Peter Lynch, the former manager of Magellan, the once famous Fidelity mutual fund, advised people to invest in what they know.
But when it comes to the latest tech IPOs, that is very bad advice.
The reason is that public company investors are smarter than they used to be. They realize now that just because they use a company’s product, it does not make the company’s stock a good investment.
When Lynch — who presided over a money-making period in Magellan’s history from May 1977 to May 1990– published his now-30 year old book, One Up on Wall Street, the idea of investing in index funds that would yield attractive after-fee returns had not been popularized.
Instead, Fidelity promulgated the idea that its handpicked investment stars could pick individual stocks and more than make up for the high fees that investors had to pay to get access to their talent.
But Lynch’s book seemed to set the stage for individual investors to try their own luck. His argument was that “by simply observing business developments and taking notice of your immediate world — from the mall to the workplace” investors can get the jump on professional analysts and discover stocks that go up ten-fold.
Things have changed in the last 30 years. When it comes to investing in IPOs, for example, during the dot-com boom, investors sometimes did not require a company to even have revenue for it to go public.
Venture capitalists and public companies that would create a subsidiary — such as CNN.com — and sell its shares to the public knew that the bubble was poised to burst. So they rushed their companies to the public markets and landed quick gains.
These days investors — with the exception of those who purchase shares of biotechnology companies — require revenues. In general, investors like to see $100 million or more and growth of 30% to 40% in order to buy shares in an IPO.
But, as the Wall Street Journal pointed out, there is another phenomenon that’s occurred over the last decade — much larger pools of money, such as Softbank with its $100 billion in capital, are seeking even bigger private companies in which to place capital hoping to make huge gains on giant investments in companies that fit Lynch’s buy what you know dictum.
These giant private consumer-focused companies — like Uber and Lyft — have more money than they would normally need were it not for the relentless pressure they face to sustain their 30% to 40% even as their revenues reach into the billions of dollars. All that capital goes to cutting prices below costs to gain market share — which keeps the companies afloat despite their high burn rate.
To be fair to Lynch — he suggested that investors analyze companies that they learned about through personal experience. And based on my analysis of Uber and Lyft, he may well have advised investors to pass on these companies.
It seems that individual investor familiarity with the brand — that used to be a big help to investment bankers who flogged these companies before their IPOs — is not enough to compel investors to buy the stock.
Instead, it appears that investors are happy to opt for more obscure companies if they can grow faster than rivals and also earn a profit.
I am guessing that none of the investors driving down shares of Uber and Lyft have read my new book, Scaling Your Startup — which offers an effective solution to the problem these money-losing companies face: make sure you have a scalable business model before you invest in growth.
In the book, I suggested that in the journey from idea to large public company, a CEO should pass through four stages of scaling. But Uber and Lyft chose to skip the second stage of scaling– Building a Scalable Business Model— rather than jumping to the third stage– which I call Sprinting to Liquidity– before they accelerated their growth.
A company with a scalable business model gets more efficient as it grows in key processes like selling, marketing, service, and product development. At the same time, it must develop new products, win new customers, and provide them excellent service so they will keep buying the product.
Zoom Communications — whose IPO was so successful that it is now worth around $19 billion, or roughly 19 times its peak private share price, according to the Journal — did not skip the second stage of scaling.
First of all, Zoom has became more efficient as it scaled. This shows up in its numbers — for instance, as I wrote in April, in the year ending January 2017, operating expense to sales was 79% — the same as in January 2019. Meanwhile, Zoom’s gross margin increased from 79% to 82%.
At the same time, it has been much more responsive than competitors to the requests of customers for new product features as I wrote last month. As a result, its product has become more valuable to customers — yielding a net promoter score of over 70 in 2018.
Startup investors are too greedy. Rather than leave upside opportunity on the table for people who invest in a company after it goes public, too many VCs push their portfolio companies to grow as fast as they can to boost the value at which they can take it public and get out.
The earliest investors in Uber — whose July 2010 seed round valuation was $4 million — have certainly done well with that strategy. Even though Uber’s valuation is $30 billion below the $100 billion at which Uber’s bankers hoped to sell its shares to the public, those seed rounds investors are not crying.
After all, they’re sitting on a cool 17,500-fold increase in their investment. At that rate, a $100,000 investment in Uber back in July 2010 would now be worth $1.75 billion. By contrast, an investor who purchased stock in Uber on May 10 has enjoyed no return at all.
But had Uber’s investors encouraged the company not to complete the second stage of scaling, as Zoom did, perhaps those Uber post-IPO investors would be much better off.
One thing is for sure — if Uber and Lyft had enjoyed the kind of post-IPO performance that Zoom did, the overall tone of the IPO market would be much more optimistic. And that would help the sagging reputations of the venture capitalists and help the bankers they hire to take more of their portfolio companies public in the near future.
Buy what you know does not work anymore.
My advice for anyone considering investing in an IPO is to figure out whether the company has a scalable business model. If it does, wait until after it’s been public for a few quarters — after which locked up insiders can sell chunks of their holdings — before considering whether to buy.