To The Moon

Warren Buffet's investment advice is to put 10 percent into short-term Treasuries and 90 percent into a low-cost index fund on the S&P 500 index. For the sake of simplicity, we'll assume that that includes only U.S. stocks. The late Jack Bogle wouldn't invest outside the U.S. either. The typical American investor has less than 20 percent in stocks outside the United States. Now most investors have a "home bias," but in this case that "home bias" is extreme. Now it helps that U.S. stocks have performed extremely well since the Great Financial Crisis. People tend to place a greater value on events in the recent past than events further back in history. The last thing said to us is best remembered. This is also known as the recency bias (recentness effect). Furthermore, from the world's most liquid stock market (the U.S.), there are some hurdles to overcome to invest outside the U.S. Usually, the costs are higher and they face currency risk. This is different for a U.S. investor than for an investor outside the United States who wants to invest in U.S. stocks. Because the dollar is the reserve currency, it becomes stronger in times of crisis, providing additional protection for investors who have not hedged their dollar risk. Still, it is not wise to invest almost exclusively in U.S. stocks.

The reason for this article is an interview with Ludovic Phalippou in the FD last week. According to his research (a few years back), the return on private equity is not superior to that of the stock market. Now there is nothing wrong with that research, it's just that he is using for his research just now a period when U.S. stocks have performed extraordinarily better than other stocks. More specifically, it is U.S. growth stocks that have performed much better over several years during this period. If you look at U.S. value stocks over this period and compare them with historical returns, you don't see that many differences, but if you compare the returns on growth stocks with history, you see very large differences. On top of that, it is precisely due to private equity that U.S. stocks have shown such high returns over this period.

There are at least three components by which private equity has contributed to the returns on publicly traded stocks since 2006. First, private equity is an incubator/financier for young companies. Unlike the rest of the world, this very component (venture capital) is much better developed in the United States. In fact, starting a company with a good idea is so easy that just about every Nobel laureate leaves for the United States after winning the prize. The cooperation between private equity and the top universities is excellent and many of these young companies have been acquired by big tech companies or become big tech companies in the past few decades. A private equity fund like Sequoia Capital alone was behind Apple, Cisco, Google, Nvidia, Airbnb, Palo Alto Networks, ServiceNow, YouTube, Snowflake, Stripe and Whatsapp, among others. That concentration of tech companies cannot happen without a well-functioning private equity sector.

Furthermore, private equity is primarily interested in companies that generate high stable cash flow. They are usually not interested in capital-intensive cyclical companies. Now it is the case that a company consists of different parts and capital-intensive and low-yielding parts are combined with high-yielding parts. Such a company can be optimized by private equity by outsourcing capital-intensive parts (usually to Asia) and keeping the high-yielding parts. This substantially increases the return on equity and at the same time has freed up capital. In practice, these are called platform companies, and there are more than a thousand of them in the United States alone. These operational improvements can, of course, be devised by companies themselves, but they have come about through the discipline of private equity.

In addition to the operational side, there is also the financial side that private equity has had a lot of influence on. Not so long ago, companies liked to hold a large amount of liquidity, liquidity that was also low-yielding. Private equity is constantly looking to free up capital in order to recover some of the investment. Listed companies that have not optimized their balance sheets can expect attention from private equity firms. As a result, the biggest buyers of U.S. stocks since 2006 have been the companies themselves, helped of course by extremely low interest rates. There was even plenty of borrowing to buy back their own shares. The result was sharply rising earnings per share, and eventually, stock prices cannot help but follow.

The nice thing about Phalippou's study is that he inadvertently managed to draw attention to the added value of private equity. Partly as a result, the U.S. stock market has become one of the most efficient in the world. This has contributed to its exceptional performance in recent years. The big question now is whether the same is true for the next 15-plus years. If you just look at Japanese equities, for example, you can see that there is much more to do there for private equity. In the somewhat longer term, the outperformance, including that of U.S. equities, is indeed cyclical and not structural in nature.