Global markets are buckling under the weight of two major worries — inflation and geopolitical tensions — that are growing by the day, with the latter feeding the former. Commodity prices have been rising steeply, as a result of more supply and logistics disruptions stemming from Russia’s invasion of Ukraine. High energy prices, in particular, will be a material contributor to global inflation, being the common denominator affecting all economic activities. And that will drive up broad inflationary pressures. We expect prices for goods and services — likely across the board — to spike in the near term and stabilise at higher levels than previously anticipated over the medium term. Much depends on how long the conflict and sanctions last.
There are a lot of unknowns at this point. The extensive — and expanding — array of sanctions against Russia will surely have significant consequences, intended or otherwise, for better and worse, some of which will be immediate while others will play out over the longer term. For instance, on the positive side, energy supply security concerns will hasten the transition from fossil fuels to renewables. But there is little relief in the short term. Producers, it appears, are less keen to boost output this time around, preferring to pocket bumper profits from the current high prices. A case in point: OPEC+ is sticking to its scheduled, gradual output increases. Anecdotal evidence suggests major shale producers too are signalling higher returns to shareholders instead of increasing capex, at least for now.
Given the magnitude of the prevailing uncertainties, it is not surprising that the US Federal Reserve will try to tread cautiously. Indeed, uncertainties have already tempered market expectations for a more aggressive quantum of interest rate increase in the Fed’s upcoming meeting, scheduled for March 15 and 16. Still, a series of rate hikes appears inevitable at this point, given fast-rising prices — fuelling the current broad market sell-off. High-growth stocks are unsurprisingly harder hit — remember, stock valuations are inversely correlated to discount rates, and earnings further into the future are worth less today — but the sell-off in shares for high-growth and loss-making companies is nothing short of brutal.
In the years following the global financial crisis, major central banks worldwide subscribed to unorthodox and extreme monetary policies and, in the process, created massive liquidity. With interest rates falling precipitously, the search for yields forced many investors towards higher-and-higher-risk ventures and assets. Liquidity and cheap money also increased the competition to fund perceived exciting start-ups, sometimes at the expense of proper due diligence, substantiated evidence that the products are as advertised or even if they exist at all. A case in point is the boom and bust of once high-flying healthcare tech company Theranos.
The Covid-19 pandemic drove interest rates even lower, to negative territory in some major developed countries, while central banks and governments added to the already excessive liquidity situation. Studies show a strong positive correlation between the timing of government pandemic cash payouts and meme stock rallies. When money is free, most will make the highest-return bets — on the basis that they will be no worse off even in a complete wipe-out scenario. This is why direct cash handouts (helicopter money) make for good fiscal stimulus — we tend to save hard-earned money but immediately spend free money.
Among the major beneficiaries of this free flow of cheap capital are tech start-ups that epitomise the “growth at all cost” strategy. These companies and their investors focus, excessively, on the total addressable market (TAM). It then becomes a race to gain the biggest market share and scale up as quickly as possible, by spending hugely — and outspending the competition — on customer acquisition through marketing, incentives, promotions and so on. All funded by cheap capital. Sometimes, over-hyped TAM can, literally, be the entire world. Imagine the prospects!
Analysts enthusiastically price these stocks based on multiples of sales, never mind the huge losses, even at operating levels. What is often left unsaid, but implied, is that fast-growing revenue will, after the initial start-up period, turn into huge profits as economies of scale kick in. Indeed, this is one of the most compelling aspects of tech platforms — the ability to scale without a corresponding increase in costs. And one of the best examples is Meta Platforms (previously Facebook), which grew rapidly, thanks to its network effects, and was very profitable, owing to decreasing marginal costs. We wrote about the social media platform company some weeks back on how the network effect may now create its own constraints on demand (The Edge Singapore, Issue 1022, Feb 14).
The assumption of “marginal cost approaching zero”, however, does not apply uniformly across all tech companies. For example, in the case of utility platforms such as food delivery, ride-hailing and e-commerce, the marginal costs — the costs for food, goods and delivery logistics, including fuel and rider costs — do not fall with every additional sale. They are fairly constant and may even rise, for instance, when there are limited drivers-riders. A potential game changer in the future would be if autonomous vehicles and robots are factored into the equation — replacing costly human labour. How fast this will happen, however, also depends on government policy on the inevitable labour displacement.
In addition, it is not just about TAM. Market share and potential revenue are also a function of the price elasticity of demand. The question is, will companies that are currently attracting users and growing sales with huge subsidies be able to raise prices without losing the aforementioned users and sales, if they are to turn a profit? For instance, if Shopee no longer offers free delivery, will shoppers continue to buy from its platform?
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The collapse in the stock prices of some of the most high-profile “high-growth but unprofitable” companies — such as Peloton Interactive, Nikola Corp, Lordstown Motors and SEA — is a timely wake-up call. Certainly, some of the selling appears overdone. This just goes to show that market sentiment and herd mentality drive prices in the short term. We are under no illusion that this is the end for speculative and excessive stock valuations.
Interest rates are going up and the best days of cheap and easily available liquidity are very likely in the rear-view mirror, at least for the foreseeable future. So, we think, increasingly, investors will be forced to ask the hard questions, against this liquidity tightening backdrop. Which are the companies that can sustain the current cash burn when cheap capital is no longer available? Is there a viable business model and what is the path to profitability? This means going back to basics — determining the economic moat, in terms of proprietary tech, brand, competition and barriers to entry, the availability of substitutes, strength of network effects and switching costs, and so on and so forth. To quote Warren Buffett, “Only when the tide goes out do you discover who’s been swimming naked.”
The Global Portfolio fared poorly, falling 7.1% for the week ended March 9, with all stocks closing in the red. Shares in Grab Holdings (-40%) fell sharply after reporting larger losses in its latest reporting quarter while CrowdStrike Holdings (-15.8%) gave back some gains from the previous week. Other big losers included The Walt Disney Co (-9.3%), Amazon.com (-8.4%) and Alibaba Group Holding (-7.4%). Total portfolio returns have been pared to 41.7% since inception. This portfolio is now underperforming the benchmark MSCI World Net Return Index, which is up 47.1% over the same period.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
Cover photo: Bloomberg
