This article was first published in the National Post on December 10, 2022. It is being republished with permission.
by Tom Bradley
Emerging technology and growth companies have been in the headlines constantly in recent years, though not always for the same reasons.
Until the end of 2021, they were on a roll. Investors wanted growth at any cost and interesting, innovative companies garnered stratospheric valuations and were able to raise seemingly endless amounts of capital. Growth was the priority. Profits could come later.
In 2022, investors changed their tune. They’re less starry-eyed and want to see profits, or at least a credible plan to get them. Later has arrived. Stock prices and private valuations have been crushed even though many companies are successfully executing on the plan everyone was so excited about last year.
I’m talking a lot about profits here because they’re needed to pay dividends and, ultimately, they drive stock prices. But investing isn’t about profits today as much as it is about what could be in the future. Mr. Market is always looking ahead.
How do successful growth managers identify future profit machines? Well, they all do it differently, but when they’re looking at early stage, growth companies (that is, no profits), the following factors are definitely on their lists.
Is the product or service addressing a need or solving a problem? Will it have a positive impact on how people live, or, as one manager puts it, “break down the barriers to human progress?”
Is it meaningfully better than what already exists? Growth investors are looking for game changers, not incremental improvement.
What will the competitive response be from incumbents? The size of the opportunity often depends on how quickly established firms can adapt or copy.
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How big is the addressable market? Investors want something that is applicable to millions or billions of users around the world, not something that targets a small niche.
Are there barriers to entry? A company needs to have an edge, or a lead, that will give it a competitive advantage. The size of the market matters less if it’s easy for everyone to join the party.
Are sales growing rapidly? The growth rate is important if the company is already producing revenue. It indicates how quickly customers are adopting the new idea. An innovation can be truly amazing, but the market may not be ready for it yet.
Is there recurring revenue? Growth investors will pay more for companies that have ongoing revenue as opposed to a one-time sale. They’re interested in razor blades, not razors.
Is the management team capable of building a large company? The founder(s) may be able to do this, but investors often want experienced, professional managers in the mix.
Who is backing the venture? The big, successful venture-capital firms make lots of mistakes (it’s the nature of the business), but their sponsorship of an emerging company is still an important factor in bringing on other investors. There must be something to the business if Sequoia Capital or Bill Gates is investing.
How much capital will be required to get there? This is more important than ever. There are still billions of dollars of growth capital available, but it’s being more selective now and driving a harder bargain.
And, importantly, is there a path to profitability? Investors are looking for products or services that will be profitable after they’re fully rolled out. Scale must equal profits.
As you look at the hits and misses in your portfolio, you might evaluate them against this set of criteria.
Does cannabis have any barriers to entry, or will it continue to be a free-for-all? Can Uber and Lyft make meaningful profits in a competitive, labour-intensive industry? How big is the addressable market for Beyond Meat?
Does Zoom have a big enough lead and is its offering unique enough to stave off Microsoft? Is WeWork’s model of committing to long-term leases and offering customers short-term flexibility sustainable?
Have the “buy now, pay later” companies adequately accounted for the risk of loan losses? And when there’s only two or three food delivery companies left standing, will diners be willing to pay enough for DoorDash to make real money?
Finding the next Nvidia, Shopify or Moderna is an art, not a science. There’s no guarantee the idea will scale and become profitable. There are no solid metrics to rely on. And, as we found out this year, the stocks are highly vulnerable to changes in investor sentiment.