Through this article, I intend to convey that (a) there is a difference between a great company and a great investment (we often do not acknowledge that) (b) the cycle of disruption is the only constant (what digital did to television, short reels is doing to digital), and (c) seemingly small issues can have a disproportionate impact on investments if there is not enough margin of safety.
Let me start by elaborating on the second point first, i.e., the cycle of disruption. The pressure on advertising revenues started last year when Apple changed how different apps tracked user data (or the Identifier for Advertisers (IDFA) policy). There is an old saying in commercial broadcasting, “if you are not paying for the product, you are the product”.
Data collected from apps and website cookies has been the backbone of the digital economy. Starting with iOS 14, users were given the ability to opt out of sharing the IDFA tag, and 62 per cent of users indeed opted out. The impact: $10 billion in lost revenues for Meta alone – c8 per cent of its annual topline.
Second, short videos have upended social media. TikTok has started luring billions of eyeballs away from Instagram and Snapchat. Meta’s loss would have been TikTok’s gain, but the latter earns only around $5 billion in revenues, a fraction of Meta’s. The problem: As our attention span shrinks, so does the time to serve us advertisements. Short reels mean lower ad revenues for the whole digital economy.
Third, with the onset of Covid, interactive entertainment boomed, and game publishers became big advertisers for digital platforms. As gamers start looking at screens other than games, these advertisers are starting to scale back as well.
The final nail in the coffin came in the form of rising interest rates, but that ties in with point (c) above as well – i.e., seemingly small issues having a disproportionate impact. It might sound counterintuitive that higher interest rates could result in lower ad revenues, but that is indeed true.
A sizeable part of aggressive venture capital-funded start-up businesses were starting to contribute decently to the digital ad ecosystem. With rising interest rates, the financing for many of them has dried up; ergo, lower ad revenues. In addition, the valuations of these platform companies also took a hit from rising interest
rates. They have a disproportionate impact on valuations, especially of businesses with back-ended cash flows. I have previously written about it but let us revisit it here.
In the exhibit below, you find two companies. Company A is a traditional company that has been generating regular cash flows and keeps growing. Company B is a new-age tech business that incurs negative cash flows for the first few years, and generates large cash flows a few years out. The total cash flows of both companies are the same, but the timing is different, which results in hugely different outcomes in a rising interest rate scenario.
Before I move to the final point, let us take a brief detour to whether we in India are in the same boat as these few digital platforms. The Indian ad market will likely hit $11 billion in 2022 (compared to $260 billion in the US, and $123 billion in China), driven primarily by digital advertising (growth of 32%) compared to television ads growing at c15 per cent.
The digital advertising market is closing in very fast with TV – as its market share will rise to 33 per cent compared to a 42 per cent share of TV. Considering that just a few years ago there was no digital ad market, this is a remarkable feat. This in turn has two implications. One, it forces large Indian broadcasters (like Zee and Sun TV) to increase their spending on creating an alternative digital presence (OTT), and two, investors are wary of paying premium valuations for such businesses; Zee trades at one-year forward price-to-earnings multiple of 16 times and
even lower in single digits.
I will finally end by elaborating on point (a) – i.e., the difference between a good company and a good investment. Many investors believe that their work ends when they identify a great business, and different investors come up with their own versions of elaborate mechanisms to do that. However, they then jump from a “great business” to a “great investment” seamlessly, which is problematic. In very pedestrian terms,
Chart 1 (on the left) is what many such investors believe in by implication – that earnings and share price of businesses move in tandem, and therefore, identifying a great company automatically makes it a great investment.
In practice, however, the world dishes out a situation that is more along the lines of
Chart 2 (on the right). When the market identifies a business that is growing its fundamental value (earnings or free cash flow) at a constant click, it initially gets excited, and valuations move ahead of fundamentals for a few years. At a certain point, the market realises that it is paying too much for this business and the stock prices flatline, for many years (Coca-Cola (1998-
2016), IBM (1999-2010), (1999-2010), (1994-2009), L&T (2007- 2016), (2009-2020), (2000-2018), Dr Reddy’s Labs (2015-2020), (2008-2014, 2015-2020) and the list goes on).
A great business in Chart 2 above is a great investment at points A and C, but a lousy investment at point B. The distinction between the two is often the difference between average and superior long-term investment returns.
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