Innovation Insights: Forest fires and innovation—the case for long-term thinking

History matters. We have been investing in innovation for over half a century. We have every intention to continue this tradition. This leaves us with a mindset that we are stewards of something larger than us. The consideration of longevity is an important part of how we approach investing; it reflects the taking of a differentiated perspective. While others may view downturns as times of panic, stress or fear, we view them as a necessary part of investing capital in innovation. If one truly takes a long-term perspective, one starts to understand how a downturn can be healthy for the ecosystem.

One analogy that might help explain this idea is that of a forest fire. In California, where our team is based, forest fires are often in the psyche and part of frequent conversation. They are world famous for massive plumes of smoke, dramatically high flames, and their ability to jump freeways and cause significant destruction. However, one of the most counterintuitive aspects of forest fires in California is that, in a natural setting, they are quite healthy and even necessary for the health of the forest. Natural fires burn low to the ground and allow new room for plants to grow, they release seeds trapped in pinecones, and clear overgrown and dying vegetation.

In fact, many native Californian plants and trees are well adapted for fires. Some pinecones only release seeds in extreme heat, and the bark on some species of redwoods is almost hairy in composition and up to a foot thick, protecting them from flames. Although I can’t imagine any animal or even plant enjoys the fire—certainly they don’t enjoy it like they might a gentle rain or the warm touch of sunlight hitting the soft forest floor—the fires serve an important function to the long-term health of the forest.

Like the natural world, the economy follows similar cycles of growth and destruction. This can be particularly true in areas of new growth and innovation. Thus far this year we have seen many companies, and their stock prices, go through their own stress. In general, as with the natural fire, we view this as healthy. In many industries or subindustries, we believe we are experiencing the equivalent of a natural fire and clearing out. This should allow room for new companies and new industries to grow, while removing underfunded and failing companies. My guess is few employees enjoy the poor funding environment, defensive mergers, private equity take outs, down rounds or bankruptcies, but these challenging consequences are an important part of the ecosystem.

To fill out this analogy a bit more concretely, let me share a few examples. We think the consumer food delivery and electric vehicle (EV) industries are likely going through a natural fire. Over $100 billion has been invested toward ridesharing and delivering food to our homes via various apps. That’s probably too much. Delivery Hero, Caviar, Grubhub, JOKR, Fridge No More, Postmates, ChowNow, Deliveroo, Uber Eats, Wolt, Just Eat Takeway, Didi, DoorDash and Grab are only a few of the larger ones. There are many smaller ones as well. In many cases, these companies were founded by a charismatic, competent, hard-charging chief executive officer who believed they would be the one to win it all. To fuel their growth, the funding environment forced them to spend for as long as the funding lasted. Now the market environment has shifted; funding has stopped, and mergers are starting to take place. Although we view this long-term as potentially an attractive space, competition and funding will need to rationalize, and profitability will need to become the focus. Similarly, within the EV industry, Rivian, Lucid, Fisker, Faraday Future, Polestar, NIO, BYD and Tesla are new car companies embracing the EV market, and that is just a representative sample. Many of these companies are well funded, but not producing cars at scale. In addition to this, almost all legacy carmakers have an EV program. We don’t know how this will shake out, but we didn’t feel there were too many car makers before EV became the focus of the future.

Not all fires, of course, are controlled burns. In California, efforts were in place to prevent any forest fires for decades. The result of suppressing natural fires has been that fires that do occur here can be devastating. If combustible debris isn’t removed from the forest floor or the trees aren’t thinned and grow too compactly, they can become water stressed even during years of normal precipitation. In this case, the fires often burn at very high temperatures and destroy everything in their path. In California, it can take a forest a generation to recover from a “hot” fire, whereas natural forest fires can recover in a season.

Even though destruction can occur in any part of the economy, its effects don’t necessarily apply to the entire economy. It took almost 11 years for the banking index to make new highs after the global financial crisis and Lehman and Bear Stearns bankruptcies in 2008,¹ but the rest of the market, particularly technology and health care, had very strong returns in the years that followed. The Nasdaq didn’t reach its previous high from the dotcom bubble in 2000 until 15 years later, however, the first 14 years of that period were very good for commodities.² The life of an economic cycle may be shorter than that of a forest, but similar to post-burn regrowth, the economy can also take significant time to recover.

In 2022, it may be a bit early to know exactly what burned too hot in 2020 and 2021; however, we do have some predictions. Some highly speculative digital currencies may take a long time to recover—if ever. Over the long-term, we believe this damage will bring rationality to the sector and may strengthen the infrastructure and regulation of digital assets, which is necessary to support wider adoption. The meme stock craze, over the long-term, does not seem to be sustainable, in our view, and some of those names are trading well above any reason-able discounted cash flow.³ Additionally de-Special Purpose Acquisition Companies (SPACs)⁴ and initial public offerings (IPOs) from 2020 and 2021 are trading in aggregate well below initial prices, and the appetite for new supply has dried up. We are unlikely to see SPAC issuance return in such high volume. It also may be many years before we see the volume of IPOs return to 2021 levels. Reduced exit opportunities in private markets likely mean private companies will need to reset valuations the way public markets have. This is a positive, in our view, as a seemingly lower return on venture capital should prune the number of companies that are able to secure funding.