Between 1996 and 2002 , a new bubble was set by a wave of internet start-ups with mega valuations that defied traditional logic and norms. A new benchmark for assessing the intrinsic worth of such companies referenced multiples of quantums of losses or the rate of burn of cash while the idea of profits was a quaint notion. In some cases, value was attributed to numbers of customers—terms that have a nebulous relationship with conventional business drivers like profits, cash generation or even sales. The period saw a heady bubble fuelled by a plethora of investment companies flush with cash, creating a hugely speculative market with a domino effect across the globe. By end 2002, the bubble crashed and US stock markets lost over $5 trillion, triggering a fall in housing prices and jobs, bringing about a tailspin in the global economy.
Although India did not significantly experience the adversities of the dot-com bubble then, today it is very much in the midst of a start-up euphoria and one of the highest receivers of private equity (PE) and venture capital (VC) in the world, having received $35.1 billion in PE in 2018, a 35% increase from 2017 and a total of $120 billion in 2013-18. This expected gain or market size (much of it is speculative) when compared to the Indian GDP in 2018, at $2.6 trillion, amplifies the risk and effect such capital can have on the second most populated country in the world.
Bubbles are easy to spot in hindsight or in retrospect but always a challenge to accurately predict in real time. One research by Epoch Investment Partners identifies at least seven bubbles in the past forty years and all have two similar characteristics and, currently, we have both of these conditions—a flow of large tranches of money from investors in the US, Europe, China, Japan, etc, with high valuations based on unconventional models that have left experts perplexed.
Many explanations are given for the mega value of relatively small and loss-making enterprises but none appear convincing to theorists and traditionalists. Are we in a bubble or is it different this time?
The single biggest factor that is different today is the tectonic change that the onset of a digital revolution has brought about, which is probably more robust and powerful than any of the earlier technologies known to mankind. The alignment of big data with cheap computing technologies create intricate linkages and powerful business models which are superior to those developed in the 1990s. As Bill Gates explained recently, “Microsoft might spend a lot of money to develop the first unit of program but every unit after that is virtually free to produce. Unlike goods that powered our economy in the past, software is an intangible asset”. Intangible assets in 2018 represent 84% of the total market value of S&P 500, up from 17% in 1975.
The pace of technology change is constantly accelerating and business models also get incessantly enhanced, becoming more efficient. This ability to scale up in gigantic proportions, called ‘blitzscaling” by Reid Hoffman, founder of LinkedIn, is the essence of domination of firms that ends up creating a market dynamic that causes an extremely high concentration of these dominant firms. The race of capital is to back the one or two firms who will outlast the others in the industry due to its better model and scale. Take ride hailing aggregators. Today, the top two—Ola and Uber—have over 70% of the market, and other platforms like Meru, Easy Cabs, Sky Cabs etc, together with regional and hyper-local ones, share the balance but are constantly losing share. This phenomena of a near duopoly of profits is reflected in the mega valuations of the leaders against the rest in the market.
What are the factors that create such mammoth value? Experts believe that while some of the basic fundamentals of commerce like large addressable markets, sustained cash flows (at least in the future) and high gross margins are the bedrock of value for all e-commerce companies, the multiplier comes from an entity’s ability to scale with efficient capital allocation. Scale in this model creates viral growth with network effects, where every incremental increase in the number of users creates value for all users and creates disproportionate gains and market size.
Cornell University analysed the network effect in Amazon’s business model and found that people don’t buy Amazon Prime because they see other people buying Prime, but because Prime has gotten better because more people now have Prime! Because more people have Prime, Amazon has more warehouses and more distribution centres, etc, so they can bring people their items faster. Efficient capital allocation by managers where they spend on technology, infrastructure, and market innovation causes expenses to grow at a lower rate than revenues, creating the road to sustained profitability. Simple!
But, are we in a bubble? Time will tell but probably not, because this disruption is paradoxically positive. It is true that many companies of today with promise will fall by the wayside to more efficient, innovative and aggressive competitors. The winners will be the ones who can scale up steeply with constant innovation and technology adoption.
-The author is Director in Thought Arbitrage Research Institute