I am writing this to share a train of thought that started when I read on the Economic Times about an Ozy Media executive impersonating a Google executive during a meeting with Goldman Sachs which had the potential to raise the media company US$40m. The article also talked about the figures shared by Ozy being overstated – figures on viewership, subscriber base, etc.
The question of trust
The ET article on Ozy got me thinking if we can trust unaudited figures shared by companies, and with certain claims by some public companies. What is leading manufacturer of xyz? – check websites or reports of some competitors in an industry and a few of them will surely claim this. Is it top 5, top 10? What if it’s a niche market and there are only 7 players – is “among the top 10” enough to show it as proof of capability of the company? The argument then goes towards the fact that long term investors understand the specific industries that they invest in, some reputed investors have a track record of investing in the right company at the right time.
Let’s look at cases like Theranos. ColdFusion, on YouTube, gives an overall view of what happened. It started with a goal to make a small machine that can be used by consumers for blood test, with a few drops of blood, without the need to draw out the amount needed by a syringe as the standard practice is. Sounds great. But is it possible? Two obvious things are that the amount may not be enough to run all the different kinds of tests needed to come to a conclusion, and that the different tests and corresponding equipments will affect each other. So, in the announcements, the machine being developed became bigger and bigger, and it might have been possible for a few tests to be conducted, but with the size of the machine, grew the list of possible tests that the machine can do, as claimed by the company. As they provided supposed proof, most did not bother to check (as found out later that Theranos was using others’ machines – standard ones already in the market – to test samples and show the “proof” that their prototype works).
With big names as investors and reputed industry professionals in the board, how did people miss the lies for as long as they did? When someone “looks and sounds” confident and is “charismatic” they suddenly become believable? Possible. Charisma is good for leadership and life in general, but it cannot be a qualifying criterion. In a recent NYTimes article, it is mentioned that Ozy Media is shutting down: “…many had wondered how the company had managed to survive. The answer had to do with a charismatic and relentless founder, a great story and a slick brand that was perfectly tuned to appeal to noted Silicon Valley investors and powerful advertising executives”.
But even audited figures can be wrong, and there have been scams. I say, it’s not fool proof, but it’s a little better than having no third-party assurance.
The stories and jargons
There’s a differing opinion on stories and jargons. Stories are important as they are a little better with conveying a point. Jargons sometimes give the statements an air of authority – jargons being industry specific, pose an image of industry knowledge. But they’re pointless if there’s nothing behind to support them. In a recent article on the Economist on academia, they mention the willingness to publish anything, in the name of research papers, that used the right jargons. Although it’s more nuanced that just that, I believe. Also, the article’s focuse is on the pressure to conform within academia, and it has a wider scope than what I have mentioned here.
In corporate, jargons do play a role, but it’s more about the story. What’s the billion-dollar idea? What problem are you solving for society? What’s the innovative leap that you have accomplished? Etc. But “is it even possible” comes much later. And as far as too much focus goes, there’s a lot of talk of multiples and margins, etc. But are we looking at all of them in context?
The right multiples
When we see the metrics being used to judge and compare companies, we see a lot of use of performance metrics like EBITDA margin, FCF yield, ROIC, etc. Of course, fundamental analysis also looks at financial health, but they are not used as much for comparative purposes, but more at an individual level. Is that why we miss cases with impending liquidity crisis?
When we look at IPOs, we see the investment cases. We see what has been and the potential of what can be. There are times when the story seems so good that we forget about cashflows. On what basis are negative cash flows being valued so high? This is something I have not read about enough, but I have read enough that it seems to me that we are looking at “what’s cool” and not at what works. The combined valuation of US IPOs are quite high this year as mentioned in an Economist article (going from ~US$60bn in 2019 to ~US$240bn in 2021 YTD), which also mentions: “new SPACs that had merged with their target by mid-February have lost a quarter of their combined market capitalisation since then, wiping out $75bn in shareholder value”.
When we are looking at SPACs acquiring start-ups, we see cases of multiples being used. As the earnings are low in the initial years, we see multiples of around 5 years forward being used valuation. But should we relay on valuation multiples as much in such a case? Often when a new company is bringing in a new solution to the market, finding the right peer-set becomes a challenge. And what about the payback period? I haven’t read it completely – an FT article talks about the slowing trend of SPACs.
In some cases of relative valuation, we are not skipping immediate future years and we end up with rather high multiples. Should we trust these? As we look at immediate forward multiples instead of skipping a few years, we risk buoying the valuation higher than it should be. This is especially apparent when we look at the players in the electric vehicles market. Are we ready to believe that only these players will be left at the top? Granted some of these will be big names, but should we value all of them just because they are in the same field – a market that’s still in an early stage? This phenomenon is partly because of the buzz around ESG.
The responsible ones
There’s a lot of talk around ESG. Green initiatives, green funds, sustainable investing, etc. are some of the words being used to focus on the ESG aspect more than anything else. Are we ready to accept losses in the name of sustainability? Can a loss-making enterprise even sustain itself, its shareholders and other stakeholders? Yes, I do believe that investments should be made and initiatives should be taken to reduce environmental damage, and if a positive impact is possible, it’s even better. But we should not focus solely on that one aspect when we are looking at business.
Aswath Damodaran shares his views here, and I agree with some of these. What about the scenario where the investor makes money without an explicit focus on ESG and gives back to society through other purely social initiatives? Granted that a negative environmental impact is bad and not sustainable (hence the word sustainability), but value creation must be there. One cannot keep on burning cash perpetually and call it a business. And what if this goodness is already priced in? This would again be a similar case of buoying the prices of the stocks.
An expert had remarked, when I shared the post by Damodaran with him, that it’s not so black and white and I agree, but I do sense a buoyancy here. A more visible challenge that most can agree with is the lack of standardisation. There’s a strong possibility that without standardisation and regulation, companies will focus on those metrics that make them look good and on achieving those metrics that would support a better ESG score. Coming to these scores, each rating agency has their own and being that this is a relatively new topic, we don’t know how holistic and reliable the scores are? And a company which does not mention ESG or related terms in its reports – the “not reported” one – is widely shown as bad, when compared to a company which just uses jargons to paint a good picture. Something is better than nothing, I suppose. But it’s like comparing a private company which may be profitable, with a public company which says, “we have been making losses, but look, our EBITDA is positive”. Wait, where does all that D&A go?
What about innovation
Yes, one cannot be questioning everything so much that innovation is halted. But there’s also a cost of lost opportunities. The money that could have been invested in other ventures that might have generated better value.
I realise that I am referring to an old and traditional view of finance when I say, we should be prudent. I also realise that higher risk is associated with the possibility of higher returns. Yes, we should invest in new ideas, and in young and promising companies, but we should also have measures in place to minimise the loss when it seems that the cost is going to be higher than the returns. We should also be reasonable and utilise our industry knowledge to distinguish between a promising idea and a hollow sales pitch.
There are a lot of missing pieces that need to be found and the spaces filled. For example, we see companies using advanced logistics internally, but we don’t see as much buzz around third part logistics even with the global challenges being observed every now and then. We see a lot of buzz around EVs. We even see buzz around charging technology and battery technology, but not as much around charging infrastructure. What’s going to happen then? 50 different types of charging points for EVs, until finally we see an issue and come up with a USB equivalent for EV charging (standard I/O)?
An argument can be made that it’s easier said than done, but why should we always go for a case study of a crisis and what went wrong, and not go for a case study on a successful idea implementation and sound investment practice?
There is much that I don’t know. But I sometimes consume content and think. And I did sense a hype in the market, before reading a title on FT, “High-priced VC tech deals raise overheating fears”. I wanted to share this train of thought, and I’m thinking about writing more such pieces in the future.
I wanted to cover a few more topics, but it has been a relatively longer article for my blog. I’ll probably pick them in another attempt.
I’d like to conclude it with this. We should look beyond the hype at the underlying trend and try to build up to a valuation from there.
What are your thoughts on these? Any feedback about the article? Would you like more of such pieces? Feel free to leave a comment or let me know through other channels.