Start-ups: Does one participate?

The sky-high valuations are worrying, but can investors just ignore these companies?

The Indian start-up scene is incredibly vibrant. Every week we hear of another unicorn being created. Transactions are now on a global scale. Witness the $3.6-billion raised by Flipkart, or the just announced $4.7-billion sale of Billdesk to Prosus. These are global scale deals and demonstrate the coming of age of the Indian start-up ecosystem. This is wealth creation and monetisation at a scale seen rarely outside Silicon Valley.

There are numerous reports highlighting how this trend will only deepen and further accelerate. India currently has 65 unicorns, most expect this number to cross 150 by 2025. The top 10 unicorns already have a market capitalisation exceeding $125 billion, this is even before they have gone public. Since 2014, start-ups have raised over $70 billion and the current value of the ecosystem exceeds $300 billion. It would not be an exaggeration to assume that today’s start-ups will be a significant chunk of market capitalisation in the coming years. The path for domestic listing has been laid. These new age disruptive business models should make up an increasing share of the economy and therefore of the markets as well. I have little doubt that following Zomato’s listing, at least 35-50 start-ups will attempt to list in the coming 18 months. This poses a dilemma for public market investors. Should they attempt to participate in these new listings (IPO or pre-IPO) or stay away?

Most valuation conscious investors find it difficult to understand the multiples being ascribed to these businesses. They struggle with the valuation metrics being used and suspect that no one really knows how to value these loss-making businesses. There is a limit to the relative valuation argument.

Seasoned investors used to paying 20 times earnings cannot understand how do you willingly pay 20 times sales? Will these companies ever make a profit? They are priced as if they will dominate their respective industries and wipe out the incumbents. Is that realistic? When you enter at these valuation multiples, even if the company delivers on all its potential, will you make money? These are legitimate concerns.

Many investors suspect that we are in bubble-like market conditions for these new age disruptive companies. The bubble is not just in India but across the world. The hype is immense and in the momentum and euphoria all types of businesses are getting positioned as technology-enabled or disruptive. A combination of extremely low interest rates, excess liquidity, lack of secular growth opportunities and the value created in technology companies globally have all combined to create the euphoria. Long duration growth assets have been bid up disproportionately.

All this is unambiguously positive for the country, the more capital raised the better, but not necessarily so for investors putting their capital at risk.

Illustration: Binay Sinha

So what should public market investors do? You will have this wave of new listings coming to the market. Most priced at valuation levels you do not really understand. However, for the most part, these are very good companies. First generation entrepreneurs, backed by top venture capital and private equity and with disruptive business models. Can one just ignore them?

There are some investors taking that approach. They consider this is a bubble. They do not understand the valuations and prefer to ignore this whole space till the bubble pops. Buying these companies at the IPO is effectively playing the greater fool theory. So, they will not buy something they do not understand. Their argument is that they have seen market cycles before; this hype will die down and valuations normalise. Markets, in their view, are underestimating the incumbents and the valuation pendulum has swung way too much in favour of the challenger business models. They argue we just needs one or two of these new listings to flop and better sense will prevail. Perfectly reasonable arguments. A disciplined approach. Makes sense to emphasise caution when uncomfortable.

There are others who are taking a slightly different approach. Their point is that from all these new listings, the future blue chips of the market will emerge. The next blue chip to emerge in India will not come from an established business house or be an incumbent player. It will be a disruptive business model, funded by start-up capital. This is where the next $100-billion market capitalisation company will come from. India will leapfrog, as China has, and technology adoption cycles will keep shortening.

These new listings will eventually make up 15-20 per cent of the market capitalisation. One cannot afford to just ignore the whole pack of new listings. One has to pick their spots and the companies they think will scale. The risk is paying too high a price today, therefore they must size their positions accordingly. Be prepared for these companies to have a drawdown at some point. When their prices crack, investors must have the conviction and capital to scale up their holdings. They cannot panic at that point. These are the companies of the future. Some of them will dominate their markets and create huge value. If one focuses on the leaders and the best business models, then one is taking price risk, which can be managed through position sizing. For all anyone knows, even after correcting these companies may still trade above their IPO price, depending on the scale-up and when the correction comes.

Investors will have to decide whether they wish to participate in this wave of new listings. Not an easy decision if you are a disciplined valuation-conscious investor, worried about market cycles. The short-term odds are stacked against buying. However, longer-term investors may have a different point of view. The future leaders of India Inc are being created in front of us. Can you afford to be totally absent?

An interesting dilemma. Ultimately, each investor will have a different answer depending on tenure of capital, flexibility in investment approach and willingness to handle drawdowns. There is no easy or even right answer. Like in many other things, in investing, it just depends on your circumstances.

The writer is with Amansa Capital