Read our key Excerpts from a fantastic blogpost written by Buoyant Capital. (Emphasis Ours)
In his book, The Wisdom of Crowds, James Surowiecki argues that under the right circumstances, groups are remarkably intelligent and are often smarter than the smartest people in them.
He begins by telling the story of Francis Galton, the English Victorian-era polymath. In one of the poultry contests in 1907, some 787 people paid six pence for the opportunity to guess the weight of a rather large ox. A few guessers were farmers and butchers (maybe classified as experts), but a far greater number had no specialized knowledge of farm animals. Based on that, he anticipated his 787 participants would come up with a dumb answer.
The ox weighed 1,198 pounds. Galton took all guesses and plotted a distribution curve. He found that the median guess was within 0.8% of the correct weight and mean guess was within 0.1% (average guess was 1,197 pounds). The crowd, as a collective, just knew! They knew it better than the “so-called” experts could guess. How?
Surowiecki writes that two critical variables are necessary for a collective to make superior decisions–diversity and independence. One, if a collective can tabulate decisions from a diverse group of individuals who have different ideas or opinions on how to solve a problem, the results will be superior. Two, independence does not mean participants remain in isolation, but each member is free from influence of other members.
If the “smart collective” always comes to the right conclusion, how come we end up with booms and busts in stock markets? Why does the “diverse group” not come to the right prediction for the market as it did in Galton’s country fair?
Surowiecki argues that with markets, condition No. 2 (independence) is often not met and more so in modern times. People make decisions based on actions of others rather than their own private information. The age of social media accentuates this process.
And, it adds up. Prior to March 2020, the market had never fallen 35% in one month and never before had it recovered in one straight line; and yet it did.
Earlier, two cohorts existed: (a) “Trend followers” (momentum strategies) who bought more when prices rose (and vice-versa); and (b) “Fundamentalists” who bought based on underlying value. They used to balance each other out and historical market corrections (or recovery) were not as pronounced.
Increasingly, that difference has blurred. Whereas momentum strategies continue, fundamental investors have devised ways of valuing businesses that did not exist before. Thought process moves to relative–B is cheaper compared to A, hence one must buy B. Regardless of whether B deserves to be valued at current absolute valuations. PE multiples are just a state of mind, they say, right?
When everyone starts operating looking at others, it eventually results in market rallies (and corrections) assuming extreme proportions.
Blog 2 – NO SUCH THING AS A FREE MEAL, OR… FREE MAKE-UP, APPARENTLY!
Another fantastic blogpost on understanding business Vs valuation framework of young age fast growth companies. (Emphasis Ours)
Malcolm Gladwell has an interesting start to his book, Outliers. He argues that “I did it by myself” kind of explanations to success don’t usually work. Most of them are invariably beneficiaries of hidden advantages, extraordinary opportunities and cultural legacies that enable them to learn, work hard and make sense of the world in ways others cannot.
I was reminded of Outliers earlier this week as many brokerages presented their views on the upcoming IPO of Nykaa.
As Spark Capital succinctly put it (and I paraphrase) over the last decade, a lot of factors have aligned to create a conducive runway for growth for Nykaa i.e., the rapid penetration of smart phones, affordability of data, adoption of digital commerce, evolution of logistics ecosystem and Covid-led digital adoption.
The consensus opinion from most reports appears to be along these lines: (a) it is a great business; (b) in a nascent industry with a massive runway; (c) it has cracked it in a way that competition never would be able to (d) without burning cash … and that too; (E) right–the category and channel (there weren’t many players in online BPC space)
Consequently, it deserves to be valued quite close to stratosphere. Nykaa last raised capital in May 2020 at the valuation of USD1.2bn. One year later, by March 2021, news reports (1) had started pegging IPO valuation at USD3.5bn. By June 2021 (2) that rose to USD4.5bn. Most recently, one brokerage report suggested a one-year forward target of cUSD9bn.
The venture capital model runs on probability rather than cash flows. A 10% probability of 50x returns over five years implies 33% CAGR… that math is easy. For secondary markets: (a) cash flows; and (b) its timing, take precedence.
In developed economies, investments in new-age, hyper growth, cash burning businesses are treated akin to an investment in an ultra-high duration bond (a cash flow stream that will probably generate high cash flow after a long period). So long as interest rates stay very low, secondary investors happily match their ultra long-term liabilities with investments in equity of such businesses. The moment interest rates rise above a certain threshold, these equity investments become untenable to fund. And, without continuous funding, the ‘probability’ of future cash flows dwindles.
“Look at the mess the US economy and the Fed balance sheet is in,” you might say. “Why would the interest rates ever rise?” The short answer is, because economic activity is rising due to liquidity, not necessarily due to productivity gains.
Richard Nixon was inaugurated in 1969 and despite widespread belief of being ‘fiscally conservative’, he turned out to be one with “liberal ideas”.
In 1971, he broke away from the gold standard, which devalued the USD. Initially, the Fed in the 1970s kept seeing inflation as driven by high crude oil prices (and therefore “transitory”, which also saw mankind invent the term ‘core inflation’). Eventually, US had both–high inflation and high unemployment. By 1973, inflation doubled to 8.8%, on its way to 12% later in the decade. It eventually took a new fed chair Volcker in 1979 to raise interest rates to double digits, which put the economy in recession.
Milton Friedman, later, eloquently said it in his book Money Mischief, “inflation is always and everywhere a monetary phenomenon.” To summarize, something will eventually give in and interest rates will rise. May not be now, not next quarter, but soon enough. And once that cycle starts playing out, a lot of business models will become questionable. With that, valuations of all such businesses will be questioned.
Nykaa has created a phenomenal business out of hardly any investment. Even if evolution of the ecosystem benefitted the company, one must credit it for getting almost everything right. Regardless of that, the question of valuation is still one for secondary investors.
After reading this, while scratching your head, if your question for me is, “dude… I just want to make money on listing pop; will I?” I would do you one better and ask this in return, “if there is a huge runway ahead and the company isn’t burning cash, why the IPO in the first place?”