Growth and Incentives
Some housekeeping: last week I had hammered out a blog on bad uses of data, but I reverted it to draft. I stand by what I said in it, but it was incomplete and some of the arguments weren’t given enough words. I’m going to try to parse it out in a series of blogs illustrating when numbers miss the mark, hopefully coming soon. Today I’m discussing something close to that, it’s how the numbers we choose to chase determine how we think about “value”.
In the US, and in most developed and developing countries, relevant leaders always talk about how they are going to grow the economy. Business people talk about how they plan to grow and expand businesses, politicians talk about how they plan to grow jobs, economists discuss the best policies for growing GDP. Outside of a small number of academics who champion, and who haven’t thought about the real consequences of, degrowth, growth is consistently on the political agenda. But the term means very little unless we have a good way to measure growth, and that involves making choices and value judgments. Those judgments are central to how we allocate capital. I want to talk about the impact of investors and investor logic on how businesses view growth and why a myopic focus on a specific kind of growth can undermine and deteriorate real value even when the dollars are flowing.
Technical analysis and financial ratio analysis has a shorter history than you might think. Up until the early 20th century, investments were mostly a matter of qualitative analysis. Investors were either well-versed in the industry in which they were investing, and felt like they could get a sense of the health of a sector, business, or venture by discussing it with the business owners, or they had a close relationship with the managers themselves and trusted them to make a return on their investment dollars. There are older examples, but in the US early technical analysis started with Charles Dow in the late 19th century, who made a bunch of observations about market movement. Financial ratio analysis didn’t become popular in investing until the ‘60s and ‘70s, through Warren Buffet’s success, though it had roots in a 1934 paper. As analysis changed, businesses tried to keep up with what made investors happy, so capital not only started flowing to different companies based on new investor priorities, as those investors’ preferences changed businesses would manage their own finances in ways that would make the investors happy. This has major implications for how businesses choose to grow, and in turn how investors allocate capital.
Some of this financial analysis is straightforward and sensible. A company that is profitable, especially if its profit margin is similar or better than other companies in the same industry, is probably a decent investment (plenty of caveats aside). If a company makes and sells widgets, financial analysis can help us understand how long those widgets sit in a warehouse, and at what cost, before they are sold. Companies that make and sell their widgets quickly and efficiently are probably more valuable than those that make and sell similar widgets less efficiently. Analysis becomes murkier when the things a company makes or owns are less tangible, or when technological progress becomes part of the story. Intellectual property, for example, is recorded at cost in financial statements. Companies and analysts estimate the future value of the IP, but valuations can vary wildly. If you asked a group of people what the value of Marvel is to Disney in dollars, they’d all give different answers. If you asked them the same question a year from now, their value will have changed. In social media, companies report daily active users (DAU), and ascribe some value to those users, but there is no good way to tie a specific dollar value to a user. Users see and click ads, and so DAU theoretically can provide us some view of average user value, but user behavior changes over time, and it’s very hard to put a dollar value on an ad that is seen and not clicked, for example.
One would think that the industries with fuzzier value propositions (I use fuzzy on purpose, this doesn’t mean bad! It means unclear!) would come under more scrutiny from investors about the health of the company, but actually quite the opposite has happened. The tech sphere, led by VCs, has essentially said “screw your fancy financial ratios, the only number that matters is revenue and it must go up”. In 2017 the Harvard Business Review agreed, and investor behavior since the financial crisis has valued growth over fundamental analysis, the returns in the 2010s favored growth over value.
An application, or perhaps a corollary, of the efficient-market hypothesis should indicate that in a world of infinite investing strategies, strategies that incorporate more information (like fundamental-analysis-based strategies) would win out, but in practice that’s not how things go. There is a feedback loop among core, high dollar, investors where the investment strategy flavor of the month wins out. Retail investors have been able to create this feedback loop in the past, but only for a brief period of time. High dollar institutional investors articulate a coherent strategy, and there can be more logic to it, but just like the GameStop short squeeze, often the market moving investors are just engaging in groupthink on the same investment strategy, and they can sustain it over a longer term. Over the last decade, the revenue growth chase has been the flavor of the month. Tech, generally, has lower capital requirements than other industries, so there is more of a direct line from investment to revenue generation. Consequently, over the last decade, the tech sector's contribution to GDP has grown substantially as more capital has been poured into the sector.
The Harvard Business Review astutely points out that the revenue-first management approach is mostly viable in a low capital cost environment (which is clearly changing). When money is cheap, and a dollar tomorrow is closer to the value of a dollar today, it makes more sense to pour tons of money into your business and eschew profits today for bigger profits tomorrow, which is effectively chasing revenue growth. But when revenue growth becomes the central data point in determining whether a company is worth the investment, a lot of perverse incentives kick in. And you see these incentives when you interact with tech products today. Google search is, in many cases, useless now. If you try to search for the best computer to buy, you will be served with a series of sponsored links, a series of sponsored click-to-buy placements, SEO-optimized listicles that are likely native advertising, and perhaps one or two links to thoughtful articles comparing and contrasting different computers. Most of what you get from your search result is only vaguely related to your original search. Google is actively degrading the original search product in order to make more ad revenue, and the use of the real estate on the search result page reflects that choice. Other tech products also reflect that choice. Instagram is basically operating as an ad primary, content secondary space now. Imagine if TV networks in the 90s showed 20 minutes of ads for every 10 minutes of programming (ok, I’ll give you that maybe MTV did this), that’s how a lot of social media works today. This is all because of revenue chasing.
Uber is another example of the growth conundrum, but from a different angle. Uber has only been profitable in (I believe) one year of its entire existence, but they grow revenue like crazy quarter over quarter and year over year. Of all the tech products I’ve mentioned, Uber is probably the best functioning product, and the only one keeping essentially the same promise it made to its customers from the beginning. But what if they never become profitable? What does it mean for us to keep pouring capital into an unprofitable investment?
Beyond bad products and unprofitable businesses, a myopic focus on revenue growth led to essentially all of the unfocused bad bets that the tech industry made during the pandemic. Those bad bets led to mass layoffs that the companies have and will continue to blame on economic headwinds, despite the fact that those headwinds, at least in 2022, seemed to miss nearly every other sector. The markets reacted to the layoffs by boosting the share prices of most of the companies that made those layoffs, so they were rewarded for two years of mismanagement.
Chasing revenue is just chasing a number, and those numbers reflect choices we make about value. Pure growth focus has us incentivizing the development of bad products in one of our fastest growing sectors, to the point where companies that originally made good products are consciously making those products worse. The companies and their investors keep telling us they are valuable because of growth, but sometimes Occam’s Razor should apply, mature companies that are actively trying to make much worse products today than they were yesterday should not be more valuable today. Certainly not to the degree that big tech’s market cap growth shows. It's a direct result of our poor methods of measuring value. We are unable to distinguish between customers who use a product excitedly or begrudgingly, and in the case of many current tech products, it sure seems like customers are dying to have alternatives. But until investors value customer experience over essentially a dressed up bait-and-switch scam, the money won’t be there.
Perhaps the old value investors had it right. The tech world loves to reinvent other industries, and make them seem simpler than they are, so it makes sense that they would try to tell the Warren Buffets of the world that fundamental analysis is silly, the top line is all that matters. Hopefully, just like they did with crypto, NFTs, and Silicon Valley Bank, they’ll learn that oversimplifying the old way of doing things may hold up in the short term, but it won’t hold up for long. Then we might get back to a more nuanced, sophisticated, and valuable view of growth in tech and elsewhere, and perhaps we’ll put more of our capital into helpful widget makers instead of glorified ad spammers. But I’m just a retail investor, so I’m stuck chasing the flavor of the month.
Some notes for the finance professionals, I understand the technical analysis that can drive growth investing. Dividends are less important in a low interest rate environment, for example. I simply want to think about what we incentivize when that is taken to the extreme, as it has been over the last decade in tech.