As of this bull market, fundamental investing is dead. Look at all the companies with outsized gains for last year and you’ll find that majority of them aren’t even profitable or worse, cash-flow positive. Yet their stock is skyrocketing which leads us to a simple question, why?
For those of you too lazy to read the entire article, the short version is that the market is incorporating VC (venture capital) elements such as betting on high growth while focusing on profitability later. In fact, a lot of venture capital firms don’t want their portfolio companies to be profitable because as soon as they start generating profit they won’t be seen as startups anymore and would have a lower valuation but this is a different story altogether which will be covered in a different article.
Let’s take a look at ARKK, an ETF focused on innovation. This fund focuses on highly speculative companies that are shoving their money into R&D in hopes of delivering a better product/service which in turn would deliver greater revenues. However if you look at the constituents of the ETF, a lot of the companies are not profitable. People are simply holding on in hopes that these companies turn profitable or get greater sales, similar to venture capital investing.
Above is a 1-year graph of ARKK’s stock price; you’ll notice that the dip last March where the pandemic was the most severe was only a slight blip in its bull-run and it continues to climb. Even if you bought at the high points in any of the months prior you would still be making money. So what’s behind this bull-run? The answer is hype.
Hype is also the same factor that’s driving venture capital. If you look where all the startups are spending their money after raising capital, you would simply invest in Google and Facebook! Why take on the risk of investing in a startup when all they do is turn around and spend it on advertising with Google and Facebook? Additionally, these startups are pressured to not be profitable and only focus on growing sales to justify their enormous valuation multiple. If they suddenly became profitable by a dollar, it would no longer be seen as a startup and its valuation would tank! We would not be surprised if the companies of ARKK faced similar pressure to retain their “startup” multiple and as long as they claim to be innovative, people will continue giving them money.
Now does this mean you should short ARKK or some other startup company? No! In fact, if you shorted ARKK you would actually lose money as indicated on the graph above. Valuations are through the roof for many of these companies simply because the venture capital mindset is creeping in and the market believes that these companies have “potential”. In fact, Uber is still losing money but its stock keeps climbing and now they’re expanding into helicopters and private jets despite their core car business being unprofitable. Growing sales from $1 to $1,000,000 is not impressive if we’re losing $2 per sale. It would be better to have fewer but profitable sales but the market doesn’t believe this. Thus, we’re stuck in a game of musical chairs and will just have to wait until the music stops for all to come crashing down.