Forget About IPOs, This Is Better (And Safer)

Have you noticed all the hype about unicorns lately? 

No, I’m not talking about the mythical horned animals, but rather private startup businesses (usually in the tech sector) with valuations in excess of $1 billion. The term was coined by a venture capitalist in reference to their extreme scarcity. 

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By her own estimation, just 0.07% of all private companies ever reach the $1 billion level. But these beasts aren’t as rare as they once were. In fact, you might say there are entire herds of them roaming free. 

Not surprisingly, the internet is abuzz with talk of unicorns. I read once such article this morning. And then another around lunch. And then a few hours later I stumbled on a third. So out of curiosity, I did a quick Google search (side note: Google itself was one of the first unicorns) to see what was out there. 

Here are several of the more notable entries on the topic:

-Magical Thinking About Unicorn IPOs – Wall Street Journal 

-We Need More Unicorn IPOs – Bloomberg 

-Why the Unicorns are all IPOing Right Now – TheStreet 

-The Next Wave of Unicorn Startups – The New York Times 

-More than 100 Tech Unicorns Could IPO in 2019 – Business Insider

It’s easy to understand the excitement. Football fans might remember the 1983 draft as one of the greatest pools of quarterback talent ever assembled. It was chock full of Superbowl MVPs and future Hall of Famers like John Elway, Dan Marino, and Jim Kelly. 

​We might be looking at a similar phenomenon right now in the IPO market. Ride-hailing service Lyft (Nasdaq: LYFT) was one of the first highly-touted names to go public about a month ago. It was joined by its archrival Uber (NYSE: UBER). Other promising hopefuls making their market debut include business communication specialist Slack, internet lodging company Airbnb, and social media platform Pinterest (Nasdaq: PINS), among others. 

Business valuations among this group range from $15 billion for Pinterest to $17 billion for Slack to $38 billion for Airbnb to a whopping $100 billion for Uber. These four businesses alone have a combined value of $170 billion — greater than the market capitalization of entire countries such as Ireland and Greece. 

But are they worth it? That’s the real question. I would say no, at least not yet. In all fairness, I haven’t yet evaluated their books (most are still privately owned businesses). But I can tell you this: none of these companies has yet to turn an annual profit. 

While their revenue growth is staggering, most are still reporting steep bottom-line losses and spending colossal amounts of cash to attract new subscribers and customers. Slack lost $138 million in the latest fiscal-year filing. Lyft doubled revenues to $2.2 billion in 2018 but posted a hefty loss of $911 million. 

A Valuation Disconnect
Of course, it’s not really about what’s happening now. Investors are banking on future earnings potential maybe five to ten years down the line. Still, a lot can happen between now and then — including the emergence of disruptive new competitive threats. While projecting their cash flow streams might be a fun exercise, I’ll defer to professor Aswath Damodaran, widely known as Wall Street’s “Dean of Valuation”. He literally wrote the book on equity valuation. I’ve got a copy on my bookshelf and have also heard him lecture. Trust me, he’s as sharp as they come.

He valued Uber at $65 billion. That’s still an extraordinary figure. But it’s well short of what some pie-in-the-sky investors are willing to pay. He added that Uber is struggling to convert revenues into profits and that, “paying $100 billion for a company that still doesn’t have a viable business model is scary.” 


Beyond Burger packaging

How about Beyond Meat (Nasdaq: BYND), which makes plant-based burger substitutes for customers like Whole Foods? On May 2, the stock rocketed 160% on its very first day of trading, from $25 to $46, and has since surged to $80. 

There is certainly a growing market for vegan products. But Beyond Meat has only taken in a scant $56 million in revenues over the past nine months and is nowhere near profitability. By contrast, Wendy’s (NYSE: WEN) has 6,700 global locations that generate $1.6 billion in annual sales and $230 million in free cash flow — not to mention a dividend that was just raised by 18%. 

Wendy’s, which has been operating since 1969, has a market capitalization of $4.4 billion. Yet, in less than two weeks, Beyond Meat has already garnered a richer market price of $4.6 billion.

My Advice
That explosive growth is what makes these stocks so irresistible. There’s also the fear of missing out — we all want to grab the next Google or Facebook. You’ll have your chance. According to UBS, there are 162 private unicorns in the United States and a similar number overseas. Many from this crop will make their way to public exchanges. 

#-ad_banner-#But without prior due diligence, I’d keep a safe distance. I’m not saying to automatically avoid every new IPO that hits the market — only to be extremely cautious. For every winner, there are dozens of losers. Once the initial pop from the first week fades, newly-minted shares typically lag the market. One study from the University of Florida examined more than 7,000 IPOs over a 35-year period and found that over half (60%) went on to deliver negative returns over the following five years. 

And in my experience, the hotter and more exciting the IPO, the frothier the valuations get. That doesn’t mean these aren’t good businesses with exciting growth prospects. But once they hit the market, the low hanging fruit will have already been plucked from the tree. Once the six-month lockup period expires, the early financial backers and venture capitalists will be cashing out and moving on.

I imagine some of the first investors into Lyft last month at a price near $75 per share may already feel suckered with the stock having deflated back to $55. 

If you like the idea of getting in on the ground floor and aren’t one of the lucky few allocated shares in an upcoming IPO, consider business development companies instead. Also known as BDCs, these are companies that put debt and equity financing into small and mid-sized private businesses. 

We own one of the best over at The Daily Paycheck, my premium newsletter: Main Street Capital (NYSE: MAIN), which returns 90% of its profits back to investors each month. Aside from a compelling yield of 7.5%, the stock has delivered a powerful total return of 550% since we first added it to the portfolio back in 2010 (compared with 145% for the S&P 500).

You won’t find risky start-ups in the portfolio. Instead, MAIN looks for traditional or basic small-cap-sized businesses with solid track records. 

Perhaps not as exciting as investing in an IPO, but it’s safer.

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