Check your Ark for leaks
Over the past five years, disciples of Cathie Wood’s Ark Fintech Innovation ETF have had capital growth of 18%. This is a through-thecycle return that ignores the extraordinary peak-to-trough story that broke many hearts among market newbies during the pandemic. That was a time when media houses were giving Wood far too much airtime to share her nonsense with the world.
For context to that Ark return, “boomer” favourite Berkshire Hathaway has delivered capital growth of nearly 90% over the same period.
The aftermath of the pandemic has been an apocalypse for growth stocks. But as in all great zombie movies, there are a few that survived and even flourished. These are the companies that worked hard at building sustainable, profitable businesses rather than cashburning machines. Often, they had enough optionality in the business model to flick a few switches and improve the unit economics once a large enough market share position had been achieved.
An excellent local example is Purple Group, which now has vastly improved unit economics thanks to the introduction of monthly account fees at EasyEquities. The product remains compelling enough for its target audience that this had a net positive impact on the numbers. There aren’t many companies that can pull this off.
Pick the right costume
As for the start-ups that got eaten by the zombies, they’ve been the victims of macroeconomics and poor incentives. In a low interest rate environment, growth stock enthusiasts have a wonderful time. The market rotates from value into growth, as money is cheap and dreams are flourishing. Metrics such as user growth are far more important than profitability, leading to a growth-at-allcosts mindset.
These conditions allow investment houses such as Ark to put outrageous forecasts out into the world and attract capital flows in the process.
It becomes a self-fulfilling prophecy, with venture capital money flowing into companies that are given a mandate to increase the number of users. If that money gets pumped into advertising, or if pricing structures are kept artificially low, then it’s really not difficult to achieve user growth. Venture capitalists then write long blogs (or worse: white papers) about how wildly clever they are at picking companies with the potential to grow user numbers. More assets are put under the control of those venture capitalists and the cycle continues. Until it doesn’t.
When interest rates go up and money becomes expensive, the rotation out of growth and into value begins. As the tide goes out, the venture capital money dries up and so does advertising, which means user growth stagnates. Far too often, the product was actually a solution desperately in search of a problem. Founders can’t understand where the money went, especially after they hired huge teams of developers. The retrenchments begin, start-ups fail and venture capitalists blame the Fed for ruining their party.
There’s an important lesson in this: when it comes to growth stocks, investors don’t pay enough attention to unit economics. If the core business model is broken, then selling more products simply creates an even larger problem. When the funding runs out, the house of cards collapses overnight. You can’t (or at least shouldn’t) scale something that isn’t sufficiently profitable, unless you are convinced that the product is so good that the pricing can be increased materially down the line without losing customers.
The lack of focus on unit economics is particularly problematic for growth stocks because these companies are typically still establishing their market positions and proving their unit profitability. They are in a scaling phase, with investors asked to believe in the big dream rather than what is on the table today.
When it comes to most value stocks, you won’t often hear anyone talk about unit economics. Instead of thinking about growth and reaching profitability, value investors will focus on reasons the existing business won’t be disrupted. In other words, why the stream of cash flows at a cheap valuation might diminish or even disappear.
If you think about it, a successful growth stock probably disrupted a few value stocks in its chosen industry along the way, whereas a broken growth story is a company that wasn’t able to win enough market share or at least do so in a profitable manner.
Whenever you are tempted to invest in something, always give careful thought to the unit economics.
When the tide goes out, that’s the swimming costume you’ll wish you were wearing.