One of the biggest complaints against finance theory from practitioners of investing is that it is not “practical enough” and does not represent the real world. We all know that an economy is the culmination of decisions being made by millions of individuals every day and unlike hard sciences, finance has to deal with people’s emotions and feelings. But just because those emotions and feelings cannot be neatly encapsulated into precise models does not necessarily mean that those models are completely useless. There are cases, where I feel that finance theory is really insightful and the only reason those insights get overlooked is because investors fail to connect the dots between theory and practice.
In this post, I have tried to take a phenomenon that we are currently witnessing and connecting it to finance theory – yes! I am attempting to connect theory to the “real world”!
E-commerce/ online businesses the world over have had an excellent run over the last year. From an Australian perspective, one only needs to look at the results of companies like Adore Beauty, Kogan and Red Bubble to see the exceptional time these businesses have had. This phenomenon hasn’t been restricted to the bigger companies. In fact, many young businesses have been able to utilise the power of platforms such as Facebook and Google to create “brands” of their own, making enormous returns on the capital in the process.
Much of these returns, however, have come from an extremely low customer acquisition cost, a result of a sudden shift in buying habits with people being forced to shop online and spending more time on major platforms. I’ve seen numerous examples of businesses which have struggled to turn a profit over the years suddenly make a windfall simply by targeting a customer base that has developed a “let’s try it” attitude to products being sold online.
Economics of competition catching up
As many people are realising now, these businesses were making money, not necessarily because their product/ service was good, but because of the power of social media platforms. Now that some time has passed, we are starting to see some adjustments kick in. Facebook, for instance, has increased its price per ad impression by 70% and 47% over the first two quarters of 2021, respectively, and has recently stated it will continue to do so for the remainder of 2021. One reason that Facebook has been able to pass on such significant price increases to businesses is because more established brands, looking at these supernormal returns, are now starting to shift more of their marketing budgets towards these platforms. Not just that, these “bigger” brands are happy to accept returns that are lower than what young businesses were earning earlier.
For example, suppose your margin from a sale is 50% and you used to buy ads at $1 per ad impression, generating $2 of sale from each ad impression. This implies a 100% return from ad impressions. Now looking at these lucrative returns, larger companies will be attracted to advertising on Facebook and drive up the price of Facebook ads for others.
Think of it this way, if you are the CEO of P&G, you are happy buying ads at increasing prices as long as the return from those ads is more than your hurdle rates. And given the low interest and growth environment that we find ourselves in, hurdle rates are significantly lower than the returns some of these companies have been generating over the last year. Thus, smaller brands, used to earning 100% returns on the ads are being PRICED OUT OF THE MARKET because the marginal buyer of these ads is willing to accept a much lower return.
This is, of course, a very simplistic computation and it is further complicated by customer retention rates. Companies that are able to generate repeat purchases from customers that have been acquired once, are able to pay much more than those which have to regularly find new customers to maintain their sales.
From the business world to investing and finance theory
Does this ring any bells from your graduate finance course and how it relates to investing?
Finance theory suggests that risk needs to be seen from the point of view of the marginal investor and not from the perspective of our own perception of risk. Just like Facebook’s ads have a price attached to them, so do equities with the equity risk premium representing the price of risk in equity markets. And just like Facebook’s prices for its ads fluctuate depending on how much market participants are willing to pay for its ads, so does the equity risk premium change over time depending on how uncertain or risk averse market participants feel about investing in equities.
Marginal investors in equities today are large, diversified institutions and their cost of capital currently is closer to 6%, i.e., given a 10-year government bond rate of 1.5%, larger institutions are demanding 4.5% risk premium for investing in equities. If large, marginal buyers of equities are pricing risk at 6% then, it behoves us to use that hurdle when valuing an average risk business in the market today. If we use an arbitrary hurdle rate of say, 15%, we risk being similarly priced out of equity market just like the young business which is not willing to wake up to the reality of higher cost of Facebook ads.
There is another issue with using a 15% discount rate when the marginal investor is happy with only 6% and that is that you will end up self-selecting a portfolio of businesses that are inherently riskier than the average business in the market. This is because those are the only businesses you are likely to find as being undervalued using high discount rates in the current environment.
Does it mean that nobody can earn 15% returns from equities?
No, that is not what I am saying.
Firstly, equity returns in any single year can vastly overshoot or undershoot long term expectations. But more importantly, in a world where equities are priced to deliver close to 6% over the long term, equity investors as a class are highly unlikely to make a 15% risk-adjusted return over the long term. Of course, there will always be individual investors who would do better than the market just like there will be investor who vastly underperform. But earning a 15% return is harder when the market is priced to deliver 6% than when it is priced to deliver say, 10%. Earning such double-digit returns would require hard work and luck in equal measure.
In order to have a better chance at outperforming in investing, it is important to judge expectations being set by other market participants. Living in your own bubble or using arbitrary hurdle rates when analysing potential investments can often lead to analytical mistakes. Finance theory gives us great insight on how to think about and setting reasonable expectations. The trick, of course, is to grasp the fundamentals and apply the principles to suit the needs of the world as it is today.