Does The Recent Fall In Tech Stocks Warrant Buying The Dip?

by Sourav Datta - Jan 25, 2022 03:12 PM +05:30 IST
Does The Recent Fall In Tech Stocks Warrant Buying The Dip?Tech Stocks Decline
  • Here are some reasons why catching a falling knife might not be a good financial decision.

New-age technology companies across the world have taken a beating, and Indian stocks are no exception. A few of these stocks have nearly halved from their peak, while others trade significantly below the listing price. Almost all of these companies, barring a few, have been battling losses nearly since their inception.

The steep fall in the valuations of some companies such as Paytm, has induced fear among the market participants – bringing into question the validity of the Initial Public Offering Valuations.

So, should investors buy the dip?

Probably not.

Here are some reasons why catching a falling knife might not be a good financial decision.

No Established Business Model

A business with an established business model is one that can sustain itself on its own without having to rely on external capital. Apart from FSN E-Commerce Limited (Nykaa) and PB Fintech (PolicyBazaar), the other companies have not displayed any signs of being near profitability.

Nykaa and PolicyBazaar operate near breakeven levels, with Nykaa having displayed profitability for a few quarters. These businesses could become profitable with relative ease if revenues rise or if basic cost-cutting measures are taken up.

But other businesses are far-off from the breakeven point. Even breaking even would assure investors, and allow them to create models for future earnings.

However, Zomato and Paytm are yet to form a business model that can reflect the business’ true potential. So far, these businesses have grown by raising funds continually and are yet to demonstrate cost discipline.

For Paytm, the path to profitability would likely be contingent on regulatory approval. The only way Paytm can begin generating enough money to cover its costs, would be to begin lending on its own books.

And if that happens, it would have to be valued as a bank, rather than as a technology company. Zomato has a price sensitive audience, and hence is reliant on heavy discounting.

In addition, most of the food delivery businesses over the world struggle with profitability, even in countries like the United States and China.

Lack Of Focus

The absence of a reliable business model also meant that some of these businesses have been trying their hand at various businesses with the expectations of at least one working out.

Paytm for instance has experimented with Paytm Mall, Paytm Money, Payments, lending and several others — none of which have given the explosive revenue or profitability growth Paytm expected.

Macquarie’s report highlighted that Paytm was spreading itself too thin by diversifying across various businesses, rather than focusing.

Paytm’s competitors are building similar financial supermarkets, but no one is anywhere near profitability.

But Paytm alone isn’t guilty of a lack of focus. Zomato, whose core food delivery business is still unprofitable, is investing in start-ups of all shapes and sizes.

It has invested in Magicpin, Grofers, Shiprocket, Curefit, Fitso, and was reportedly even in talks with Zepto for a deal. These investments have been made despite a surge in Zomato’s losses, even as the company’s revenue grew.

Zomato’s strategy of investing in other start-ups, especially when it itself has been unable to turn profitable is quite surprising. In addition, valuations of technology companies in private markets have been quite hot in recent years, and a devaluation of its investees could put Zomato in trouble.

Some of the deals could have a of conflict of interest as well. Shiprocket, for instance, originally received investment from Deepinder Goyal, the Chief Executive Officer of Zomato.

Later, the company raised money from Zomato and other investors. However, Goyal clarified saying that the company follows strong governance principles.

Goyal has commented on the company’s start-up investments as well, comparing them to investments made by Alibaba and Tencent. Both Alibaba and Tencent have been successful investors in the private markets.

However, these businesses began making these investments after building a sustainable business model that threw off extra cash — a business model similar to the one developed by Info Edge.

The investments could significantly decrease Zomato’s existing funds, which could ultimately lead to equity dilution for existing shareholders.

In contrast, businesses such as Nykaa, PolicyBazaar, and CarTrade, have more or less stuck to their core businesses. The prudent use of capital and strong focus on core businesses is usually a sign of a management that is focused on value creation for shareholders.

Should One Pay Up For Growth?

One justification that is continually given for the high valuations is the growth potential of these businesses. While these businesses are relatively easier to scale when compared to traditional businesses, does the growth potential truly justify the growth expectations of the markets?

It is rare for companies to demonstrate spectacular growth over a long period of time. It is even rare that the growth would be truly value accretive to investors.

Growth that simultaneously generates a high return on invested capital would be value accretive for shareholders, or else, such growth would mean little.

Given the fact that these companies are yet to find the right business model, it is difficult to determine whether growth would be value accretive. Further, whether rapid growth itself would prove to be sustainable without heavy discounting or cash-backs, and amid rapidly emerging competition, would be a key factor to watch.

Valuing The Business Is Difficult

The points highlighted above ultimately imply that valuing these businesses is a pretty tough task for investors. And without a strong understanding of business trajectory and valuation, it is difficult to develop conviction in one’s holdings.

For instance, would it make sense to value Paytm as a technology company, if it is burdened by the regulations and requirements of becoming a digital bank?

Would it make sense to invest in Zomato at today’s valuations, if it ultimately dilutes shareholder capital significantly?

The lack of even the most basic information makes it quite difficult for investors to determine even a rough valuation range for these businesses. The significant fall in stock should not be a reason for investors to buy the stock, unless they have a strong grasp on the situation. In today’s markets, there are several other opportunities that could yield good returns without a high risk of permanent loss.

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