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How central bankers breed unicorns, why they’re dangerous and how to avoid being caught in a dream

Equity Analyst Nicholas Hyett explains his approach to avoiding some of last year’s high profile stock crashes.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

One of the striking features of the post crisis years has been the explosion in the number of unicorns.

In finance circles the term “unicorn” is used to describe a company which is valued at $1bn or more, but isn’t listed on a stock market. Research group CB Insights now list 418 unicorns worldwide, ranging from internet giants like Airbnb to rebel brewers BrewDog.

But as we saw with WeWork’s pretty disastrous attempt to IPO last year – which ended up seeing the value of the company written down by as much as 84% – high private valuations don’t mean stock market investors should necessarily jump on board.

So why has the unicorn become the phenomenon it has, and how can investors avoid being caught out by a company that’s more fantasy than reality?

Remember that all investments rise and fall in value, meaning you could get back less than you invest. This article is not personal advice. If you are unsure if an investment is right for you, seek advice.

How central bankers have bred unicorns

Since the financial crisis we’ve been locked in an era of incredibly low interest rates.

With the income generated by government bonds so low, usually conservative investors have looked to corporate bonds and stocks & shares, pushing up prices in these markets too. That in turn has pushed more adventurous investors into private equity and venture capital.

That might sound less than ideal, but pushing investors into higher-risk investments is exactly the point of current monetary policy – encouraging investment rather than saving to kick start economic growth.

A side effect of all this cheap cash is there’s a greater amount of money prepared to take an outsized risk in the hope of potentially better returns. Given the ability to disrupt established markets and potential for rapid growth, tech has been a natural home for much of the extra spending.

Why unicorns can be dangerous

The best way to understand why unicorns feeding on low interest rates can be dangerous is to understand the “time value of money”. This is the idea that money is more valuable today than tomorrow.

If you give me £100 today I can put it in a bank account and earn interest. Assuming an interest rate of 1.2% that means I would have £101.20 next year. In other words I should be indifferent between £100 today and £101.20 next year – all things being equal.

A consequence of this is interest rates affect the value I put on money in the future compared to money today. If interest rates were 5% then you would need to give me £105 next year to be the same as £100, whereas if interest rates were 0.75% you’d only have to give me £100.75.

How does this all apply to unicorns?

Well, companies are valued based on the current value of future profits. When interest rates are low, the current value of future profits is higher. That means companies not making any profit today, but promise the potential for bumper profits in the future are more valuable than they might otherwise be, and they find it easier to raise new investment, though of course there are no guarantees of any future profit.

That makes it easier for companies with great stories to raise money. In other words, when interest rates are low, prophets get a leg up relative to profits.

3 tips on avoiding the fairytales

1. Selling something cheap isn’t smart or clever

When it comes to investing in high growth companies the key is not to get too focused on sales.

Anyone can sell something for less than it’s worth, and if that’s also less than it costs to make, companies are inevitably going to run into problems over time. Now all companies start off in that position, and scaling up requires supportive investors. The danger is that as investors get sucked deeper and deeper into a company it becomes obvious that the company is never going to be profitable at any scale. If investors lose confidence, and the company can’t raise more money to cover its losses, the price will crash.

2. Profits today keeps the administrator away

To avoid that we always advocate focusing on companies that are already profitable. These could become even more profitable as they get bigger – which is great – but you’re not speculating that an unprofitable company will suddenly switch into the black.

This is nicely encapsulated in an old stock market saying that “if sales are vanity then profits are sanity”. Investing in loss making sales machines is a sure fire way to lose money over the long term, but profitable businesses are at least generating some kind of return although of course it’s not guaranteed to continue.

3. Cash is the word

The stock market saying concludes with “but cash is king”, and it’s something investors neglect at their peril. It’s possible for a company to generate significant amounts of profit without very much cash. That’s because a growing asset base counts towards a company’s profits.

This makes sense – a company which doubles its asset base could theoretically close down tomorrow and sell-off its assets, returning the cash to shareholders. It’s worth more on paper.

The problem is that there’s often a difference between paper and reality. A manufacturing business’s equipment won’t be easy to sell quickly, and it might have to accept less than it’s worth in theory. Meanwhile the value of brands and other intangible assets is notoriously difficult to estimate.

If profits are tied up in replacing and repairing equipment then that reduces flexibility. It makes it more difficult to opportunistically invest, pay down debt or pay shareholder dividends.

Will a focus on profits over blue sky predictions mean you avoid every crash? No. Will you miss out on some screamers? Yes. Is it a sensible approach to long term investing rather than speculating? We think so.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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