During the history of mankind, there have been a few defining events that led to progress at a disruptive pace. The biggest of such disruptions was ‘Industrialisation’ in the first half of the 19th century. Another such disruptive event was the use of Information Technology and the creation of a world wide web also called the Internet which started to gather pace during the 1990s. We experienced significant changes as information was more freely available and businesses went online. There were many new business models that came up which led to the famous ‘Dot Com’ boom and bust thereafter.
At that time, there was a great rush to try and consolidate position. At the peak, we heard of terms like ‘eye balls’ i.e. the number of people visiting a website and ‘burn rate’ which meant the rate at which the company was making losses, as an indicator of the aggression of the business model. Everyone was in a hurry and all attempts were being made to increase the valuation of the business with an eye to cash out. Many did, many got stuck after the bust and many businesses could not scale up to ever be in the reckoning.
The current wave of new-age businesses is an extension of the same philosophy of using IT and the internet to improve and make more efficient, the existing business models. The difference we see is that there are many companies that have been around for several years and have a tested business model. However, similarities with the last time relate to a focus on increasing valuation and poor financial performance of these businesses. While we have not reached the stage of valuation based on eye balls this time around, many businesses are burning cash to consolidate their market share and aggressively win over customers.
The euphoria in the listed equity markets since the bottom in March/April 2020 has had its own effect on such new-age companies. With valuation of listed companies more than doubling on the average, the valuation of unlisted and even early-stage companies has gone up manyfold over this period. We are reading in the papers of large deals being done by private equity players where they have been committing large sums of capital to new ventures or are cashing out on some of their previous investments. Abundance of flows, as reflected in the listed equities market is also prevalent in the unlisted markets.
The cashing out of private equity players can happen either by stake sale to another private equity player at higher valuations or by selling part of whole of their stake in a company to the public via an initial public offering (IPO). Increased strength and heightened activity in the markets have led to some of the large and well known brands opting for listing in the recent past.
With keen interest seen from the investing community in new-age businesses, shares have been offered at rich valuations to the public. The consequent even higher valuations on listing and significant short-term profits for the initial public shareholders have further accentuated the interest in such companies. In this matter, it is clear that investors are taking a view that ‘the trend is your friend’ and expect the share prices to keep rising.
Many of these companies, due to the current stage in their life cycle, are not profitable. Some are even continuing in the game of consolidating their position while increasing losses. It is therefore quite uncertain as to ‘if’ and ‘when’ these companies will make profits at the net level and have cash flows to pay investors through dividends. In the interim, investors can only look forward to stock price appreciation as a means of generating returns on the investment made.
While it is unclear what will happen next, looking at the experience of some of the established players in the West, we conclude that there will be a few winners in this exercise, and these few will achieve much higher valuations. However, there are bound to be many losers along the way. Investors who look to invest in a new-age company should be comfortable holding onto its shares for the long term, have a fairly high level of conviction that they have a winner and posses the wherewithal to suffer significant losses if things do not work out. If you believe you do not have all the above abilities, please reassess your investment strategies to determine if such investments are suitable for you.
(Pankaj Chopra is the founder of Five Rivers)