust in news media is at an all time low, and carrying water for obvious crooks when you’ve previously maligned people in the exact same situation is exactly the way you get people to believe that you are filled with fake news and hypocrisy! Already I’ve seen conspiracy stories circulate that SBF’s favorable media coverage is because he donated so heavily to Democratic Party causes, or because he said all the right things to get a good ESG score. Coverage like this coming from the New York Times does so much harm to media trust precisely because it’s such a 180 turn from their usual fair, and without a good reason for saying why this Robber Baron needs to be humanized, it really does feed into the conspiracy theories that the only reason he’s getting this is because he said the right things in liberal spaces.

Stock buybacks are very similar to dividends

There’s an old saying in the Tech industry: “Tech companies only give dividends when they have nothing better to do with their money.” It’s been used as an explanation for why so many Tech companies don’t have dividends, and why that’s a good thing: they’re spending their money in better ways which should bring more value to the investors. Yet this is honestly nothing more than a lie: Tech companies don’t give dividends because they found a more tax-efficient way to give money to investors: buybacks.

Amazon is the poster child for buybacks instead of dividends. It has long defended its no dividends policy by saying it spends all its money on capital expansion (ie growing the business). And to be honest it has posted impressive growth numbers for years. But while it has never given a dividend, it has almost always used a buyback.

A buyback of stock, like a dividend, is merely a way for the company to hand value back to its investors. The company floods the market with asks for its stock which raises the stock price, and those investors who wish to cash out can now do so at the higher price. It’s no secret that buybacks increase a stock’s price, pretty much everyone who isn’t economically illiterate understands this, what is less understood is why Amazon uses them instead of dividends.

Dividends are an unavoidable capital gain for investors, unless the stock is held in a preferential account (an IRA or 401k) the investor will have to pay tax on the dividends. A stock buyback though, only creates realized gains for the investors who do want to cash out, and they were going to take a realized gain anyway. For everyone who wants to hold the stock, a buyback raises their stock price without them having the realize the profit, the investors become measurably richer but don’t get taxed. Stock buybacks were illegal until 1982, which is a damn good reason for why most “boomer” companies (Coke, Ford, Boeing) never got into them. Tech companies like Amazon and Google were incorporated in the 90s though, and once they IPO’d management quickly became aware of the tax benefits to buybacks over dividends. For these tax reasons, Tech companies perform buybacks instead of dividends, while giving lip service to the idea that they’re actually fully committed to capital expansion and not shareholder value.

Make no mistake, Amazon, Tesla, and other growth companies are just as committed to shareholder value as Intel and Ford if for no other reason than to enrich Bezos, Musk and the other major investors. They do so with buybacks instead of dividends because it’s more efficient tax-wise, but they are still committed to handing money back to their shareholders. If congress presses ahead with raising taxes on buybacks, we may see a change, or if Amazon and Tesla’s growth begin to slow their shareholders may start to demand a true dividend in addition to buybacks. Either way the shareholders will always be compensated, that’s just how companies work.

Can retail investors make money in real estate?

Maybe not

This is going to be a kind of short post that may prove me to be a dumbass, but I’ve been thinking about real estate and I wanted to talk about it.

For background, I had a friend at work who had to quit her job and move back to her hometown because she could no longer afford rent in the city. She had a steady job at a big research university but it just didn’t pay her rent and so she moved away. I was saddened by both her loss (since she could no longer do the job she loved) and the loss to science, how many other bright minds have been pushed away by low pay and the cost of living crisis?

But it also got me thinking. I’ve talked before about how dividends are supposed to help cure inflation. The housing crisis is caused by a lack of housing supply, and this should mean that housing investors are making bank (much like oil investors). While we think of housing investors as just the individuals who own their own home, the landlords who own most of America’s rental stock are often incorporated and can be invested in. A common investment vehicle for investing in these companies are REITs (real estate investment trusts), which are often publicly traded just like stocks and ETFs. So if landlords are making bank, then REITs should be making bank, so people investing in REITs should also make bank, right? Maaaaaaaybe not.

I did a quick scan of popular REITs and for whatever reason almost all of them seem like strong underperformers. A REIT invests in the real estate market much like an ETF invests in the stock market, and you can grade how well a REIT or ETF is doing by a few metrics, such as alpha, beta, and Sharpe ratio. Note that all REITs and ETFs will be graded relative to a chosen index, $VOO is an ETF that seeks to track the performance of the S&P 500 so it is graded relative to that index. REITs track the performance of the housing market and so will be graded according to a housing market index. Anyway let’s start with alpha, this tells us how much better or worse the fund is doing than it’s chosen index. If $VOO goes up more than the S&P 500, then it has a positive alpha, if it goes down more than the S&P 500 then it has a negative alpha. Beta is a measurement of volatility, $VOO may track the S&P over time, but if it swings wildly up and down (moreso than the S&P) then it will have a higher beta. The Sharpe ratio then is a measurement of reward relative to risk. A higher Sharpe ratio means the ETF or REIT has over-performed on a risk-reward basis, and a lower Sharpe ratio means it has underperformed.

What does this all mean for REITs? They all seem to underperform. The most popular REITs I could find online all had negative alpha (meaning they underperformed their index) and surprisingly low Sharpe ratios of below 0.2 (meaning they weren’t stellar on a risk-reward basis either). Compare that with the most popular ETFs out there, $VOO (mentioned above) has about 0 alpha and a Sharpe ratio of 0.5, meaning it tracks its index almost exactly and is at least OK on a risk/reward basis. $QQQ (another popular ETF, this one tracking the NASDAQ) has a positive alpha (overperforms its index) and a Sharpe ratio of 0.6. Add to this that the stock market has higher expected returns than real estate (meaning you’d expect $VOO and $QQQ to do better than REITs anyway) and it doesn’t look like REITs are a good investment. Past performance does not determine future performance and all that, but the real estate market would have to moon while the stock market tanked for me to expect these REITs to overperform the most popular ETFs.

So it seems that despite skyrocketing housing costs, it’s hard for a retail investor to make money on real estate. I’m not sure who exactly is making money on real estate, if the landlords are making money then it isn’t coming back to the investors, and if the builders/maintainers are making money then it isn’t coming back to their investors either. It seems at this point that the housing market is hurting us all in ways we can’t even make money off of.