In the last 10 years, software applications have moved from desktop, to mobile apps, to bots that we can speak to. Taxis have gone from being cars we have to whistle at in the street, to something that will come to your location at the touch of a button. This evolution of the tech and business landscape that led to an era of dynamic change, has also caused a loss of predictability and stability. At 15 years, the average lifespan of a company in the S&P 500 Index is roughly a third of what it was in the 1950s.
The issue is, while the business landscape is changing rapidly, the investor toolkit has not adjusted. Investors still focus on the quarterly earnings season, which by nature is backwards-focused and thus unsuitable for rapidly evolving companies. Investors still lean on schools of thought from the 1950s and 60s championed by experts such as Benjamin Graham – a former professor of Warren Buffett – which were tailored to pre-information age companies.
At the same time early stage tech startups, with exciting business models and products, but lacking established customer bases, are being given huge valuations based on potential rather than real profit. This is an ecosystem where GrabTaxi, Southeast Asia’s answer to Uber, received a $1.6 billion valuation – and $890 million in equity funding, despite only having 620,000 monthly active users. Therefore it doesn’t come as a surprise that established corporates are also increasingly investing in early stage ventures, which changes the risk structure of their business as well. A recent study found that 38% of the world’s top 200 companies have set up innovation centers — accelerators and innovation labs– to work hand in hand with innovative early stage companies.
So how can investors upgrade their toolkit to accurately assess the strength of companies and products based on potential, not past performance?
Adapting to the Era of Instability
The rules of business and investing have evolved, thanks to changes to entry barriers and sources of competitive advantage. In the late Industrial age until the early ’90s, developing a new product required R&D grants, access to hi-tech laboratories and equipment, and funding. Now, anyone can potentially develop great products and services from the comfort of their own homes, using only a computer, the internet, and a range of D.I.Y.development tools. Similarly, production and distribution of products has been democratized thanks to Foxconn, Amazon (AMZN) and the likes.
In addition, products themselves have increasingly become intangible. Some of the most successful ‘unicorns’ like AirBnB, Uber, or Snapchat don’t actually have a unit product to sell. Amazon is no longer solely reliant on product sales, but has launched Amazon Destinations–a marketplace for booking local hotel getaways and Amazon Home Services, allowing users to book services like plumbers for their homes.
Where once there was predictability, there is instability. Established companies live in constant fear of being disrupted ,illustrated by the skyrocketing of accelerators, innovation labs, corporate ventures and defensive acquisitions. But even the best funded startups can crumble and fall as quickly as they grew. At this year’s World Economic Forum, SalesForce founder Marc Benioff predicted that 2016 will see ‘lots of dead unicorns’.
For the 21st century business, soft factors such as innovation capabilities can offer a competitive advantage, and provide more security for investors. But so can marketing. Like never before, the brand and community which a company creates around a product can be more valuable than the product itself.
Take the example of GoPro (GPRO). The camera component of the GoPro product was not particularly innovative in itself, and could have been reproduced, but what made GoPro a multi-billion dollar company was its creation of a community. GoPro doesn’t only sell the camera but also the experience of capturing and sharing adventures. The company built a community around the sharing of those experiences by pushing hard on social media channels and developing a strong presence on YouTube. GoPro’s main YouTube Channel has close to three million subscribers, placing it on par with media stalwart the BBC and ahead of established tech giants like Apple (AAPL).
Competitive advantages are now increasingly based on ‘soft power’ concepts such as customer relationships, social media impact, brand, innovation capabilities and design.
The tricky part is that these areas do not include capital assets and may require time to yield profits. As such, they cannot be easily tracked in the financials of a business, making it difficult to use the past as a predictor for the future. Understanding this change, and developing an efficient system to assess companies based on metrics other than previous sales and profit has become ‘the great need of our time’.
Like a software application may need an upgrade when the operating system changes, the investor toolkit needs a makeover.
Finding the Right Metrics
With so many changes, decision making for investors has become more complex. The modern investor needs to look at new metrics and profit alone may not be the best indicator of future success.
When trying to predict future performance, forward looking investors need to consider many factors, such as a company’s sales efficiency, whether the company is a middle man or sells directly to clients and whether the company will be able to ‘integrate’ their product with a larger platform or service. With changing unit economics, profitability has become a lot more complex.
In the same way that market leaders are pivoting to adapt to the current market, investors need to do so too, becoming change assessors rather than simply profitability hunters.
A starting point is to develop a solid understanding of the specific business model and its unit economics. Investors who want to understand a hardware company like GoPro also need to understand media economics. If they want to understand Amazon’s new home service, then they should get acquainted not only with retail but also with platform economics.
With this understanding they can see through which channels and at what cost the company acquires its customers. They will also understand why the customers stick with the company and whether this is sustainable. Understanding how the business model translates into customer acquisition cost and customer lifetime value is a good starting point to make intangible businesses tangible. Having the creativity to find additional metrics and indicators enables forward thinking investors to further upgrade their toolkit. Product reviews as well as interviews with customers can provide insights on a company’s innovation capabilities. Employee reviews provide valuable evidence on the culture that drives these innovation capabilities.
21st century investing isn’t as black and white as it was before the internet. As the variety of businesses has increased, so have our information sources. The key part of the toolbox has become the ability to combine analytic and intuitive thinking to determine the real hue of a business.