Why investors should think hard before feeding a ‘unicorn’
We are all for technology and entrepreneurship, here on The Value Perspective, yet we do not believe buying so-called ‘unicorn’ businesses on elevated valuations is, on average, a sustainable way to make money
This year’s London Tech Week, which kicked off on 10 June, was boosted by the revelation Britain is now creating more unlisted technology businesses valued in excess of $1bn (£778m) than any other country apart from the US and China.
According to research by Tech Nation and Dealroom, UK-based entrepreneurs have built 72 such ‘unicorns’ over the past two decades, including 13 over the course of the last year.
UK-stabled unicorns such as Checkout.com, Deliveroo, Monzo, and Ovo Energy look well on their way to being household names – indeed some, at least for certain generations, already are – and naturally such news brings a flush of patriotic pride.
This being The Value Perspective, however, all emotions must be tempered with objective data, which leads us to the cyclically-adjusted price/earnings ratio – or ‘CAPE’ for short.
This measure encapsulates the average earnings generated by a business or market over the preceding decade, adjusted for inflation, and one exercise we find very constructive as value investors is to group businesses by their CAPE to build a picture of which industries look cheap or expensive.
As the following chart shows, at the turn of the millennium, technology, media and telecoms stocks were trading at very elevated valuations.
Source: Schroders and DataStream as at 1 January 2000
Turn the clock back a further 30 years and a similar chart would show consumer staples sectors such as food and beverages and food and drug retail populating the more expensive end.
This is because the late 1960s and early 1970s saw the ascendancy of the so-called ‘Nifty 50’ US stocks, such as Coca Cola, Johnson & Johnson and Wal-Mart, which were widely seen as ‘must-holds’ – until, that is, the 1973/74 market crash.
Returning to the present, it occurs to us the same chart updated to 2019 could – with its mix of technology and consumer stocks amid the more expensive valuations – very well be mistaken for a lovechild of the 2000 and 1970 versions.
And the bones of that idea gained a good deal more flesh when we read a recent Economist article, entitled The wave of unicorn IPOs reveals Silicon Valley’s groupthink.
The internet unicorns
The piece contains an analysis of 12 “former and current internet-focused unicorns”, which it says is weighted towards “both prominence and accessible data”. The list includes most of the largest of the species and covers a range of industries, including transport, music-streaming, real estate and e-commerce. Six are based in the US, five are Asian and one European. In common with unicorns at large, they are on average 10 years old.
As the Economist article goes on to note, the 12 businesses have a combined valuation of $350bn, which – interestingly enough – is roughly the same as that which resulted from the floatations of Alibaba (2014), Facebook (2012) and Google (2004).
“Those IPOs, which led to the creation of over a trillion dollars of value, were among the most successful ever and have been burned into the memory of fund managers,” it adds.
“If you owned those shares you outperformed; if you didn’t you risked being fired.”
To put it another way, then, there is a serious risk of professional investors having their judgement compromised by the behavioural sin of ‘recency bias’, also known as the ‘availability heuristic’, where humans tend to ascribe greater significance to more recent events.
Throwing that risk into sharper relief still are a couple of other numbers in the Economist article, which points out that 11 of the 12 make nothing in the way of profits – a characteristic they share with 84% of businesses pursuing IPOs, according to data from Jay Ritter of the University of Florida.
A decade ago, that proportion was just 33%, meaning today’s lack of profits is far more reminiscent of, yes, the dotcom boom of 2000.
Furthermore, the Economist’s dozen has “burned” through $47bn attaining their current size – including $14bn in 2018 alone – something the piece describes as “profligate even by the standards of Amazon, which before and after its IPO was seen as a particularly profit-averse”.
While such numbers do not mean these are necessarily bad businesses, the article stresses, “it does make them look like very pricey ones”.
To support this view, the Economist points out that, based on a discounted cashflow model, the dozen firms would in aggregate need to increase their sales by a compound annual rate of 49% for 10 years to justify that combined $350bn valuation.
“That is the same as the average growth of Amazon, Alphabet and Facebook in the decades after their IPOs,” it observes.
Don't forget the losers too
It is only human nature to remember life’s winners and yet, for every Amazon, Alphabet and Facebook, whose share prices have done well after they (eventually) grew into their valuations, there are the hundreds of tech businesses – the likes of eToys.com, Pets.com and Webvan.com – that failed and sank without a trace.
They are much more easily forgotten but, in their day, they saw a huge amount of value destroyed.
None of which is to argue the Economist’s 12 unicorns, or any others, will not ultimately turn out to be success stories – only that, as value-oriented investors, we do not believe buying “profit-averse” businesses on elevated valuations is, on average and in the long term, a sustainable and repeatable way to make money.
Fund Manager, Equity Value
I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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