The imminent end to the free flow of cheap and easily available capital will surely raise more questions about the valuations of high-growth tech stocks and, in particular, startups that embraced the “growth at all cost” strategy. As we wrote last week, many of these companies have been able to scale up rapidly, gaining market share from traditional players through heavy subsidies funded by cheap capital — but are now faced with increasing pressure to turn those sales into actual profits.
In fact, this is no different from what is required of any business — that there must be a viable business model. Rapid technological advancements may be transforming our way of life at an unprecedented speed and scope but at the end of the day, technology is — and will always be — just the enabler. Similarly, no matter how exciting the tech-driven stories, success still depends on the “boring” underlying fundamentals like operating margins.
We have previously distinguished tech platform stocks based on whether they are social or utility ones — to provide better analytical clarity between the two. Very briefly, social platforms tend to have declining marginal costs and they see quick gains from the network effect, the combination of which turns strong sales growth into huge profits — and high valuations. However, these gains are not limitless, as was assumed, and at some point, will actually work against the platform as people do not want to be the same as everyone else. Hence, we see the number of Facebook users stagnating and even starting to decline. How and whether Meta Platforms (the parent of Facebook, Instagram and WhatsApp, among others) can reverse this trend remains to be seen.
The issues for utility platforms, on the other hand, are very different. The initial gains from the network effect are slow — you are not compelled to hop on the bandwagon simply because your friends and family have — but people also do not mind using the same platform as everyone else to order food delivery, ride-share, buy goods, perform payments and so on. More importantly, marginal costs do not fall quickly with more users, and are generally far from “approaching zero”. If marginal cost is relatively constant/flattish, then the path to profitability becomes highly dependent on the ability to raise prices (starting with subsidy cutbacks). And this, in turn, depends on the price elasticity of demand.
Many tech platform disruptors gain market share by heavily subsidising customers. But clearly, prices would eventually have to go up to cover costs — no business can sustain a perpetual cash burn situation. We think this is where the majority of investors may not yet fully comprehend the implications — lost among all the hype over total addressable market (TAM), market share gains and double- or triple-digit sales growth. What is the expected change in demand when prices are raised?
The price elasticity of demand is defined as the percentage change in quantity sold for each percentage change in price. Demand is inelastic when the quantity does not change when the price changes, and perfectly elastic when demand totally disappears with the smallest of price change. Most goods and services fall somewhere in between — the steeper the demand curve, the less elastic the demand is (see Diagram).
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For example, demand for oil and gas is relatively inelastic in the short term. This is why prices have soared on the back of supply disruptions caused by the ongoing war in Ukraine and resulting sanctions on Russia. With time, demand will become more elastic with increasing options for substitution, for instance, from renewables. Take another example, demand for very highend luxury goods such as Patek Philippe and Rolex watches or designer clothing and handbags from the likes of Chanel and Louis Vuitton is quite inelastic, even with time. The super-rich are unlikely to be swayed by price changes. On the other hand, demand for, say, a generic pair of slippers or T-shirt is very elastic. They are readily available and are more or less indistinguishable between one and another. Raise the price, even slightly, and people will move on to the next seller offering a better bargain.
Clearly, the price elasticity of demand depends on the availability of substitutes and alternative suppliers — which is all the more transparent for online platforms — and switching costs. It may not be static over time nor is it uniform across countries, even for exactly the same goods. Therein, we think, lies one of the biggest misconceptions for both tech companies and investors. Price elasticity of demand matters, and so does the target market. The pricing structure — and therefore, value of each user-customer — can differ greatly, based on the people’s “ability to pay”. And this, in turn, depends on their underlying standard of living and earnings potential. A case in point: The price of a Big Mac varies significantly around the world. McDonald’s can sell the Big Mac at a much higher price in the US than in Malaysia (in US dollar terms) — if prices were the same, we suspect a substantial portion of demand in Malaysia would evaporate overnight (see Chart 1). In short, pricing strategies must be a lot more nuanced. There is no one size fits all.
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Tech platforms therefore assess their operations in each target market differently rather than as a whole — decisions such as how much to spend on subsidies for customer acquisition should be based on the expected potential returns for that customer (market). An average user in the US would generally be worth more than an average user in Malaysia. A higher wage rate — the proxy for cost of time — implies that the US consumer would be willing to pay more for convenience and is able to, owing to the difference in income-purchasing power, all else being equal (see Chart 2). It also means that a business model that works in the US may not work in Malaysia.
For this very reason, investors should value companies based on their price elasticity of demand, user profiles and operating markets. This is why across-the-board application of a broad concept like price-tosales as a valuation tool makes little sense. It doesn’t take into account the price elasticity of demand and margins.
Right now, sentiment has swung against yet-to-be profitable tech platforms. Many are under tremendous selling pressure, on expectations of rising interest rates in a risk-off environment. Grab Holdings’ market cap has fallen sharply from its US$40 billion valuation at listing to just US$11.3 billion ($15.4 billion) at the point of writing. Less net cash of US$6.8 billion, the company’s underlying business is now valued at only US$4.5 billion. Surely, this is yet another sign that investors are overly emotional and sentiment-driven.
The Global Portfolio recouped some lost ground from the previous week’s hefty selloff, closing 3% higher for the week ended March 16. Some of the notable gainers were Grab (+12.4%), CrowdStrike Holdings (+11.7%) and Amazon.com (+9.9%). Meanwhile, Alibaba Group Holding (-5.8%), ServiceNow (-2.2%) and Apple (-2.1%) were among the big losers. Total portfolio returns since inception now stand at 45.9%, trailing the benchmark MSCI World Net Return Index’s 50% returns over the same period.
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Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
Cover photo: Bloomberg
