Zero Profits and Market Instability, Part 1

Last week I noted that the concept of profits appears to have been lost on a whole new generation of entrepreneurs. So-called tech unicorns – privately owned billion-dollar businesses supposedly at the cutting edge of technology – go to the stock market with dreamy IPOs and score insane valuations.

They do so without making a profit. It is now perfectly established that a business can go public without having ever made money. With the sprawl of this profit-free corporate culture, the stock market itself will gradually experience increased volatility. With increased volatility comes, eventually, systemic instability.

Accommodations broker – or limited-service travel agent – AirBnB is a case in point. Although this company has actually turned a profit at some point in its past, it is currently operating with an EBITDA (Earnings before interest, taxes, depreciation and amortization) that is half-a-billion dollars in the red. Its profit margin is a negative 28.9 percent, with an operating margin at -18.5 percent.

Despite all this, after last week’s introduction on the stock market AirBnB soared to a $100-billion market value.

DoorDash, a pizza delivery company, also made its IPO last week. Its profit record is even more astounding:

DoorDash has lost money in every year since its founding, citing the cost of developing its platform and expanding into new markets. Last year, for example, it spent $410 million to acquire Caviar, an upscale rival. DoorDash reported a net loss of $667 million in 2019 and lost $149 million in the first nine months of 2020. The company said it turned a profit of $23 million in the second quarter this year, but followed that with a $43 million loss in the third quarter.

It might be good to remember that not all companies notoriously operate at a loss. According to MacroTends,

  1. FedEx has reported a positive profit consistently since at least 2006, with only six quarters in the negative; during the same period of time their EBITDA has been positive every quarter except three;
  2. Coca Cola is one of the most solid companies in the world, with a positive EBITDA since at least 2006 and positive profits every quarter except Q4 in 2017;
  3. WalMart is as solidly profitable as Coca Cola, reporting a net profit of 9.86 billion in 2018, 6.67 billion in 2019 and 14.88 billion in 2020; their EBITDA is in the black and their net profits have only dipped into the negative in one quarter (Q2 2017) since 2006;
  4. General Motors has a profit track record comparable to FedEx: not big, but overall reliable; made a loss in 2017, but has reported a profit since then; their EBITDA is equally reliable;

By contrast,

  1. Uber has reported a negative EBITDA since 2017; they managed to squeeze in a net profit in 2018, but lost money in both 2017 and 2019;
  2. Tesla reported a negative EBITDA consistently until Q2 of 2016; for two years it was basically a wash, but since Q2 2019 they have been in the black; their profit has actually been positive for five quarters now.

Yet for some reason the stock-market euphoria is concentrated to businesses in the second category.* This euphoria has not subsided with the successful IPOs by AirBnB and DoorDash. On the contrary, these two profit-free businesses will now have money enough to keep going without profits for a good long time.

As they do, they contribute to a trend on the stock market, a trend where pure speculation drives market values. This trend, in turn, gradually becomes a threat to the systemic stability of the stock market itself. Specifically, the problem lies in how the market will guarantee that those who bought these stocks will get their money back one day.

Buyer interest in these stocks will not be based on the prospect of earning dividends; it is hard to pay out meaningful dividends when you, as with AirBnB, run a negative EBITDA and can’t even pay your own bills. Therefore, once the dust settles on these two IPOs and the initial investors have cashed in on the post-IPO euphoria, the next question pops up: who is going to buy the stock next time?

So long as this question is related to a single company, it is really just a matter for the fringe of the stock market. But when the profit-free business model becomes a sizable portion of daily trade, and when those companies take up meaningful space in investor portfolios, they start affecting the market as a whole.

The key term here is “liquidity”. A market that is highly liquid is a market where there is always cash available for anyone who wants to sell. Prices vary, of course, but where liquidity is abundant the fluctuations in prices will be limited and predictable. By contrast, the less liquidity there is in a market, the more volatile that market will be. The ebbs and flows of liquidity will translate into a price amplitude that adds to the risk an investor takes.

As risk increases, all other things equal, investors become more short-sighted. Risk increases exponentially with the linear extension of time; beyond a certain point, risk turns into uncertainty – which is not quantifiable – and investors have no real way to assess the possibility of getting their invested money back.

The risk, of course, varies with individual stocks, but by and large they all fall into two categories. The first is that which pays meaningful dividends, i.e., where the shareholder earns a regular income and therefore de facto gets his investment back in installments. Dividend-paying stocks reduce investor risk (again all other things equal) and therefore extend the time horizon over which the investor can hold the stock with relative confidence.

Stocks in the second category do not pay dividends. They, in turn, fall into two subcategories: profitable and profit-free stocks. The former present a reasonable prospect of future earnings and therefore give investors a sense of confidence that they – again – will get their money back. The latter, on the other hand, consists of stocks that do not even come with the confidence support that profits provide.

Investors in the dividend-free category can expect to get their money back by means of capital gains. The real problem is the profit-free subcategory, where there are no apparent vehicles for investor confidence in the operations of the corporation itself. Here, the prospect of a return to shareholders lies entirely in the hands of future investors.

Which brings us back to the liquidity problem. If prospective stock buyers do not feel confident enough that the corporation will become profitable, they will withdraw their money from the market. There is a decline in liquidity. When investors who hold stock in DoorDash, Uber or another profit-fee company, realize that there is a decline in liquidity, they start selling the stock to cut their losses.

At that point, the stock declines, and it can do so fast.

This is the prospect that every investor in profit-free companies dreads. His mortal fear of it is shared with the executives of the profit-free company itself.

It is also shared by stock-market executives and investors who do not include the profit-free subcategory in their portfolios. The bigger this subcategory grows, the more influential it becomes on the rest of the market. Investors who buy broadly have to adjust their investment policy to their growth; the bigger the high-risk end of their portfolio becomes, the more important it will be to counter with more solid investments at the lower end.

For a while, this counter-balancing can keep the market liquid. The problem is that the gap increases over time between the high risk in profit-free stocks and the low risk in profitable, dividend-paying stocks. As this gap grows, liquidity problems will emerge in terms of the higher-risk segment of the market.

With deteriorating liquidity, the risk of holding those stocks accelerates, and the run-away scenario opens up.

The key question for investors in the profit-free stocks is: how fast will we get to the point of deteriorating liquidity? We do not have enough experience with this type of stock to answer that question with quantitative confidence; essentially, the process taking us toward that point is in the hands of investors and their risk assessment skills.

What we do know, though, is that the more the liquidity of a market depends on expectations, and the less it depends on hard facts about the corporation itself, the more fragile the expectations are. In tangible terms: the higher the price-earning ratio and the faster it grows, the less of investor doubt it takes to bring the stock value surge to an end.

Plainly, as the profit-free segment of the stock market expands, investors are forced to be more and more speculative in their assessment of the market. Speculation is almost by definition a risk-generating activity. It is also an activity that provides a high inflow of liquidity so long as the market is bullish, but rapidly pulls money out when pessimism takes over.

The more speculative a market is, the less liquidity can be expected in the future.

This is the systemic instability that everyone wants to avoid. But how can we do that when the market itself generates it?


*) In fairness, Elon Musk is actually trying to turn Tesla permanently profitable. His efforts essentially mean that he is trying to move the company away from being a “tech” business and toward being a traditional manufacturer. He still has a long way to go; so far, Tesla’s recent profitability has come at the price of deplorable product quality, with JD Power ranking Tesla worst of all brands on the U.S. passenger vehicle market.

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