Wednesday, 14 August 2019

Why profits matter (and value investing is not dead)

We have currently reached the point in this (unusual in many respects) cycle where many investors/commentators have started to question whether profits no longer matter, and also whether value investing is dead. As is often the case, the arguments put forward in the affirmative derive mostly from recent market experience/outcomes, rather than reasoning from first principles. Hyper-growth (and generally loss-making) tech companies have seen outsized share price gains (or when privately-held, significant valuation up-marks), with many recent IPO vintages also seeing triple digit gains, despite the absence of any profits either in the past or foreseeable future, in echos of the dot.com bubble. Meanwhile, many profitable and cash-generative companies with low growth, and especially with (even marginally) falling earnings/revenues, have been absolutely massacred.

Shunning the former and buying the latter stocks has been a generally losing strategy over the past several years, as profits have stagnated/declined for many constituents of this group and multiples significantly fallen, whereas loss-making companies have galloped ahead as sales have rapidly grown and P/sales multiples have also dramatically expanded. Quite naturally, given the propensity of investors/commentators to extrapolate recent experience forward, it is now an increasingly subscribed belief that profits (and particularly near term profits) don't matter, only revenue growth.

This line of thinking is a bubble, and in the sober light of the eventual bust, will be acknowledged to have been as such, in my view. In truth, profits are vitally important, not only because that is the only means by which stocks ultimately generate returns for investors (as Buffett has said, in the aggregate, investors cannot take more out of the market than what companies collectively earn - a truism that is indisputable on a first-principles basis), but also because profits (and losses) are absolutely vital to the healthy functioning of a capitalist economy, and indeed are the ultimate test of whether a company is doing anything worthwhile at all. Allow me to explain.

If you think about what it is that companies ultimately do at a base level, it is to attempt to combine scarce inputs (capital and labour) in a way that generates an output of greater value than the sum of the combined inputs. They attempt to fulfil the equation 1 + 1 > 2.

Companies that succeed in transforming a given level of inputs into outputs of greater value (in the form of useful or desirable goods and services) will be profitable. This is important, because it ensures a net inflow of resources (profits, the monetary value of which reflect claim-checks on society's resource inputs) into such companies, which are 'adding value' by utilising society's scarce resources efficiently. This allows these companies to reinvest those resources and expand (or for mature companies, to sustain their current existence while paying returns to owners - freeing those excess resources for more productive re-deployment elsewhere).

Conversely, companies that use resources inefficiently, and produce less output value than the value of their consumed inputs - where 1 + 1 < 2, so to speak - will be unprofitable. This unprofitability is equally important to the healthy functioning of a capitalist system, as it deprives the said companies of reinvestable resources, and will ultimately lead to bankruptcy. When this ensues, it may be painful for some of the individuals involved (e.g. the employees who lose their jobs), but it ensures the scarce resources these value-destructive enterprises were consuming are freed up and are able to be redirected to organisations able to use resources in more productive and socially useful ways.

This bottom-up process is an important component of why capitalism drives economic growth and rising living standards over time. The process allows a growing share of society's resources to be steadily redirected to the control of companies/individuals able to utilise them most efficiently, and in ways that maximally satisfy unmet needs or wants. No foresight or central planning is needed - it happens in a spontaneous, algorithmic way very much akin to Darwinian evolution in nature. And an important corollary is that failure is as important as success to a thriving capitalist economy. It ensures resources are not perpetually tied up in wasteful and inefficient activities (this is also why low taxes and small government is good for economic growth - it hastens the flow of resources to productive managers of those resources subject to market discipline).

However, something very interesting has happened over the past decade or so: this process and the normal market discipline imposed by the need for profitability has broken down in many areas of the economy (those touched by VC-funded tech), as loss-making companies have not only been allowed to survive, but also rapidly grow, while resources have increasingly been drained away from profitable companies. While the growth of many loss-making tech enterprises is often seen as healthy 'disruption' typical of Schumpterian creative destruction, the real truth is that many of these enterprises are actually value destructive. In many cases, they have only grown because an extraordinary amount of capital has flowed into venture capital (VC) and other (predominately) tech based funds, which have allowed their investees to not only sustain their existence in spite of large losses, but continue to rapidly grow, when market forces ordinarily would have resulted in their swift bankruptcy. It doesn't matter if 1 + 1 < 2 if investors are prepared to keep tipping exponentially more money into the business. You can still survive, and indeed grow rapidly, so long as the funding spigot remains on.

The conventional wisdom is now that profits don't matter for hyper-growth tech upstarts, because acquiring scale (users and revenues) ought to be given due priority, and a 'path to profitability' can be sought later, aided by economies of scale. Now I'll accept that there are some instances where this reasoning is valid - winner takes all/most platform companies with scalable economics, for instance. Another seemingly obvious example would seem to be many SaaS businesses who are providing genuine economic/productivity benefits to their customers/the economy, where the cost of customer acquisition is being expensed upfront, but where the unit economics (in terms of the lifetime value of customers relative to the cost of their acquisition) are highly attractive. However, the issue here is actually not the lack of profits, but the accounting. Accrual accounting is supposed to match expenses with revenue, and there is a serious 'matching' problem with writing off the full cost of customer acquisition up-front for these businesses. The CACs actually ought to be capitalised and amortised over the period of expected customer activity (the same way life insurance companies capitalise policy acquisition costs). If this accounting approach was undertaken, many supposedly unprofitable SaaS businesses would actually be robustly profitable.

However, this 'it's just the accounting' calculus does not apply to a large number of other upstart tech companies/Unicorns, including many online e-commerce businesses, as well as various online service segments such as ride-hailing. Here, the absence of profits (and indeed, the existence of large losses), is actually a serious issue, because it calls into question whether the companies are in fact generating any economic value at all, or are merely giant engines of value destruction. To the extent that this is the case, what we are actually witnessing with these companies is not healthy disruption/innovation, but instead simply a giant misallocation of capital - something that is a hallmark of almost all bubbles.

I have written about Uber in the past, and it is an archetypal example. The company recently reported its 2Q19 results - its first as a listed company - and true to form, the company booked another quarter of negative adjusted EBITDA of some US$650m - extending a long period of sizable losses without any clear trend towards improvement. This is before including the cost of recurring and economically material stock-based compensation expenses (albeit this line-item was inflated well above-trend in 2Q19 on account of significant crystallised gains following the company's IPO).

I discussed in my Uber article why the ride-sharing business may very well be consuming more resources than the value of the output delivered, given the inherent economic inefficiency of the average punter being chauffeured around town when they could drive themselves or use alternative forms of transportation. The loss making nature of the business is providing false price signals to the economy about the resources required to provide the service, making it appear to be a more efficient choice, when in fact the cost of the service is not being reflected in the price paid. Market share and resources are therefore being misallocated. The taxi business has long existed (ride-sharing without the online interface), but has been consigned to niche applications because of the inherent economic inefficiency/cost of two people sitting in a car instead of one. It is a waste of society's scarce labour resources, unless there are good reasons why someone can't drive themselves (intoxicated; short trips in built-up areas like NYC with a scarcity of parking; travelling or heading to/from the airport, etc).

While the bulls argue Uber's losses reflect a 'lack of scale' - an argument made despite the fact that the company has been in business nearly a decade, and has already has acquired tremendous scale - the truth is probably more that the lack of profits reflects the fact that the business model is actually consuming more resources than the value of the economic output it is producing. That reality has required that they price their service below the cost of its provision in order to grow, which is why they have lost more and more money as they have scaled. If the above were not true, they would be able to provide the service profitably and grow. Even if there was vigorous competition, the industry ought to be able to operate at at least break even levels. The same can be said of Tesla. They have built many great cars. I've been in a Model S - it's very cool. But the company keeps burning cash because the cost of the inputs continues to exceed the value of the output.

This is why profits matter. It is evidence that the product/service is economically viable, and that the value of the output exceeds the cost of the inputs. Many investors today are currently impressed with rapid rates of revenue growth, regardless of the state of the bottom line, but as far as I'm concerned, high rates of revenue growth are a complete irrelevance and are unimpressive if a company has not demonstrated that that revenue growth is in conformance with the equation 1 + 1 > 2. If that equation is not met, then rapid revenue growth does little more than destroy more and more value at a faster and faster rate. It's not worth anything. 

At base, what the current zeitgeist of ignoring profits and focusing only on revenue growth in upstart tech businesses is enabling is not a hyper speed of innovation and economic growth, but rather simply the widespread misallocation of capital (and labour). Furthermore, the consequences have not just been the excess allocation of capital to value-destructive enterprises, but also the concomitant draining of capital from profitable, value-creating enterprises, not only through reduced access to funding (lower share prices), but due to lower sales/market share/profitability.

Suppose you're a profitable business meeting the equation 1 + 1 = 2.5, but new well-funded entrants come in with 1.3 + 1.3 = 2.0 economics. The new entrants will underprice you and take market share, which will pressure both your revenues and your profitability (as you need to reduce prices to stem the loss of market share, and suffer operational deleverage as volumes fall).

What ought to happen is that the latter company ought to fail, but instead, as funding markets shower more and more money on your loss making competitor, it continues to grow and take more and more market share off you. Your profitable enterprise suffers falling sales and profits, and on account of the widespread perception that your company is being 'disrupted', it also suffers a massive decline in its trading multiples. The net effect is to deprive your company of investable resources.

Something akin to this has been happening across an array of industries, from automobiles (Tesla vs. traditional automakers), to e-commerce/retail and streaming/traditional media, and dovetail into the second much-discussed trend in recent times - the apparent 'death of value investing'. There have been many causes for the record underperformance of value vs. growth in recent years, but one much under-discussed cause has been the fact that profitable, cash-generating 1 + 1 > 2 companies have been forced to compete - to an unprecedented degree and for an unprecedentedly long time - with loss making, 1 + 1 < 2 companies, who have been taking market share and pressuring profits.

Much as with the dot.com bubble and its subsequent unraveling, where many 'old world' value businesses were left for dead and considered destined for disruption/the dustbin of history, only to stage dramatic recoveries in the following decade, a likely consequence of the coming tech wreck will be a significant resurgence in the performance of many 'value' stocks, as their sales, market share, and profitability recover as 'disruptive' competitors go broke, and their multiples dramatically recover.

When will the reckoning occur? It is impossible to say, but it will occur when the funding bubble bursts, and companies are forced to once again fund themselves from operating cash flow. Much as in the dot.com bust, there will likely be widespread bankruptcies at this point, along with disillusionment and a much-overdue questioning of many now widely-held assumptions. Once again, we will probably be reminded that the old rules do still do apply after all, and that this time wasn't different.

What will be the tipping point? In my opinion, it will be the point where the pace of cumulative losses across the upstart tech ecosystem starts to exceed the pace of new upstream fund raisings into tech/VC funds, as well as in the public IPO market. The reverse has been true in recent years - the pace of fund raising has exceeded cumulative Unicorn operating losses - with a major contributor being Softbank's outrageously-sized US$100bn 'Vision' Fund. Incredibly, Softbank has already blown through the majority (US$85bn) of this funding in only two years, and its deal-making spree has been a meaningful contributor to squeezing Unicorn valuations sharply higher at a time when other VC fund raising has also been active. Softbank et al's epic fundraising and investment splurge has absorbed all of the Unicorns' underlying losses, and then some.

But the pace of operating losses continues to mushroom, and Softbank is now running out of money. As a result, Softbank is currently trying to hastily prepare a second US$100bn Vision Fund to keep the house of cards intact. Time will tell whether they succeed. The pace of IPO activity has also hastened, which suggests that even the flush private VC funding market is starting to struggle to keep pace with the rate of underlying losses its needs to fund, so it is starting to tap the public market.

It remains to be seen how long the music will keep playing. However, as the amount of aggregate upstart losses grows (which must happen if all this VC funding is to be absorbed), at some point the equilibrium point will be reached where the pace of fund-raising falls short of these aggregate losses. This could occur, for e.g., if Softbank is less successful with its Vision Fund 2 fund raising than it hopes, and/or more high-profile IPO failures such as Lyft/Uber sour the market's appetite for Unicorn IPOs to the point where meaningful negative marks need to be taken by VC funds when they monetise their investments via IPO (notable also is that the listing of Uber et al will now expose a growing share of the Vision Fund's investments to potentially significant mark-to-market losses, impairing its ability to manufacturing paper gains by funding - sometimes as the sole bidder - up-rounds in its investees). At this point, capital will become scarce and Unicorn valuations will start to fall, as loss-making enterprises compete for scarce funding to keep the lights on.

This will result in negative valuation marks being taken by VC funds/the Vision Fund, which will then in turn sharply dampen the appetite for investors to tip more more money to these funds (high apparent returns and 'low volatility' have been their chief attractions, particularly as pension funds, insurance companies, etc, try to replace lost income from falling bond yields with the illusory high returns/low volatility provided by private equity/VC vehicles - another disaster in the funded status of these investors' long-tailed obligations that is waiting to happen). The whole ecosystem will then start to quickly unravel, and an epic bust likely awaits the sector (my prediction is that investors in the Vision Fund(s) will ultimately lose the majority of their investment, and Masayoshi Son will no longer be seen as a visionary, but instead as a poster-child for this cycle's utterly irrational excesses).

It remains to be seen when this happens, and what the broader macro implications are (i.e. if it's enough to generate a recession in the US), but it certainly promises to be interesting.


LT3000






15 comments:

  1. Thanks Lyall.

    Part of the reason the narrative for Uber et al. has been so prevalent is because of Batesian Mimicry. In the real world, this occurs when non-poisonous snakes have adapted to mimic the skin color of poisonous ones in an effort to scare off attackers.

    Similarly, today's entrepreneurs have mimicked the business qualities of yesteryear's successful businesses in an effort to attract capital - but often lack the crucial advantages that made these businesses successful in the first place (as you mention above).

    Investors used to chase around for "outsider" capital allocators within management team spurred by BRK / Liberty -- and that brought you hundreds of others (ex:Valeant) masquerading as one.

    Amazon "succeeded" by running large losses in its early years to build up scale, and now many pretenders (uber et al.) follow the same playbook and investors seeing a pattern have thrown money in.

    Clearly a psychological bias - but humans are pattern recognition driven and are prone to seeing patterns when there really are none.

    This gets expounded by the fact that growth stocks are akin to long-duration bonds/assets and perform well in a low interest rate environment.

    What you also described in this article is a pure example of reflexivity from Soros. Which is very interesting.

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    1. Couldn't agree more.

      It also reminds me of what Lynch used to say - when people say this stock is 'going to be the next X', you should be wary. Usually the stock blows up.

      I think that is because outsized business success requires a unique combination of factors that exist in combination at the right place and at the right - an alignment of stars. Often, many of those stars are invisible to investors and companies trying to immitate the prior company's success.

      A lack of competition is an example of one such star. AMZN survived the tech wreck, and was therefore able to flourish in its aftermath in an environment of limited competition. The same circumstances do not exist today - every man and his dog are raising capital and attempting to burn at tonne of capital to get big fast & cash out at a big profit.

      If some of these companies do end up surviving and doing well, it will only be after an epic bust that wipes out most of their competition. That will be the time to buy them, not now!

      Cheers,
      LT

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    2. Arun,
      Not sure if the long read is worth your time, but I read another, similar take on your mimesis observation just recently. But it's a very interesting point you make.

      A representative quote from the piece linked to below: "During bubbles, companies find it easier to replicate the surface attributes and let pattern-matching do the rest."

      https://www.scribd.com/document/420334402/Manias-and-Mimesis-Applying-Rene-Girard-to-Financial-Bubbles?source=post_page-----e442a2a58544----------------------

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    3. The We company is by far the best example. Very low gross margins, and basically a commodity business, but somehow gets a software revenue (with often veyr high gross margins) multiple.

      There is literally a company trading on the London exchange, that has higher revenue AND profits with the same business model as wework and yet it trades at a far lower valuation.

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    4. Thanks Anonymous,

      Yes I agree. It actually occurred to me after I published the article that I should have discussed & made reference to We. It is absolutely a paradigmatic example - an even better one than Uber.

      Cheers,
      LT

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    5. Well you were right about scrambling for new funding:

      https://www.reuters.com/article/us-softbank-group-vision-fund/softbank-plans-to-lend-up-to-20-billion-to-employees-to-invest-in-new-fund-wsj-idUSKCN1V70FM

      >Japan's SoftBank Group Corp (9984.T) is planning to lend up to $20 billion to its employees, including Chief Executive Masayoshi Son, to buy stakes in its second Vision Fund

      What could possibly go wrong??

      This guy is going to blow up in spectacular fashion at some point.

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    6. Thanks. Yes saw the article over the weekend. This smacks of outright desperation. Clearly, the level of interest in the Vision 2 fund is falling well short of expectations, and they are desperate for funding to keep the music playing. The end of this cycle appears nigh.

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  2. i drive for Uber part time.. other day with surge price drove a rider to the airport.. about 30-40 mins drive.. i was paid appx $64 dollars, the rider appx paid $65... uber received $1... lol

    Thats the problem with their model.. to keep drivers happy and not leaving there is only so much commission they can take.. at the same time, at the moment, they are keeping prices low and offering huge promotions to retain and keep customers happy... eventually something will have to give.. either raise prices, take more commission, etc.. but it will come at price..

    I think they are betting on e-scooters and e-bikes to drive revinue/growth.. however i think thats capped as well.. only so many bikes scooters can be around .. also many complain that sometimes battery down, brakes dont work etc.. and that also has competitiom.. citybikes, lyft, lime, etc... barriers of entry not that high for this..

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    Replies
    1. Thanks for sharing your experience. Doesn't come as a surprise. Agree with your views. Cheers

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  3. The issue with your analysis is that many of these new companies don't have traditional capex that can't be capitalized. For example, these companies are not capitalizing R&D or "growth" SG&A spend. So until accounting is able to properly reflect these type of investments, they will continue to be unprofitable on a pure GAAP basis.

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    Replies
    1. I specifically addressed the issue of companies with high CACs but strong unit economics, and noted that the problem was with the accounting, not the lack of profitability.

      With respect to R&D & software development expenditure, however, this is highly recurring in nature. These companies need to constantly upgrade their platforms & features in order to remain competitive. You'll note that a significant number of 'traditional' companies - many of which are value stocks today - also have very significant R&D budgets. BMW's annual R&D budget is not too much smaller than Tesla's annual sales, for instance. Samsung spends massively on R&D. No one ever backs this R&D spending out from multiples.

      In addition, because these tech companies have been writing off R&D for many years instead of capitalising it, their current earnings benefits from a lack of amortisation of historical R&D as well.

      Finally, contrary to your argument, I've actually seen many tech companies capitalise software development spending, much of which is recurring. They then point investors to 'EBITDA', which of course excludes the both the amortisation of past cash development spend, and current cash development spend.

      Also very important is that these tech companies have very significant stock compensation expenses, which are usually ignored/excluded from 'adjusted' earnings/EBITDA. However, the truth is that this expense line is not only a real expense, but is actually understated. That's because the employees all expect to make major gains on their stock options, as that's been the case historically. However, if stock prices start going down, stock-heavy compensation packages are going to start looking a lot less attractive to employees. Probably, they will have to significantly boost their cash compensation to retain them.

      People can attempt to rationalise it any way they want. The reality is that these are vastly overpriced companies that in most cases are losing money. As noted, there are genuine exceptions, but they are in the minority.

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    2. You're missing my point. Just like capex, not all of it is maintenance. There's a portion that's growth and a portion that's "maintenance." D&A should be able to somewhat reflect the recurring maintenance capex. Currently, there's not a good way to properly reflect "growth" SG&A spend or "growth" customer acquisition costs on the income statement, other than to capitalize software spend. It's therefore up to the investor to properly account for what "normalized" R&D or SG&A spend will be and not the current amount. Agree w/ your point on EBITDA and especially SBC but that's a separate issue. I'm more focused on "normalized" and "steady-state" FCF while many tech companies are still investing for growth.

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  5. Very interesting post, thank you. Some comments: 1. The "CAC" issue is problematic and I will dare to call it fallacy. Why companies such as CRM (slaesforce.com) are barely profitable with more than $10B (!!!) in revenues? GOOGL and FB were highly profitable with a fraction of the revenues and very high growth rates (see IPO prospectus). Maybe CACs are very high because customers can switch to the competition easily, so companies need high selling expenses to keep customers from leaving. But SAAS companies can still grow because they get the cash upfront. It doesn't mean that margins will be high. AMZN retail has the same economics and thin margins. Shale oil stocks boomed for years without making FCF but by making profits (the other side of the equation compared to SAAS companies) because they convinced the investment community that unit economics are good so it's reasonable to invest. Now investors understand that unit economics (cost of churning oil out of the ground) are actually bad (they always were) compared to traditional oil. Maybe SAAS unit economics are the same?

    2. I saw that you touched the issue in one of your comments: There is a "shadow" funding in terms of options/RSU/etc. Again, see the dilution that CRM shareholders experienced overtime. AMZN success in doing just that was important precedent. And AMZN became profitable not because of scale but because Bezos understanded that the company will not survive. See the book "The everything store".

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