The Misallocation of Capital

The misallocation of capital... Reality catches up to a (former) Silicon Valley pizza company... Why money was cheap and easy for so long... Billions of dollars in investor capital is gone... The current crisis will be worse than the last one... If you want to prepare, here's a great place to start...

During a massive mega-bubble, everyone loses their sense of reality...

Even the worst companies can raise hundreds of millions or billions of dollars. And then, they live off the proceeds of those investments for longer than you would ever believe.

Reality will finally catch up to them. But it can take years for bad investments to go bust.

For example, as I (Dan Ferris) mentioned in our March 31 Digest, ARK Investment Management founder Cathie Wood touts the "six-to-seven-year runways" for the companies in her flagship ARK Innovation Fund (ARKK).

Wood spins that as a good thing, of course. But in reality, she's just measuring the length of the fuse that needs to burn down before these companies blow up...

It just means the companies raised a ton of money in the mega-bubble (mostly in 2021). And at current burn rates, they won't run out of cash for another six or seven years.

The key piece of the puzzle is that they're burning cash, not generating it.

That's the case with a company we'll talk about in today's Digest...

As you'll see, it was one of the dumbest-sounding capital misallocations of the mega-bubble. And just this week... reality caught up to this company, and it's now liquidating its assets.

Now, this company took about eight years to burn through all the capital invested in it. That's even longer than Wood's "runways" for her handpicked growth companies to start paying off.

And at the end of the day, this company made $445 million disappear into thin air. That figure included $375 million from a familiar name to longtime Digest readers – Japan-based investment bank SoftBank and its founder Masayoshi Son.

Frankly, I can't believe anyone ever put a penny into this business...

Zume Pizza formed in 2015 in Silicon Valley, California.

That location is important to this story. You'll notice that the company set down roots near San Francisco. And one of the key geographical features of this area is all the steep hills.

We'll get to why that's a big deal in a minute. But first, let's learn more about the business itself...

Zume Pizza started out as a robot-based pizza-delivery service – well, sort of.

These days, in the Year of Our Artificial-Intelligence Overlords, someone might be able to get some robots together to deliver the pizzas. But back in 2015, life was different...

You see, the robots didn't actually deliver the pizzas. Humans drove the vehicles.

The robots did make the pizzas at least. At a central location, they dispensed the sauce on the crust and spread it around. Then, they added cheese and toppings.

Next, humans loaded the pizzas onto "kitchen trucks" for baking and delivery. The trucks had GPS-equipped ovens to time each pizza so it would be cooked shortly before getting to the customer's house. And finally, a robotic pizza cutter sliced it up just before delivery.

Zume Pizza also used artificial-intelligence software in another innovative way. It would predict what folks would order before they actually ordered it. (Don't worry... I don't understand how that worked, either.)

Thanks to a high-profile delivery in 2018, Zume Pizza's business really got going...

Conveniently, Son lived in the Bay Area. So one day, Zume Pizza co-founder and CEO Alex Garden drove one of the company's kitchen trucks over to Son's house.

Son stepped into the truck, and Garden showed him how it all worked. They checked out the GPS oven... the robotic pizza cutter... and the algorithms to predict customers' orders.

The two men went over the whole grand vision in the back of a delivery truck in a Bay Area neighborhood. It sounds like a great movie scene – but I doubt that one will hit theaters anytime soon.

By then, Zume Pizza had secured a patent to cook its pizzas while driving to customers' houses. And it also included the algorithms for predicting what people would order.

Son was sold. Garden drove away that day with his commitment to invest $375 million.

In other words, these two wealthy tech geniuses who lived in the Bay Area – again, the place with all the hills – both thought they had come up with a great idea. And they both believed this idea deserved hundreds of millions of dollars' worth of investment to take it to the next level.

But if you're not a wealthy tech genius, you're probably wondering...

What happens if the truck hits a bump or goes up or down a hill?

So let's take ourselves back a few years to the robot pizza truck...

One of us humans is driving. The robot-made, uncooked pizza is loaded into an oven in the back. The cheese and other toppings are sitting on top of the pizza as it begins to cook.

We're headed for the first hill... and BAM!

As we come down on the other side, the toppings fly up and land everywhere. Plus, the cheese has melted into a molten mass. So it slid off the pizza and onto the floor as well.

That's what happened to Zume Pizza. Everything went all over the place on hills, turns, and bumps as the company's kitchen trucks drove around hill-, turn-, and-bump-filled Northern California.

Customers complained of skimpy, undercooked pizzas, too. That also makes sense – considering all the bumping and sliding around the pizzas did while getting cooked.

So before long, Zume Pizza had to park its trucks in central locations to cook the pizzas. Then, humans drove cars and mopeds to deliver them. Goodbye, kitchen trucks.

Two years after getting SoftBank's money, Zume finally realized it was just too hard to bake pizzas in a moving vehicle. I guess that's something they never could've figured out without burning through hundreds of millions of dollars.

So Zume cut the 'Pizza' from its name and left the making-food-while-driving world forever...

Specifically, in 2019, Zume bought Pivot Packaging.

This company made boxes out of "sustainable" materials like bamboo and wheat. And after Zume shut down the pizza operation in 2020, it fully committed to the packaging business.

I guess that business wasn't as sustainable as the packaging, though. Three years later, Zume is now officially insolvent and liquidating its assets.

At less than a half-billion dollars in total investment, Zume is a relative flyspeck on the market's windscreen. But as you've seen today, it's a fun story because of its ridiculousness...

I wonder how many folks have thought about baking pizzas while driving – through the rolling hills of Northern California or otherwise. And more importantly, I wonder how many of those people simply dismissed the idea... without spending nearly a half-billion dollars.

But that's what happens when money is cheap and easy. When everyone loses all sense of reality, any whacky idea can get funded to the tune of hundreds of millions of dollars.

That brings us to why money was so cheap and easy for so long...

Last Friday, I said that holding interest rates at 0% or less for many years – as global central banks have done since 2008 – is the worst economic calamity in history.

Interest rates are the most important prices in the world. And they're not just about the price of money. Interest rates also put a price on the most precious commodity of all...

Time.

In his 2022 book, The Price of Time, author Edward Chancellor covered this idea perfectly. He detailed how time is scarce and has value. And in the end, interest is the time value of money.

Chancellor's book aligns with my belief that low interest rates are a huge economic calamity.

In the book, Chancellor quotes many excellent sources – including economist William White's 2012 research report, "Ultra Easy Monetary Policy and the Law of Unintended Consequences." From the book...

Furthermore, ultra-easy money was responsible for the misallocation of capital. Creative destruction was thwarted. "It is possible," White concluded, "that easy monetary conditions actually impede, rather than encourage, the reallocation of capital from less to more productive uses."

In other words, easy money encourages investment in unproductive uses – like making pizzas in a moving truck...

That's just one example, too.

Hundreds of companies got all sorts of money with no better business models than Zume's...

We've talked about WeWork (WE) many times over the years. The co-working space startup attracted $22.2 billion in funding from 23 separate injections. And it was only one of more than 1,200 private companies that attained valuations in excess of $1 billion.

WeWork finally went public through a merger with a special purpose acquisition company in October 2021. And today, less than two years after that, its market cap is less than $200 million.

Roughly $22 billion of investor capital is gone.

Cryptocurrency exchange FTX, which we've written a lot about as well, raised more than $1.8 billion from equity investors. It was valued as high as $32 billion. And Theranos, the medical-device fraud and brainchild of the now-imprisoned Elizabeth Holmes, raised more than $720 million. It was valued as high as $10 billion.

Just look at Wood's ARK Innovation Fund. It has lost more than $20 billion in value from its February 2021 peak. A lot of that value – maybe even most of it – is never coming back.

A substantial portion of those losses resulted from the misallocation of capital.

Now, not all capital losses are bad...

Regular readers have certainly heard us mention "creative destruction" in the past. And they know that it's an essential element of capitalism...

Capitalism is anti-fragile, meaning that distress makes it stronger. In a capitalist economy, some amount of failure is good for all of us – even if it's really painful for a few of us.

It's sort of like our immune system. By fighting various illnesses, it gets stronger over time.

But like White's 2012 report said, low interest rates thwarted creative destruction. They didn't help it along.

The people pulling the strings try to save us from the consequences of a previous period of easy money by simply starting a new one. But they always make the same mistake...

They don't allow creative destruction to clear out the misallocated capital. And in turn, that doesn't give the system a chance to refresh itself.

When the cycle never ends, everything just keeps getting worse. And inevitably, the mistakes made during a mega-bubble fueled by the lowest interest rates in recorded history lead to the worst-ever capital misallocations – like Zume Pizza and the other examples.

The extent of the initial mistake could be worse than I thought, too...

I believe the low-rate calamity started in 2008. That's when the Federal Reserve slashed the benchmark federal-funds rate down to zero during the financial crisis.

But former politician and businessman David Stockman believes the calamity goes back even further. In a recent article, he reasoned that it started back in October 2001.

That was a month after the September 11 terrorist attacks and seven months into the dot-com bust. Back then, the Fed dropped the fed-funds rate to less than 3% – the level at which it had bottomed in 1994 in the wake of the savings and loan crisis.

Central banks sent interest rates lower than they've ever been in 5,000 years of recorded history. They dropped them to zero (in the U.S.) and even lower (in Europe and Japan). And they kept them there longer than ever before.

This chart of the fed-funds rate since 1971 shows the historic nature of this move. It covers 52 years. And as you can see, the low-rate calamity takes up almost half of that period...

This cycle of events occupies much of Chancellor's book. It's all about monetary authorities lowering rates in response to a crisis – only to cause another bigger one in the future.

For example, the Fed lowered rates in response to the crash of 1929. Of course, the Great Depression followed not long after that. And eventually, it led to World War II.

Then, the Fed thought it had beaten inflation twice in the late 1960s and early 1970s. It lowered rates both times... only to watch inflation return hotter than ever.

Inflation eventually surged into double digits. That led to the 20% fed-funds rates of 1980 and 1981. And ultimately, we endured a brutal recession.

The Fed lowered rates in response to the dot-com bust at the start of this century. That led to the housing bubble and the financial crisis.

And even today, 15 years later, I'm afraid we've barely begun to feel the pain from the Fed lowering rates after the financial crisis...

The cycle is on the path to repeat once again...

We have every reason to believe the next crisis – the current crisis – will be worse than the previous one. All of recorded history is pointing us in that direction...

Billionaire trader Stanley Druckenmiller chimed in on this topic in a Bloomberg interview last week. He even mentioned Chancellor's book...

There's a 500-year history of asset bubbles well documented in... The Price of Time...

Every time you've had a significant asset bubble, economic trouble lay ahead.

When you had 11 years of free money, people do stupid things...

All you had to do is look [at how] someone paid $80 billion for Dogecoin, which was invented as a joke. That can only happen in a world of free money...

This was arguably the most disruptive economic period we've had since the late 1800s.

The Price of Time covers 500 years. But other books about all this stuff cover even longer periods...

Carmen Reinhart and Kenneth Rogoff's classic, This Time Is Different, covers "eight centuries of financial folly" (its subtitle). And Chancellor's 1999 classic, Devil Take the Hindmost, starts with tales of Roman speculation from 2,200 years ago.

Maybe I'm a victim of my Catholic school upbringing, which I remember fondly because it regularly exposed me to the great wisdom in the Bible. But when I think of economic and financial cycles, I think of Ecclesiastes 1-9...

The thing that hath been, it is that which shall be; and that which is done is that which shall be done: and there is no new thing under the sun.

Bad stuff happens all the time. And in the financial world, I believe it happens in proportion to the level of speculation and capital misallocation that came before it.

Don't ask me exactly what bad stuff will happen...

But for starters, bank failures aren't great. And like Druckenmiller, I believe the three bank failures from a few months ago are just the tip of a large iceberg that we haven't hit yet.

If the next few years pass without much economic trouble, I'll admit defeat...

But until the day I concede, every chance I get, I'll crow about the bad, unintended consequences of keeping interest rates too low for too long.

I get one opportunity per week to do that here in the Digest. I get another one every week on the Stansberry Investor Hour podcast. And I get two more chances every month in the pages of my subscribers-only services, Extreme Value and The Ferris Report.

So if I fail to get this message out or muddle it somehow, it isn't for lack of trying. And as I've said before, nobody else will do it if I don't...

The message is simple. The mistake has already been made – and it's a colossal one.

In The Price of Time, Chancellor cited English banker John Mills. In 1867, Mills said...

As a rule, panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works... Something has passed away, and left an appalling blank behind it.

Given the scale of the "too low for too long" interest-rate debacle of the past two decades, I don't believe we've experienced enough Zume-like "appalling blanks" at this point.

We can't know what the future will hold. No one can predict that. But I expect whatever happens over the next few years will hurt a lot of people who aren't currently ready for it.

Studying history can help us all prepare. And Chancellor's book is a great place to start.

A FREE Ticket to Join Me in Florida Next Month

If you'd like to visit sunny South Florida to hear me speak in person, you're in luck...

We have a handful of free VIP tickets to my good friend Rick Rule's annual conference, The Rule Symposium. The event will take place in Boca Raton, Florida, from July 23 to 27.

I'd love to see several Digest readers in the crowd during my presentation.

The tickets are available on a first-come, first-served basis. So if you're interested, I recommend acting quickly...

Step 1: Review all the conference details – including the speaker lineup, venue details, agenda, and more – on this page here.

Step 2: When you're ready to secure your free VIP ticket, click here or simply enter the promotional code STANVIP at checkout.

Important: These VIP tickets are free, but Rick's team will need to place a refundable $300 deposit on your credit card to guarantee your spot and ensure you will attend the event. Unfortunately, in the past, folks have claimed the ticket and then failed to show up.

After you check in and pick up your name badge, you can apply the $300 deposit you pay today toward your hotel bill (if you stay on-site) or receive a full refund from Rick's team.

If you have any questions, please contact Rick's team by e-mail at info@opptravel.com.

New 52-week highs (as of 6/15/23): Apple (AAPL), ABB (ABBNY), Adobe (ADBE), Ansys (ANSS), A.O. Smith (AOS), Berkshire Hathaway (BRK-B), Cintas (CTAS), Dassault Systèmes (DASTY), iShares MSCI Emerging Markets ex-China Fund (EMXC), iShares MSCI Mexico Fund (EWW), Expeditors International of Washington (EXPD), Comfort Systems USA (FIX), Fortive (FTV), W.W. Grainger (GWW), Ingersoll Rand (IR), Iron Mountain (IRM), iShares U.S. Home Construction Fund (ITB), Lennar (LEN), Eli Lilly (LLY), London Stock Exchange Group (LNSTY), Meta Platforms (META), MSA Safety (MSA), Microsoft (MSFT), OMRON (OMRNY), Palo Alto Networks (PANW), Invesco S&P 500 BuyWrite Fund (PBP), Parker-Hannifin (PH), PulteGroup (PHM), Pure Storage (PSTG), ProShares Ultra QQQ (QLD), Construction Partners (ROAD), ProShares Ultra Technology (ROM), S&P Global (SPGI), SPDR Portfolio S&P 500 Value Fund (SPYV), Sprott Physical Uranium Trust (U.U-TO), VMware (VMW), Vanguard S&P 500 Fund (VOO), Verisk Analytics (VRSK), and Walmart (WMT).

Before we get to the mailbag, a quick housekeeping note... The U.S. markets and our offices will be closed on Monday for the Juneteenth federal holiday. Following this weekend's Masters Series essays, we'll resume our regular Digest fare on Tuesday.

Now, in today's mailbag, we've heard from subscribers on our reports this week about the Fed. And others wrote in to share more thoughts on Stansberry Venture Technology editor Dave Lashmet's Wednesday Digest on U.S. tensions with China. Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"Two very interesting articles in a row by your author Corey. Thanks." – Paid-up subscriber Fabian H.

"I got a lot of value from your writing in [Wednesday's] Digest. Well written with a lot of backup for your point of view, and I really appreciate your point of view. I get my information from many sources and I like to compare what different writers have to say about similar topics, especially if it impacts my investing decisions. As it relates to China and your paragraph that stated, 'China has already built its navy. In turn, the U.S. Navy thinks – and I (Dave Lashmet) agree – that open hostilities could break at any time. We're talking months, not years,' [this] may be accurate, I don't know.

"As an alternative position, maybe slightly, comes from Ian Bremmer, who had this to say in his TED talk recently: 'Despite all the talk about a new cold war, the U.S. and China are far too economically interdependent to decouple from each other. Bilateral trade between the two keeps making new highs, and other countries want access to both American muscle and the Chinese market (soon to become the world's largest). You can't have an economic cold war if there's no one willing to fight it.'

"That point of view may make me think that hostilities, especially war, may not be imminent.

"So again, your work is terrific and well thought through! Like everyone, I hope we don't go to war because no one wins. That said, I will use your input to help me with investment decisions as we move forward. Thanks Dave!" – Stansberry Alliance member Bill F.

"Wouldn't the bigger question be why is it logical for the U.S. to have 800 military bases around the world including surrounding China?... The U.S. military-industrial complex needs wars and pays politicians to get them.

"Can you imagine Chinese ships in the Gulf of Mexico? What would be the reaction to a Chinese military base in Cuba? We know what it would be, but if we do the EXACT same thing on the other side of the world, the other country is the aggressor." – Paid-up subscriber Wesley P.

"Thank you for the Black Swan article... Apple is a major investment for me, and I have been concerned big time about its exposure to China." – Paid-up subscriber Hugh K.

Good investing,

Dan Ferris
Eagle Point, Oregon
June 16, 2023