Unicorns are unicorns in the VC world. In the listed world, they're just fragile horses with horns; unless they can win the derby, whilst still looking sexy and farting rainbows. 🦄
All those stocks that got listed in the last few months, with Zomato leading a new-era of successful start-ups entering the public markets, haven't performed well - and that’s an understatement. All of these stocks are down 23% to 64% from their highs.
Opening day returns
Return from high
This comes as a major shock to all those who invested in these stocks, especially after all the hype, eyeballs and media shelf-space they’ve gathered over the years as startups. To the eyes following all this buzz (and blockbuster listings), it seems tough to comprehend how they wouldn't do well on the stock markets. Let's decode some bits for you!
1. The startup-VC world operates differently from the stock-markets world 🪐
Let’s just first acknowledge that there are two different worlds - one where startups and VCs operate, and the other where listed companies and institutional and retail investors operate. When companies move from private to public, the investors determining prices change.
Valuations when funding privately through VCs and PEs happen basis negotiations, stage of company, ability of the company to scale, use of funds, and a tonne of other factors that aren’t really aligned with how stocks are looked at.
Price discovery is a function of one or a handful of players reaching a consensus at discrete time periods, and not thousands of investors determining it in real-time.
VC and PE investors have an inability to make quit exits. They have to wait for the next round of funding, or strike deals privately, for which time period are rather long. Things like supply, selling pressure, large investors dumping stock in the markets, etc. don’t push prices down dramatically in the private world.
The amount of funds raised and the valuations at are looked at with glory. These are vanity metrics as far as the markets are concerned. In the stock market, you have the choice of investing in companies that are large, well-managed, are in the high-growth phase, are generating profits and have healthy cash balances. One would compare loss-making, cash-burning, wavering-direction startups to these established companies and then decide prices. In essence, vanity metrics are great to generate news, but they may not mean the stock does well.
On listing, many VCs and PEs look for exits. They have been in illiquid situations for years before the listing. Some have made multifold returns already, and they are bound to sell stock in the markets, because well, they can. The same also applies to employees, who own stock options. In these companies, employee ownership is much higher relative to established and listed companies. They may want to cash out and want to make their money as well. This may not necessarily be because they don't see good prospects for these startups. Several promoters too are usually rich on paper because of the value of their shares, but not rich on cash. They may also look for compensation through selling off shares.
All these factors can lead to stocks falling despite nothing changing in terms of their performance, visibility, disruption, and any other factor that makes them fancy.
2. Market sentiment and the run for safety 🏃🏻♂️
There's a tectonic shift underway globally. For years, global central banks have been pumping liquidity into the markets, either through low interest rates (some negative interest rate scenarios seen too), buying of bonds, or even helicopter money.
With inflation spiking up, these practices are coming to a stop. In fact they are reversing. US inflation at 7.5% is a 40-year high. The Fed plans to increase interest rates to counter this. This has led to a sell-off in tech stocks even in the US. But why?
When the US increases interest rates, investors get better returns by holding debt in the US (developed economy) versus in India (developing economy with higher risks). The better risk-reward makes them take money out of markets like India, and invest in the US. When large selling happens, the markets fall.
Valuations currently are simplistically, a function of future cash flows of a company, discounted to the current time period. The discount rate used for determining the current value of future cash flows is a mix of interest rates and the equity premium that investors want for taking the risk of investing in equities. If the interest rates increase, the discount rate goes up. And when the denominator is higher, the value of stocks reduces.
When the markets fall, wherever in the world, investors tend to run for safety. They want to lose lesser money, or reduce the probability of losses in the future. They would sell more risky holdings, and invest in less risky ones. There’s a startup on one hand, which is high on losses and it has just enough cash to sustain for a year. And on the other hand, there’s someone like a TCS which is growing, generating high amounts of profit and cash, has the cash to sustain for donkeys years, and has a proven prudent track record. In times like this, people run for safer bets.
The price of a stock, also simplistically put is a function of the earnings of a company multiplied by the valuation. For companies with losses or low earnings, like the new-age companies, usually the valuation is very high because of future growth prospects, scalability, potential, and market sentiment. Market sentiment or the willingness to value a stock at a higher multiple reduces in a falling market. In a rising market, investors don’t mind paying a higher price for the same amount of earnings. When stock prices are more dependent on the multiple rather than earnings, naturally a de-rating in valuations tends to affect prices more.
What’s the future for these stocks then? ⏳
We aren’t saying these stocks won't perform well in the markets, don’t get us wrong! The timing of when they perform well and when they don’t is all we are highlighting. The reasons for their dramatic fall can be attributed to changes in market conditions, larger macroeconomic changes, and flow of liquidity out of these stocks.
Companies with good fundamentals, high-growth, strong profitability (or even the prospects of that), do tend to perform well. Although the stocks may not have performed well in recent times, if the future for these companies looks bright, they will perform well over the long run. One needs to fall back on fundamentally analysing these companies rather than letting recent price movements affect decision-making.
Hold on or sell off? 🤷🏻♂️
We have exposure to IRCTC in Rocketship, Data Patterns in Monopolies, and Zomato, CarTrade and Policybazaar in Disruptors. These stocks have hit our portfolio performance too. But we have been selective in what we like based on fundamentals and with a long-term objective. We monitor movement in performance and standing on a continuous basis, and rebalance every quarter depending on what the situation and prospects are.
Despite poor performance in the short term, we don’t mind holding on to companies, and even adding weight if the prospects look good. We keep our long term objective of beating the benchmarks and creating wealth for our users in mind at all times.