Even if you are barely active in stock markets , whatsapp messages like below of technology stocks hitting all time high and making 5X or 10X in a year would be coming to you. This is in a year when we are in middle of a global pandemic
Value investors are simply downplaying the fact by calling it as 2000 internet bubble phenomenon and are not participating .
However I reckon that we are trying to fit square pegs (traditional linear models) in round holes (solving Non linear problems)
Evolution has taught us to think in terms of linearity
If you’re still having trouble grasping this, it’s not your fault. Decades of research in cognitive psychology show that the human mind struggles to understand nonlinear relationships. Our brain wants to make simple straight lines. In many situations, that kind of thinking serves us well: If you can store 50 books on a shelf, you can store 100 books if you add another shelf, and 150 books if you add yet another. Similarly, if the price of coffee is $2, you can buy five coffees with $10, 10 coffees with $20, and 15 coffees with $30.
Drawing parallels to public market investing, we love to own companies which can consistently increase sales and profits, generate excess cash then either redeploy it at higher rates within company or return it back to shareholders
Examples like below the profits trajectory of Costco fit the text book style of investing
But how will you apply traditional models to
Facebook which has increased it profits by 10 times in 6 years
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or Sales Force which has done even better improved profits by 10 times in just 4 years
The spread sheet analyst will find it impossible to put a valuation number to something like Atlasssian which is bleeding money
In short we are grappling with a problem that has been here for 20 years
Predicting the outlook for companies when traditional valuation models do not necessarily apply was a huge challenge during the dot-com bubble, and remains so today. If anything, putting a price on intangible assets like research prowess has become more critical as firms splurge ever-greater sums on hard-to-quantify investments.
This problem means many investors are going to miss out on outsized returns (J – Curve) when the so called bleeding companies start guzzling out profits
What’s the resolution ?
Acknowledge that Linear thinking and traditional models will not work for some of these new age companies
- Get yourself equipped with new tool set that can help value some of these companies, believe the place to start out would be understand how VCs value loss making companies
- View Operating leverage as Network Effects / Production Adoption
- Value Intangibles like Open Source Community Connect , Micro vs Macro adoption in enterprise tech ecosystem , 3rd party affiliation etc
- Cash generating ability – while Net income can be overlooked always look for self sustaining cash generation ability
- Finally and most importantly look for defensibility
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Then participate in 2-3 stories / companies by investing in them where you have understanding of the domain, its a learning curve and as value investors we need to unlearn before we get grip on this non linear way of thinking
Build frameworks
The best way to understand nonlinear patterns is to learn to recognise them. The HBR article does a good job on articulating them
By subscribing to scorecard you can look up some ideas I am finding interesting, I am constantly on look out
NB – all charts are sourced from here