Should you invest in rebels disrupting the marketplace?
They fill our inboxes, overwhelm our social media feeds and are permeating every aspect of our consuming lives. Their share prices are soaring. So should you invest in a ‘disruptor’?
It’s increasingly difficult to recall an age before Amazon – when we had to either visit the high street in person or wait weeks for deliveries at home.
The business is now the barometer for the latest thinking on everything from selling books (remember that?) to, most recently, how to break into the seemingly closed, oversubscribed world of TV.
From the outside it seems to do no wrong, using tech to leap lightly through the kind of business evolution that traditional leviathans of industry battle to wade through, often coming to a grinding halt or losing themselves completely in the process.
Amazon is without doubt the poster child for these “disruptors” – the term used with increasing regularity to describe the relative newcomers, the alternative thinkers, those businesses that have looked at a need, want or opportunity and found a different way to fulfil it, quickly and profitably.
You may be more familiar with these brands than you are with the traditional stalwarts whose existence they are disrupting. In the UK they are the Just Eats, Asos, and Purple Bricks of today’s consumer world.
So should you invest in them? In other words, now that they’ve set a furious pace for growth, can they also deliver on profitability? And can they stick to it long term?
At the beginning of the year, Amazon’s share price came in at about $750 (£570). Having smashed through the $1,000 barrier for the first time, at the time of going to press it was sitting at around $1,110.
With shares up by almost 50 per cent for the year, Russ Mould, investment director for AJ Bell, says investors still clearly think the company has the potential to hollow out older, bricks-and-mortar rivals and keep changing IT services, TV and other industries besides retail all at the same time. It has, or is building, a strong position in them all, and is nowhere close to touching the sides of the market.
“There is still a lot to go for, even in retail,” Mould says. “Amazon’s 2016 annual sales figure of $136bn represented less than 3 per cent of America’s total $4.8 trillion retail spending, while its revenues from IT services (providing servers for cloud computing, so other companies can manage their data storage more efficiently) and TV subscriptions are mushrooming.
“It may be these subscription payments are the key to the investment case for the stock. For a company valued at $550bn, its profits last year were small at $4bn, as Amazon continues to invest heavily in new products, services and technology while it acts as a price disruptor across so many industries.
“Stock market investors are clearly betting that one day – and who knows when – the company will mature, stop its land grab and start jacking up the price of its subscription services to ensure it turns sales into consistent profits and cash flow”.
If it does not do that at some stage then the shares look extremely expensive. That is the big risk with Amazon, from an investment point of view – if something goes wrong the shares could fall hard.
It is easy to forget that there is a precedent for that too. During the collapse of the tech-stock bubble in 2000 to 2003, Amazon shares fell from over $100 apiece to barely $8.
“When assessing Amazon, investors must therefore assess what could wrong as well as what could go right, just as they would with any other company,” warns Mould.
“We’ve seen a great deal of industry disruption across various sectors of late, mainly thanks to the rise of mobile computing and the effect this has had on consumer behaviour,” adds Laith Khalaf, senior analyst for Hargreaves Lansdown.
“The likes of Asos and Boohoo.com have entered into the territory of the likes of M&S and Next, Purple Bricks is taking on the established estate agency industry, while Just Eat is providing a new marketplace for takeaway food.”
And the optimism in those brands is playing out in the share price. Though not quite in the same league as Amazon, at the beginning of 2017, Just Eat’s share price was £5.84. It’s currently about £7.76. Purple Bricks started the year at £1.41 and now demands £3.57, while Asos was valued at £49.64 a share in January and now comes in at £57.15.
“Some of these companies have exciting prospects, but often a large amount of growth is already baked into share prices,” says Khalaf, who notes that Amazon’s share price currently trades at 150 times the profits it makes per share because the market is expecting such rapid growth.
“While Amazon is a truly innovative company, there is therefore scope for disappointment if it doesn’t grow as quickly as planned,” he adds.
Reining them in
The growth of any disruptor relies upon its ability to dislodge other players in competitive markets without itself being dislodged. But there is also the risk of another major sideswipe.
Regulators and government could try to rein in a company if it looks like it could become too powerful. And, once again, it may seem unlikely but there are precedents. And when they get hit, they really get hit. Back in 1911, for example, the US decided that Rockefeller’s Standard Oil company had become a monopoly and broke it up into no fewer than 34 different companies on anti-trust grounds.
But what about those disruptors that haven’t yet emerged onto the market. Uber is not quoted on the stock market at the moment, although new chief executive Dara Khosrowshahi has strongly hinted that there is a plan to take the company public by 2021 at the latest.
“If Uber does float, presumably in America, then investors can apply the same four-question checklist outlined by legendary US investor Charlie Munger,” suggests Mould.
“Do we understand the business? Does the business have an intrinsic value or a durable competitive advantage? Does management have high integrity? Does the stock come at a reasonable price?
“In the end, companies have to make a profit and need to pay dividends for them to sustain any kind of stock market valuation. Cash is king – that is the ultimate benchmark as it provides a tangible value and a tangible worth.
“If there is no cash coming out of them, all investors are doing is the equivalent of trading Match Attax cards, in the hope someone will pay more than they bought them for.
“Sometimes that works, such as during the bull markets of 1996-2000, 2003-2007, and 2009-2017. Sometimes it doesn’t, such as 2000-2003 and 2007-2009.”
The best of the rest
And what of everyone else?
These tech disruptors, with their global search algorithms and cloud-based platforms have driven greater transparency in the supply chain and threatened many incumbents in well-established industries, says Craig Bonthron, the co-manager of the Kames Global Sustainable Equity Fund.
“Bricks and mortar retailers, industrial distributors, previously imperious consumer staple brands and TV networks are all feeling the heat,” he says.
“From positions of high margins and returns earned via opaque pricing models or scale dominance, these companies are staring at strategic dilemmas. The costs of deploying new technology is getting cheaper and more scalable, and the internet giants highly public price transparency is deflating prices now and depressing future expectations.”
The conundrum now facing many investors is which of the incumbent companies are disruptable or “Amazonable” and which are able to weather the storm.
According to Bonthron, it is the established companies with big addressable markets and high returns on capital that are most disruptable.
He says: “When looking at companies that won’t be ‘Amazoned’ we look for the following characteristics – good vertical integration, controlling production distribution and customer relations, they offer customer price transparency, maintain high customer contact and offer high value products with an associated strong brand.
“Companies with these characteristics tend to exhibit the best pricing power. Businesses that have horizontal business models, opaque pricing and high returns are at risk, particularly if they are valued for their stability of earnings.
“This stability premium can quickly be eroded if a disruptor enters its market.”