In last week’s Mitch on the Markets column, I made the case that market pullbacks could boost the case for technology stocks. I elaborated by pointing specifically to strong price-to-cash flow metrics for some of the best names in the tech sector (relative to the S&P 500), while underscoring robust return on equity (ROE). Though I do not advocate market timing, I made the point that during market pullbacks and corrections, investors may be able to take advantage of better entry points for long-term ownership of some of the best earnings generators in the world.

I was referencing, of course, technology companies that actually generate positive earnings.

Year-to-date, we have seen an influx of exciting new technology IPOs. Many of these companies have flashy brand recognition with exceptionally fast growth rates and multi-billion dollar valuations. But many of them have also never turned a profit.

At Zacks Investment Management, our earnings-centric focus dictates that most – if not all – of these high-flying growth IPOs will not make their way into our strategies upon being listed. We need to see sustained earnings growth and rising earnings projections over time, and we want to own companies that beat earnings expectations consistently – not companies that have no earnings at all.

Back in the late 1990’s, many investors fell into the trap of buying newly listed technology companies for reasons other than earnings. There was widespread “fear of missing out” as money poured into dot coms with excessive valuations and negative cash flow. Most remember what happened next.

You could argue that we’re seeing a similar environment today, where many IPOs are listing at valuations that are sometimes double or triple what’s justified. Interestingly enough, however, the market’s reaction appears to be much different this time around. Many of the most recent high-profile IPOs have fizzled out of the gates, with investors wary of overpriced, overvalued companies with untested leadership and no clear path to profits.

I’ll give you five examples of what I mean:

  • Uber (UBER) – Shares have fallen nearly -30% since their debut, as the company said it lost over $5 billion in Q2 and reported its slowest revenue growth in the company’s short history.1
  • Lyft (LYFT) – Uber’s main rival is also yet to post a profit, and investors may see Uber as too difficult to surmount in the long term. Shares are off nearly -50% since listing.1
  • Peloton (PTON) – The fitness/bike start-up has reported deep losses for its in-house stationary bike technology, shedding -11% on its first day of trading and off about -2% since.1
  • Slack (WORK) – The company with a mission of eliminating email from corporations for more streamlined and organized communications is off nearly -40% since its IPO.1
  • WeWork (not listed) – The shared office space company experienced somewhat of an epic downfall in its approach to listing. It went from enjoying a private market valuation of $47 billion, to watching its valuation plummet to $15 billion and its CEO get ousted right around the proposed time of listing. Investors got a look at the financials and haphazard management, and punished the company for -$1.37 billion in losses in the first half of 2019. WeWork pulled its planned IPO as a result.1

Compare these names to a company like Google, for instance. Google went public in 2004 with a remarkably high $23 billion valuation, but the company had also reported a $400 million profit for the year. Amazon went another way, selling shares only three years after its founding in 1994, but with a paltry valuation of just $400 million. Amazon raised just $62 million in its IPO but is worth almost $1 trillion today.

The point here is not that any or all of these unprofitable IPOs are destined to fail. It may be that they all turn a profit within a year or two and start growing earnings at a nice clip. The point is that as long as they are losing hundreds of millions or even billions of dollars, in my view the risk, price, and valuation are probably all way too high.

Bottom Line for Investors

When I made the case for technology stocks benefiting from market pullbacks, I was referring to the crop of tech companies with established businesses, positive and increasing earnings, and robust leadership. In the IPO world, you may find companies with some but not all of those qualities, that instead bear the promise of exponentially fast growth rates and high risk/reward profiles. Not my cup of tea.

Disclosure

1 The New York Times, September 26, 2019. https://www.nytimes.com/2019/09/26/business/tech-ipo-market.html

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