Saturday, June 23, 2007

The Madness Of Crowds


Charles Mackay was a poet, journalist and songwriter. He also had a sharp eye and obvious enthusiasm for the craziness of markets. Mackay’s been dead for over a hundred years, having been born on the banks of River Tay in the town of Perth in central Scotland way back in 1814.
But he left an enduring legacy in the form of a book with the title Extraordinary Popular Delusions and the Madness of Crowds (originally published in 1841 with the title Memoirs of Extraordinary Popular Delusions). The book, long cherished by investors, provides an entertaining narrative of some of the famous bubbles of years long past.
It is a sign of the times that many of Mackay’s bubbles litter today’s market. He writes about the frenzy for stock in the early 18th century, which to the modern reader has the flavor of an IPO boom. All kinds of promoters taking ideas to the public market, including No. 17 on Mackay’s list of bubbles: “For carrying out an undertaking of great advantage; but nobody to know what it is.”
In other words, a blind pool or a blank check. A company goes public and decides what it will do after it raises the money. Sound absurd? Well, it’s happening now. These vehicles have a fancy name: special purpose acquisition companies, or SPACs. You buy a SPAC and you really don’t know what business you may wind up owning.
There is a boom in these things today. This year, 30 SPACs have gone public in the U.S., raising some $3.5 billion. In all of last year, 40 SPACs sold their promise to investors and raised $3.4 billion. As recently as 2004, the amount of money put in SPACs was negligible.
A SPAC is nothing more than a management team. Usually, they have some great experience in some industry. A bunch of old shipping hands might put a SPAC together that plans to buy a shipping company. Investors buy into the SPAC, thinking that these guys will find something worth owning.
Investors have some say in this process. Shareholders have to approve of the acquisition. Plus, there is often a time limit. The SPAC gets 18-24 months. If the management team can’t find a business before the limit expires, then the money raised goes back to shareholders. Of course, because there are expenses in going public and you have to pay the management team, the money that comes back is less than the initial investment. I’m not sure what the typical amount coming back to shareholders is, but it is less than what they put in, that’s for sure.
For some institutional investors who buy before the IPO, a SPAC may make sense. Because they get warrants -- essentially stock options -- as part of the deal. So they could sell the SPAC stock afterward and just hold the option if they want. In some instances, their investment could be a cheap option on the ability of a management team to find a good deal.
But how likely is it, really, to think they can find a bargain in today’s environment? Consider that the number of private equity deals in the U.S. this year exceed last year’s total three-fold. There is a lot of competition for deals.
In fact, the competition is far greater than at the last peak. This from Fred Hickey’s Hi-Tech Strategist:
“According to Dealogic, nearly $2.5 trillion of merger deals have been announced worldwide this year, about 50% more than the same period in 2000 (the last top). According to FactSet Mergerstat, deal prices are running about 12.1 times the target’s cash flow versus 9.7 times in that crazy 2000 period. Virtually all of these deals are financed primarily by debt.”
Lots of deals and crazy pricing. Doesn’t sound like a good environment for investing in SPACs to me.
In any case, from an individual investor’s point of view, these things sure do resemble old Mr. Mackay’s bubble companies.

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