Watch out for the tipping point

IAM properly allergic to bee stings. It’s got nothing to do with my DNA (I don’t think). You aren’t born allergic to bees, you become allergic — it’s a tipping-point allergy. At some point a sting just results in a swollen finger, and the very next one can cause anaphylactic shock, swollen closed windpipe, suffocation and death.

Let’s face it, that tipping-point sting is highly inconvenient. And so it is with the marginal disutility of capital investment — the turning point is difficult to call, but the bubble burst is devastating.

It is hard to fully capture the significance of Uber — partly because it was so ingenious and partly because it’s not done with its inventiveness yet. At its core, though, Uber had two things for me. It came looking for you, you didn’t have to go looking for it; you no longer head outside to find a lift, you order it in; and Uber values its customers above their custom, turning all users into an effective marketing force.

It should therefore come as no surprise that, even somewhat down the road in its valuation, Uber raised $3.5bn from the Saudi Arabia sovereign fund as the equity piece of a total $5.5bn capital raising deal. The $3.5bn got them about 5%. With the cost of debt close to zero, it is obvious that debt will increasingly form part of the capital mix, at least until quantitative easing ends.

The competition, more classically defined as the taxi industry, isn’t standing still. Of course, Uber doesn’t see the competition as taxis, it sees itself as competing against car manufacturers, questioning whether we, as individuals, should own cars at all. In China, Uber’s competition, Didi, has raised even more capital ($7.3bn) in a similar debt/equity mix. Everyone is getting into the game.

Who can blame them, but where will it all end? How much can a startup in an “established” industry dare to raise, and at what price? Didi, a startup, is valued at $25bn. That’s not chopped liver.

Uber’s numbers are impressive — at well above 10-million users who have taken altogether more than 1-billion rides in more than 400 cities; a lot of clients and a formidable barrier to entry, you’d have thought. The capital, interestingly, is mainly being raised in the private equity world, not through public listings on stock exchanges, probably because it is impossible to value these “unicorns” using conventional valuation techniques. A unicorn is no longer just an imaginary horse with a spiralling horn coming out of its head; a unicorn is also a startup (whatever that is) with a value in excess of $1bn.

At the centre of most of these prospective billion-dollar ventures is technology, more particularly the mobile phone. Everybody who’s anybody has (at least) one, so everyone is accessible — just under 5-billion people, about 60% of the global population, have cellphones. Unthinkable, unbeatable penetration, but does it ever reach saturation levels in economic return terms?

I think it does, and the law of diminishing returns agrees with me. A point will be reached at which the level of profit gained at the margin will be less than the money required to get there. There are a number of reasons for this.

It has been true, and may remain true for some time yet, that the valuation of companies has moved away from classic measures such as price:earnings multiples, embedded value and other net asset value metrics, towards measures of the success of client acquisition strategies.

Amazon had about 1.5-million users in 1997. That has grown exponentially (literally, it fits the curve y=ex) to well more than 300-million today. Amazon’s market capitalisation has grown in a similarly spectacular way, from $1.3m to $350m, but the rate of growth has slowed down. By comparison, its net profit has flatlined over the past two decades. As a reality check, Amazon is valued at more than Walmart. Similar analyses would no doubt yield similar stories for Facebook, WhatsApp and others.

How long can it last? Product push strategies are surely limited by ultimate consumer spending capacity and selection as more and more services need to be delivered and adopted within a fixed budget and finite time.

The challenge for investors is when to get in. How much validation of client acceptance and economic harvest (only emerging recently in Amazon) should you wait for before joining in? Who knows? I don’t. I can only refer to the sage advice once given to me, not to start drinking when everyone else is already drunk. When exponential growth becomes normal growth, as it inevitably does, stratospheric valuations become normal valuations and that is a huge drop. It happens so quickly, just one day as one of the lead steers is seen quietly leaving the game, with his cash. Valuations are after all, nothing more than a popular consensus of the present value of future expectations.

It’s probably better to back more horses earlier than fewer later — a few spectacular successes will easily pay for many failed experiments — but we’re just not as easily convinced about the next app for our smartphones as we were enthusiastically impressed with the first ones.

Of course, there have been enduring successes like Google, which is now so much the preferred search engine that it

I can only refer to the sage advice once given to me, not to start drinking when everyone else is already drunk It’s probably better to back more horses earlier than fewer later — a few successes will easily pay for many failed experiments

spends time fighting sovereign regulatory resistance battles disguised as anticompetitive protection initiatives. I disagree with this. Google took risk, grew to be the best and it keeps getting better. Do that and you deserve every bit of entrenched market share you get. You have to virtually “contract” market share to maintain a position of leadership and earn the economics to afford continued innovation. The catchup time for competitors can’t be more than a few months in techbased startups nowadays.

Are we going to see the next tech bubble burst soon? I don’t think so, but I do see a lot of “also-rans” and latecomers not making it. Google has more than 2-million apps to choose from and the Apple store is not far behind. At some point, surely, there’s just not enough time in the day to use yet another app. Already “app-time” has increased from 45 minutes a day five years ago to four hours a day this year (no, I don’t know how they measure that). Where do they get the time? Not all apps save us time.

I think our mobile phones are filling up and the economic escape velocities of new ideas will be increasingly hard to reach, despite a vast installed user base, within acceptable capital return and running yield considerations.

I wouldn’t try and second guess the timing or bet against tech — the next great idea is already brewing in some garage and we’ll only acknowledge its simplicity once its inventors have made it obvious to us. That’s the genius, that’s what keeps capital pouring into this sector, for now.

Bees are different, bees don’t sting each other.