Why Investors Need to Be Cautious of SPACs

GuruFocus.com

- By Dilantha De Silva

American stock markets are not new to bubbles, nor the eventual burst of those bubbles. Inflated tech stocks led to one of the most severe market crashes at the turn of the 21st century, and it was an unhealthy rise in housing prices that helped lead to the market crash in 2008.

The rise of special purpose acquisition vehicles, or SPACs as they are often referred to, is reminiscent of these historical market bubbles. Investors need to dig deep to identify early warning signs of a market crash.


What is a SPAC?

A special purpose acquisition vehicle is a company that is incorporated with the idea of investing in a separate entity, so these investment companies do not conduct any business operations of their own. Rather, they scan the private markets to identify companies that have the potential to make it big in the future and then merge with such a company.

SPACs are usually operated by renowned investors and private equity firms. To raise capital for their acquisition, these investment companies list their shares in the stock market, attracting funds from retail and professional investors who believe the management team is capable enough to find a very lucrative investment opportunity using their money.

In most cases, SPACs are bound to merge with a suitable candidate within two years from raising funds in the market, or else return the money to the original investors.

This knowledge of how SPACs work will come in very handy in understanding why these schemes might lead to significant erosion of wealth in the future.

Learning from mistakes in the past

Long before the concept of stock markets reached North America, many European nations including France and the United Kingdom had formed markets to buy and sell equity securities of companies.

In their book "Learn to Earn," Peter Lynch and John Rothchild provide a good summary of the history of capitalism and an introduction to early stock market bubbles. In the book, Lynch discusses one of the most notable market bubbles in Europe that led to massive losses for investors. The chain of events that led to this crash is popularly known as the South Sea Bubble, as everything began with South Sea Company, a government-controlled entity based in the United Kingdom, selling its shares in the market aggressively by promising to bring gold and other precious items from Latin America and Asia.

South Sea was an established company back then, but many smaller companies followed this pattern and started selling their shares in the market even though many of these companies did not have any business products or even a proper business plan. According to Lynch, some companies raised funds by saying, "these funds will be used for carrying on an undertaking of great advantage, but nobody to know what it is."

These types of companies raised millions worth of money from eager investors who wanted to take part in the next big thing, even though they had no idea what it was going to be. The ending, as a rational investor would imagine, was not a pleasant one at all. When the bubble crashed, not only did investors lose a fortune, but the House of Commons in the UK ordered stock trading activities to be halted on the basis that these schemes could continue to hurt investors in the future.

As unfortunate as it is, the recent rise of SPACs has a lot of similarities to this historic market bubble that crashed more than three centuries ago.

The SPAC market is booming

Many investors consider an unusually high number of initial public offerings in any calendar year as an early sign that the stock market might be in bubble territory. Until very recently, investors did not pay attention to the number of SPACs listed as these types of public listings were few and far between. In the future, however, investors might want to especially look at the number of new SPACs listed in the market as the possibility of failure is very high for this type of company when compared to a traditional company that is involved in conducting some form of revenue-generating business activity.

In 2020, SPACs raised a total of $82 billion, which is more money than the previous 10 years combined. In total, 248 blank-check companies raised money from U.S. investors, which was a record high too. So far in 2021, SPACs have raised more than $38 billion in less than two months, which suggests that 2021 could easily become the best year in history for this asset class.

What is more concerning is the trading activity of these instruments in the market. Between 2003 and 2020, SPACs have gained, on average, just 1.1% on the first trading day, but the number has jumped to over 6% in 2021.

Why Investors Need to Be Cautious of SPACs
Why Investors Need to Be Cautious of SPACs

Source: CNBC

This unusual price jump on the very first day of trading suggests retail investors are getting behind these companies without even an idea of what they are getting themselves into. It would not make sense to invest in a SPAC if the stock is trading at a steep premium to net asset value, but this is exactly what is happening in the market today. In a research note to clients, Bank of America (NYSE:BAC) analysts wrote:


"The speculative nature of SPACs seems to be particularly appealing to retail investors. We definitely don't need to remind anyone what can happen when something speculative comes on the retail radar."



What is even more alarming to see is that SPACs have failed to generate meaningful positive returns in the long run despite their appeal.

Why Investors Need to Be Cautious of SPACs
Why Investors Need to Be Cautious of SPACs

Source: CNBC

It would be reasonable to conclude that a buy and hold strategy involving SPACs would have led to massive losses for investors, and this is something many investors are not factoring into their analysis today.

Is there a bubble?

So far, the SPAC market has been dominated by a few legendary investors including Bill Ackman (Trades, Portfolio) and Chamath Palihapitiya. These renowned investors have a strong track record of delivering the promised goods, so investors in these schemes are likely to be in good hands for now. Seth Klarman (Trades, Portfolio) invested in Ackman's SPAC Pershing Square Tontine Holdings, Ltd. (NYSE:PSTH) as well, suggesting this investment vehicle might not be as risky as it sounds.

Things, however, might dramatically change if fund managers with a lousy track record (or no track record) start raising funds in the market, creating a bubble that will eventually burst if the regulatory intervention fails to stop retail investors from investing in these businesses. There does not seem to be a bubble just yet in my opinion, but things could soon get out of hand similar to how it has happened time and again during periods that preceded market crashes.

Who will be hurt if a bubble forms and crashes?

Value investors, or investors who follow any other traditional discipline, might falsely assume that they would not be hurt as long as they do not get involved in the SPAC market.

In reality, if a group of retail investors loses a significant amount of money as a result of a burst in the growing SPAC bubble, the impact will be felt by all market participants. Many investors are likely to withdraw money from stock markets, and the general public will lose trust in the market once again similar to what happened during the dot-com bubble and the global financial crisis. Such a deterioration in the trust will take years to rebuild, and the excess liquidity that is keeping the market active could disappear overnight if the market crashes, hurting all investors.

Takeaway

Special purpose acquisition vehicles are continuing to attract more U.S. investors. There might not be a bubble just yet, but there's more than enough reason to believe this SPAC mania will end badly for the majority of investors.

Disclosure: The author does not own any shares mentioned in this article.

Read more here:

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