Growing Pains: It’s Time To Prove Your Worth

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By James Graeber

The recent downdraft in technology sector valuations is likely to bring about a prolonged change in investor and management behavior. Are investors ready?

The quest to do things “better, faster, and cheaper” has guided capital flows across the technology sector over time. A combination of bravado, storytelling prowess from founders, and a decade-plus of near-zero discount rates drove technology valuations to levels that would likely require decades for investors to recoup their investment via underlying free cash flow. Founders awash in the capital became convinced of their own infallibility on their path to the public markets.

Fast forward to today: As of June 2022, the NASDAQ Composite Index is more than 30% off its highs from November 2021, and weekly layoff announcements have swept through the herds of Silicon Valley unicorns. So, what might have changed? Interest rates have moved higher, the tide of liquidity has reversed, and in our view, many investors have grown tired of CEO pitches on how unit-level economics will yield substantial margins far into the future. We believe this change will have a lasting impact on sector behavior and lead to more rational capital allocation. Management teams will likely need to learn to do more with less (at least until the next cycle).

Compounding this pain, a rising tide of valuations, coupled with excessive use of stock compensation, has helped to keep a lid on labor expenses. This has changed with employees now likely to prefer something with more agreed-upon value, as underwater stock options do not help to pay the bills. A vicious cycle is now in motion where the more a stock falls, the more stock employers need to issue to hold compensation levels flat. As such, the stocks of these speculative businesses may become more expensive the more the share price falls absent material changes in cost structure (like we are starting to see).

We believe investors will find opportunities by focusing on companies with clear histories of profitability and free cash flow, tangible barriers to competition, and clear alignment between shareholders and management teams that treat shareholder capital as a precious resource to be spent judiciously. This environment will likely bring prolonged pain to the more speculative corners of the market that have held a winning hand with an abundance of capital. We believe that this fallout will present long-term opportunities for many self-funding, battle-tested businesses. It’s time to sharpen those pencils!

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.



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