In Profits We Trust
I was in business school during the stock market bubble, which means I've heard all the rationalizations about how unprofitable companies will eventually make money.
There were companies such as Kozmo.com, which delivered stuff via bike messenger; it was losing money on every unit, but planning to make it up in volume. (How do you scale up bike messengers?, asked a perspicacious vice president I worked for in Merrill Lynch’s technology investment banking group.)
There were companies such as Webvan, which was counting on massive investments in warehouses and technology to give it a first-mover advantage that competitors would never be able to overcome. (This is working for Amazon right now, but alas, not for Webvan.)
And then there were companies that didn’t charge any money for their products at all. They were amassing mailing lists, you see, and those mailing lists would prove so insanely valuable that …
Ten years ago, companies that were losing money hand over fist managed massive IPOs, vaporizing billions of investor dollars on nerfball courts and websites that gave stuff away for free. Then the bubble crashed. We got wiser. Investors started asking for proof that you were at least close to turning a profit.
That was then. This is now, according to a Wall Street Journal report that cited an assessment by Jay Ritter, a finance professor at the University of Florida. The article says that two-thirds of U.S.-listed tech debuts in 2013 lost money:
Data suggest that sticking to companies that already are producing income can be a better bet. Unprofitable U.S.-listed technology companies that went public from 1990 to 2011 returned an average of 21.5% in their first three years, while profitable companies returned an average of 55.2% in that period, according to research by Mr. Ritter on companies with more than $50 million in revenues.
The returns are based on performance after a stock's first day of trading. His data also show that both groups outperformed the broader market in those periods.
In the dot-com boom years of 1999 and 2000, when many investors lost money after snapping up highflying shares, 86% of tech IPOs were of companies that lost money.
At the same time, when it comes to public offerings, some investors aren't focused on averages. They are looking for home runs. Profitability even can be seen as a negative because it sometimes suggests maturity.
Some investors "want a lottery ticket on a company disrupting a very, very large market," said Paul Deninger, senior managing director in the technology group at investment bank Evercore Group LLC. "For that, they're willing to sacrifice profit for growth.
For some reason, this made me think of a line in Tyler Cowen’s amazing new book, "Average is Over" (more on which another day):
Here is what is not scarce these days:
1. Unskilled labor, as more countries join the global economy
2. Money in the bank or held in government securities, which you can think of as simple capital, not attached to any special ownership rights (we know there is a lot of it because it has been earning zero or negative real rates of return)
One of the explanations for the financial crisis, which I find convincing at least as a contributing factor, is what Federal Reserve Chairman Ben Bernanke called the “Global Savings Glut.” Too much money was chasing high-return assets, and when that money couldn’t find actual high-return assets, it created them by blowing bubbles.
For the past 15 years, we have blown bubble after bubble, as excess savings chased too few investment opportunities. As the global population ages, this is probably going to get worse, not better. Individuals and pension managers are going to be desperately looking for financial assets that will let them retire for decades even as the ratio of workers to retirees shrinks.
Many of the recent high-flying IPOs have been disasters for their investors, notably Zynga and Groupon, whose business models seemed to collapse not long after they got investors to buy in. But I’m not sure how much that matters. Desperate investors have to put their money somewhere, even if they can’t find anywhere good.