The IPO boom in internet stocks: How to separate the good from the bad

A conversation with Haresh Chawla, partner at True North, and Saurabh Mukherjea, founder, Marcellus Investment Managers

Founding Fuel

Does the slew of Indian internet companies looking to list on the stock market represent a new India rising? Or is this a mirage?

This conversation with Haresh Chawla, partner at True North, and Saurabh Mukherjea, founder of Marcellus Investment Managers, unpacks that question. The conversation, anchored by Indrajit Gupta, co-founder, Founding Fuel, was part of the Morningstar Investment Conference, 2021, held in November.

Kaustubh Belapurakar, director for fund research at Morningstar, set context by presenting an overview, based on data, of how internet IPOs around the world have performed since 2009. 

Key Takeaways

The data from across the world shows winner takes all

  • 270 internet companies listed, across categories, since 2021.  

  • While their average returns look healthy, it is skewed by outsized performance of a few stocks.

  • Information technology firms (ecommerce, payments, SaaS) have been the standout listings.

  • Travel services stocks saw the most erosion in value, especially post Covid.

  • Specialised online retail (cars, beauty products, food retailers) have done reasonably well.

  • Mid caps did well, and probably listed at a sweet spot in their growth.

  • Small caps, with unproven proof of concept, have struggled.

The big picture behind that data

  • Tech companies redefine the context: They reshape the industry rather than compete in it. Take Tesla—is it a car company or a software company? They change consumer behaviour.

  • It is intriguing that in this age of technology such few internet companies have listed—only 270 IPOs, across the world, in an 11 year period (2009 - 2021)—about 2.5 IPOs a year across the roughly 10 major stock markets in the world.  

    • It shows that successful tech companies actually don’t need that much capital. These are “empires of the mind”.

    • Roughly 1 in 6 of these IPOs have delivered money over the cost of capital. This tallies very well with what you see in India—85% of BSE 500 companies have given you returns below your cost of capital, below 15%.

  • You have to be very picky with IPOs. Tech will not shake the [investing] world. We will make money if we are sensible and discerning investors. 
  • As an investor, your challenge is, should I be in an internet company or should I be in a traditional company? And within an internet company, which one should I choose?

There’s an epic consolidation of the Indian economy

  • India is unique in that in the last 10 years, it has gone through a confluence of three factors and the impact is electric; it goes well beyond technology: 

a) The networking of the country: doubling of the highway network; five-fold growth in domestic air traffic; every family now has a bank account. Typically, in any era, when you network the country, you consolidate industry—you kill local and regional players.  

b) The rise of SaaS, cloud, and mobile: It allows cash generative smaller companies to transform their business by using low-cost world class tech.

c) The attack on black money will give easy access to domestic capital: 95% of Indian household wealth is owned in gold and real estate; the bulk of that wealth is black money. Roughly, Indian household wealth is $10 trillion, of this, $9.5 trillion is in physical assets. As you toggle even $1 trillion into the financial economy, you will bring down the cost of capital—it will make angel funding available, bring down the 10-year bond yield, and stoke the stock market.  

  • In 2010 India’s top 20 companies accounted for just 30% of national profits. In 2021, India’s top 20 companies account for 95% of national profits. We are formalising and consolidating the entire economy. 

  • A part of the spoils will go to tech companies, but there are many other well run companies that are not tech companies but are using technology.

With frictionless supply, demand will go up

  • You will see a lot of growth stories. Covid transformed behaviour; the number of participants and frequency of consumption have gone up.

  • There is massive adoption of technology (UPI, delivery). When you make supply available at a fraction of the cost and take away friction, demand goes up. The addressable market for companies—not just startups but also well-run companies that use technology—will be larger.

  • Technology also helps companies collaborate. Ola collaborates with maps and payments.   

How to discern a good tech company to invest in

  • Accounting transparency: [For traditional brick-and-mortar companies] you can see where cash is being generated and where it is being invested. That diligence is not possible with tech companies. It is difficult to tell which areas of their operations are cash generative—or even that they are indeed cash generative.

  • Be sceptical if they are looking to raise a lot of money: Historically, the best tech businesses don’t need much capital. For example, Naukri became cash generative on a couple of million dollars. More recently, Nykaa has come to profitability on well below $50 million; Policybazaar promoters say they built on $70 million. 

  • Stable leadership: Fundamentally a sound business with strong moats. And with corporate governance, succession planning, and team dynamics nicely in place.

  • The investor needs to have creative imagination too to evaluate these companies. 

    • Inherently these are high-risk businesses; their moats are easy to attack and can be disrupted overnight. 

    • Stage of the business matters. Is it already in monetisation mode? Or still building distribution and market share? Google Photos stayed free and destroyed the entire photo sharing industry. Suddenly Google decides to not include it in the 15GB free storage gift with the Google account. Suddenly, 15 years later, you have a multi-billion dollar cash flow coming in from this little asset.  

    • Does it have optionality? Nykaa is a perfect example. They have the user data and they can use it to sell apparel to the same women, virtually at zero cost.

  • The tech basket you need to look at is not just startups, but also older companies that are using tech and digital in a big way. Look at digitally powered data businesses; they will create enormous value.

  • Some of the losses they incur are going towards changing consumer behaviour. The challenge for the investor is to see if the consumer behaviour change is sustainable and will it become profitable sooner than later.

  • The index doesn’t yet reflect the realities of a vibrant India, the intellectual property rather than physical assets on the ground.

  • Price multiples (ratios such as price-to-earnings (P/E), price-to-sales (P/S), price-to-book (PB)) have no utility at all—even for the Old Economy. Instead, try and judge how long the company can sustain its cash flow generation. 

  • Is the company doing a transactional business, or is it building a higher frequency engagement with the customer? 

  • A conglomerate is used to IT being a department; it is not used to the head of IT running the business. In the new world, the head of IT is the boss.

What are the opportunities that are going to be big in India?    

  • As you network the economy, crackdown on black money and bring low cost capital to the table, the Indian economy will formalise and consolidate. Technology is the via medium.

  • In every market—be it agri, health care, or interiors—it is not tech vs traditional, but a story of tech running traditional.

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About the author

Founding Fuel

Founding Fuel aims to create the new playbook of entrepreneurship. Think of us as a hub for entrepreneurs- the go-to place for ideas, insights, practices and wisdom essential to build the enterprise of tomorrow. It is co-founded by veteran journalists Indrajit Gupta and Charles Assisi, along with CS Swaminathan, the former president of Pearson's online learning venture.

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