Newsletters > Start-up stocks | The reason why investors don’t make money in start-ups
Start-up stocks | The reason why investors don’t make money in start-ups
July 15 . 15 MIN READ
Overview
The period between June 2020 and September 2021 was one of the best for the Indian equity market but 2022 is turning out to be a gut-wrenching time. The liquidity/volumes in the market have fallen by half and correction in small- and midcaps in India is severe.
All the hyped growth stocks—even the likes of HDFC Bank, Asian Paints and Divis Labs—apart from cement and metal stocks are taking a beating. The sea (broad market indices like the Nifty and Sensex) appears calm but there’s an undertow lurking in both global markets and Indian mid- and small-cap stocks.
Nearly 50 percent of the stocks are down by roughly half from their 52-week highs. The average fall is around 38 percent from their all-time highs. In the US, the S&P 500 has seen one of the worst starts of the year and the NASDAQ is down by more than 20 percent (officially, this is said to be the start of a bear market) and the darlings of the COVID period like technology initial public offerings or IPOs, SPACs or special-purpose acquisition companies, cryptocurrency, etc. are down by 30-70 percent. So what went wrong?
Answer: Recency bias, or extrapolation based on recent events.
Not all growth is good
It was assumed that all the businesses that were growing at a good rate for the past decade or in the recent period would grow at this speed forever, and that led market participants to provide astronomical valuations to them. The most important thing for investors is to understand that not all growth is good. Sometimes growing beyond a certain rate actually kills a business.
If you look at Avenue Supermarts, HDFC Bank, Asian Paints and so on, you would conclude that all it takes to generate great returns in the equity market is consistent growth in revenues/operating profits and cash flows.
As the legendary investor Charlie Munger says, “Invert, always invert.” In this case, does this mean that every business that has grown revenues and profits has rewarded shareholders handsomely?
Let’s take an example of a company where revenue grew 174 percent, 123 percent and 106 percent in 2020, 2021 and 2022, respectively. Now, I want you to guess the return of this stock in the last one year. This stock is down 75 percent from its all-time high and down 44 percent in last one year alone. The name of the stock is Snowflake (Berkshire Hathaway also invested some portion of its portfolio into it).
Also see the fate of some IPOs in India like those of Paytm, Zomato, CarTrade, etc. Zomato is down 58 percent, Paytm 66 percent and CarTrade 65 percent. Again, any guesses on the growth rates of the above businesses? Revenue at CarTrade grew at a five-year compound annual growth rate (CAGR) of 32 percent, Zomato at 71 percent and Paytm at 44 percent.
Valuing the company right
A company’s valuation multiple is an outcome of the following:
1. Growth rates in profits and revenues
2. Duration for which growth rate is greater than the economy can sustain (growth advantage period)
3. Level of return on invested capital (ROIC)/return on equity (ROE)
4. Duration for which such high returns can be maintained (competitive advantage period)
5. Discount rates/opportunity cost of capital
If a business is growing at a fast rate with ROIC/ROE much lower than its discount rates, it actually reduces the valuation of the company. Let’s take an example.
Imagine you broke your fixed deposit, which was earning you 8 percent, to start a business. Now that business has earned on average 6 percent in the past five years. Would you put more money in this business to grow it or shut shop?
Practically, you have lost money at the rate of 2 percent per annum by starting this business. If you initially invested Rs 1 crore into this you lost Rs 1 crore x 2 percent per annum, or a total of Rs 10 lakh in five years. Now if you put another Rs 1 crore in this, will your losses increase or decrease? Assuming here that the health of the business remains the same, you will lose 2 percent on Rs 2 crore. A loss of Rs 4 lakh per annum, instead of Rs 2 lakh per annum. The increased losses will reduce your valuation. We know a lot of startups that operate this way. Well, that’s a topic for a different day.
When the bull run ends, analysts suddenly realise that a lot of businesses were like a pig with lipstick. They were growing with ROEs much below their opportunity cost, actually destroying the value of business rather than creating it.
Hence, not all growth businesses deserve high valuations. There are lot of other factors like competitive intensity changing (Asian Paints with the entry of Grasim and JSW in the segment), industry getting saturated (Colgate Palmolive in toothpastes) and so on that also support our thesis that just because a business has grown at a high rate in the past, it does not automatically deserve a high price-earnings multiple today.
How long might this correction last?
That is anybody’s guess. There have been multiple instances of sharp reversals when even after correcting by 20 percent the markets recovered within seven days (for example, in 1997, 1999, 2006 and 2012) and sometimes there are long periods of drawdowns where the market remained below the 20 percent correction level for more than a year (1992-1993, 1995, 2000-2003, 2008).
For investors willing to work hard, there are always investable ideas available in every kind of market. There are some sweet spots (growth plus reasonable valuations) like businesses related to data centres, capital goods segment, agro-chemicals space, defence, and so on.
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Note: the above material is neither investment research, nor investment advice. Marcellus does not seek payment for or business from this material/email in any shape or form. Marcellus Investment Managers Private Limited (“Marcellus”) is regulated by the Securities and Exchange Board of India (“SEBI”) as a provider of Portfolio Management Services. Marcellus is also a US Securities & Exchange Commission (“US SEC”) registered Investment Advisor. No content of this publication including the performance related information is verified by SEBI or US SEC. If any recipient or reader of this material is based outside India and USA, please note that Marcellus may not be regulated in such jurisdiction and this material is not a solicitation to use Marcellus’s services. All recipients of this material must before dealing and or transacting in any of the products and services referred to in this material must make their own investigation, seek appropriate professional advice. This communication is confidential and privileged and is directed to and for the use of the addressee only. The recipient, if not the addressee, should not use this material if erroneously received, and access and use of this material in any manner by anyone other than the addressee is unauthorized. If you are not the intended recipient, please notify the sender by return email and immediately destroy all copies of this message and any attachments and delete it from your computer system, permanently. No liability whatsoever is assumed by Marcellus as a result of the recipient or any other person relying upon the opinion unless otherwise agreed in writing. The recipient acknowledges that Marcellus may be unable to exercise control or ensure or guarantee the integrity of the text of the material/email message and the text is not warranted as to its completeness and accuracy. The material, names and branding of the investment style do not provide any impression or a claim that these products/strategies achieve the respective objectives. Further, past performance is not indicative of future results. Marcellus and/or its associates, the authors of this material (including their relatives) may have financial interest by way of investments in the companies covered in this material. Marcellus does not receive compensation from the companies for their coverage in this material. Marcellus does not provide any market making service to any company covered in this material. In the past 12 months, Marcellus and its associates have never i) managed or co-managed any public offering of securities; ii) have not offered investment banking or merchant banking or brokerage services; or iii) have received any compensation or other benefits from the company or third party in connection with this coverage. Authors of this material have never served the companies in a capacity of a director, officer, or an employee. This material may contain confidential or proprietary information and user shall take prior written consent from Marcellus before any reproduction in any form.