Hunting for victorious unicorns

Stock markets have rallied after the surprising Fed pivot.

In this post, let's talk briefly about inflation, which is still a nuisance but not a surprise in the US. The Fed's interest rate decision will also be discussed quickly. The main theme is hunting for unicorns to add to your portfolio: it's like looking for a needle in a haystack. Less than 1% of the thousands of unicorns have achieved a cash flow of more than a billion dollars.

 Inflation remains a nuisance, but the Fed pivots

We received fresh inflation data from the United States The message is familiar to active readers: inflation is easing painfully slowly. Inflation fell to 3.1% year-on-year, but core inflation, which has been stripped out by rapidly fluctuating energy and food prices, is still hovering at 4% a year. In practice, inflation is generated purely by services, and the pandemic-era upward pressure on commodity prices is over.

Well, investors expecting a rapid fall in inflation argue how shelter costs, which are still slowly updating due to their methodology, are boosting inflation. As house price rises have calmed down, rent increases should soon level off.

The problem is that if you look at inflation without shelter costs, you see almost no progress at all. On an annual basis, the so-called super core inflation rate for services is still almost 4% and has not seen a fall for a while.

The good news is that while inflation remains tantalizingly persistent, it no longer comes as a surprise to the market. The inflation surprise index has fallen in the US, which is a good thing as inflation is roughly in line with expectations. It speaks volumes that market interest rates didn’t jump, even though the inflation data was slightly above expectations. Long-term inflation expectations have also eased towards the central bank's target level of 2%. In other words, inflation would have to surprise sharply upwards to be any more of a shock to the market.

The Fed kept interest rates as expected, but the surprise came from the Fed members' reversal regarding the future direction of interest rates. Due to the persistence of inflation in speeches and central bank forecasts, the interest rate level was previously expected to remain high for a longer period. Now, members of the Fed's board anticipate three interest rate cuts for the next year. In a couple of years, the level is expected to drop below 3%, below the current market forecast. At the same time, the economy is seen as remaining strong. While the Fed doesn't have a crystal ball, such a scenario is a nirvana for stocks. As a result, the S&P 500 index rose over one percent after the decision, approaching its all-time highs.

Hunting for victorious unicorns

A kind of medal of success on an entrepreneur's chest is a promotion to the ranks of the unicorns, where the criterion is a valuation of more than a billion dollars in profits. But for an investor, hunting a victorious unicorn is like looking for a needle in a haystack. Less than 1% of the few thousand have become truly profitable firms.

Amazon, Google and Tesla are examples of hugely successful companies over the last twenty years that have made early investors rich. They have emerged as the dominant players in their respective sectors and are now generating heaps of cash flow.

Investors naturally want to replicate this success, and so in modern times, "venture capitalists", private equity angels and other investors throw billions of cash at start-ups in the hope that some company's idea will grow into a world-dominating tech behemoth.

Growth company investing took a brutal beating in the stock market last year. The index of loss-making growth companies compiled by Goldman Sachs plunged 66%, while the Nasdaq 100 index, populated by mega-tech companies, fell 33%. But this year, as the interest rate and inflation landscape has calmed, loss-making growth companies have returned to investors' favor Nasdaq is again one of the best performing exchanges with a rise of more than 40% this year.

Looks like the tech hype isn't going to die down. In a sense, this is understandable, because when the needle is found in the haystack, the reward is considerable. Second, tech disruptors eating new markets or other people's cake are attractive in a slowing global economy.

This graph shows the projected earnings growth of the current dominant tech giants and the rest of the S&P 500 over the next three years. The difference is striking in favor of the former. It pays to be where the growth is, but whether it's worth paying so much for that growth is a whole different question.



The consultancy Bain had an interesting graph of global unicorns. Whereas ten years ago there were 39 of them, in the last 20 years 2,500 start-ups have reached the billion-dollar mark.

But few of these companies that burn investors' money are profitable. Or a cash-flow-independent business, as one might put it. Continuity relies on investor appetite for new funding rounds.

Out of 2,500 companies, only 15 have achieved a cash flow of more than a billion dollars, excluding equity compensation. That's less than 1% of all unicorns. This rare group includes companies like Tesla, JD.com, Facebook, ServiceNow and Airbnb.



The rest burn money as they grow. This is then branded in cult events like Slush as somehow a "cool" way to live off other people's money.

Many of the reasonably well-known challengers are still in the red, despite billions in revenue. The viability of the business model therefore remains a question mark. Such companies include Shopify, Snowflake, or Nio.

Building a profitable business in competitive sectors is actually very difficult outside of PowerPoint presentations.

If less than 1% of companies have so far succeeded in creating a financially sustainable business, every investor can consider the probability of success when investing in early-stage growth companies on the stock market. Instead of a unicorn, you are more likely to get your hands on a donkey.

Many of these companies are financed through private channels, so they may not be listed on the stock exchange until they are at a mature stage.

Just because the vast majority of unicorns will never become profitable and at some point investors will pull the plug on funding rounds, it does not mean that the owners of the current dominant companies should not be vigilant. Such a huge amount of money chasing ideas and skills can disrupt the market for existing tech giants. For example, OpenAI, under the auspices of Microsoft, is a worry for Google's search engine monopoly. Or Tesla's success is emulated by who knows what kind of joke electric car companies around the world. Shopify is empowering small e-commerce entrepreneurs to fight Amazon's dominance. Today's leaders must run all the harder in an increasingly competitive environment.

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