Hope and optimism are a part of investing and that certainly is necessary when investing in social media and Internet companies. There's nothing wrong with high valuations for visionary firms seeking to grow in emerging industries. However, when valuations get to a point where there are no earnings and you are simply betting solely on future expectations, investors need to be aware that valuations eventually must be rooted in fundamentals. When private-equity firms and venture-capital companies invest in start-ups, their business is designed on a 1- out-of-10 philosophy. That means they hope to make a killing off one of their investments to absorb the losses in nine other losing ventures.
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This is a viable business model for venture capitalists, but is it the right business model for you as an investor?
When looking at current valuations of companies like Uber, Groupon, Twitter, Snapchat, etc., you are speculating on the ability of these companies to win in the marketplace as first movers in their respective spaces. That's not to say you should bet against driven visionaries seeking to disrupt current industries, but a healthy skepticism should be a part of your investment perspective when investing in these type of assets. If you look at these type of entities the way venture capitalists do, then you need to have 10 of these assets in your portfolio in order to capitalize on one or two home runs and make up for the companies that just don't make it.
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I recognize that this perspective is conservative and focused on old-fashioned measures such as viable earning opportunities and free cash flow. Technology companies in the social media space and other disruptive industries such as ridesharing, are not focused on earnings today. They are focused on capturing market share and monetizing this market share at some future point in time. For many social media companies, for example, the number of eyeballs glued to a particular app might one day lead to advertising opportunities as the media business morphs into a more online wireless environment. The opportunity is there for long-term success, for sure.
But just for a moment, stand back and recognize that, in the year 2000, the opportunity for success was there as well for companies like Commerce One and Netscape. Their future looked bright and the market opportunity was amazingly large but that did not stop an implosion that caused valuations to crater back to more earthly levels. I still remember the true believers' confidence in Sun Microsystems at over $100 a share state that the future was ironclad. "What could go wrong?," they said.
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What can go wrong in the current social media and crowd-sourcing space is that valuations based on earnings and free cash flow will one day matter. Some of these companies will be able to accomplish what Facebook appears to be successfully doing; turn relationships into advertising dollars. There is no dispute that some companies will win. Many will lose, however.
Diversification is a boring concept but regardless of the current frenzy in the tech space, it remains an imperative. Venture capitalists do it; so should you. Buy a group of tech visionaries with smaller weights instead of piling into one name. Be your own VC.