28 Oct 2016
Why we don’t invest in pre-profit companies
When talking to our clients we are often asked ‘Have you invested in XYZ?’, with XYZ typically being the latest Technology / Software as a Service / Biotech / loss making darling, which has just made the headlines for sometimes good, or often bad, reasons. Castle Point does not, in general, invest our client’s money in companies that have yet to earn a profit. This rules out a sometimes surprising number of companies from our opportunity set; nearly a quarter of NZ’s listed companies were loss making last year. Occasionally this means we do not participate in a great return, however, we do not suffer from ‘FOMO’ (fear of missing out), and remain very comfortable with our approach.
In the last 12 months seven New Zealand listed companies have doubled in value, and obviously made some handsome returns for their shareholders. Four of those seven are ‘pre-profit’, in terms of either negative operating cash flow, or negative earnings. In the same period five New Zealand companies have halved in value, and three of these five fall into the same pre-profit category.
Investing in pre-profits is clearly not a practice for the faint hearted. The same can be said for value investing, which we most definitely do practise. Rather, we believe that we have much better reasons for avoiding the pre-profit sector than any mere lack of constitution.
Valuing a pre-profit company is notoriously difficult, their business model has simply too many unknowns. For example, defining the size of the potential market requires assumptions about the product’s price. How does an investor know the product is priced correctly? We don’t know, although we do know the price is set low so as to gain as many customers as possible, and that it is not currently high enough for its supplier to make a profit. That covers a pretty significant margin for error. How do we know what the competitive landscape will be? We don’t know, although if a supplier does start to make a profit we can be pretty sure that any competitors will react rapidly to change that landscape. That’s two significant unknowns, and we are still nowhere close to even estimating revenue for our pre-profit candidate, never mind what any earnings may be.
In the absence of anything tangible (assets, predictable cash flows, or even dividends) to tie a valuation to, many pre-profit investors fall into the trap of making blue sky predictions, which can be dangerously close to believing the sky is the limit. The most straight forward of valuation techniques involves deciding we will pay ‘X’ times next year’s earnings. For a mature, stable company ‘X’ might be 10 or 12 times, for a company steadily growing above GDP maybe it will be 15 or so. For a company that should double earnings next year maybe paying 30x makes sense. If the earnings could double, then double again, and then double again, and then still grow, then even paying 100x next year’s earnings is justifiable. But even 100x is still a quantifiable amount. With no earnings to value, what is a fair multiple? There simply isn’t one. With no anchor, no tangible valuation, there can sometimes be no grip on reality at all, and participants start to believe the price paid by someone yesterday justifies the price being paid today. That behaviour tends to end badly.
Pre-profit companies run out of money. This shouldn’t come as a surprise to investors, but it often seems to. What happens when a company does run out of money is also fairly predictable. With few assets, and by definition no profits, they are not the ideal customer to the local bank manager, so it is invariably to existing shareholders that they come, cap in hand. The mathematics of how this works aren’t complicated, but can be unpleasant.
A pre-profit company was believed to have the potential to have a 30% share of a market that was worth a billion dollars, which meant some investors thought the company could be worth $300 million. With a market cap of only $200m they were very content with the prospects for their 1% stake, trading at $2 per share. The company has been steadily working its way through the $100m it raised at IPO, but now due to some delays in product development it’s going to need another $50m cash to get to a position where it can fund itself, so it’s going to do a rights issue. Existing shareholders will be ‘offered the opportunity’ to buy more shares at a ‘discounted’ price of only $1.80. This means another 28million shares will be issued. So investors will have a ‘choice’ to either cough up their share of the $50million ($500,000) if they want to maintain their 1% share of that market worth $300m, or they become diluted, and only have about three quarters of 1% of that market. 50% of the upside they had expected has just disappeared, and that’s before they realise that the delay in the product development has allowed competitors to gain traction. Now they may only be going to get 25% of an $800m market opportunity, and they’re under water. A vicious circle can develop, and instead of trading at $2.00 per share, the stock starts trading at $1.50. But it still needs $50m cash to reach break even, so is faced with a rights issue at $1.35, issuing 37million shares, and causing even more dilution for those that don’t want to take part. If the vicious circle really gains traction, what the issuer might call a ‘share purchase plan’ can turn into financial blackmail for shareholders; contribute more cash to maintain what could become a smaller share of an even smaller potential market, or be diluted to the point where the original investment becomes meaningless.
We don’t mean to bag every company that is not yet profitable. Very, very, few companies can be profitable from day one. Without entrepreneurial activity we would not live in the world we do, and as a society we desperately need more entrepreneurs to develop solutions to some very real problems we face. If New Zealand is to meet its aspirations to feature on the world economic stage we need entrepreneurs to help get us there, and we, as a society, need to help those entrepreneurs to do that. That being said, when our clients appoint us as guardians of their savings, we choose to honour their trust by first of all making all attempts to preserve their savings, before trying to grow them further.