Damien Grant for the New Zealand Herald writes: Eugene Fama, who believes share prices reflect all the available information, shared this year's Nobel Prize in Economics with Robert Shiller, who in contrast believes greed, fear and animal spirits drive markets and cause bubbles. Looking at the media love affair with Xero, I'm with Shiller.
Xero has a fantastic product. The business has 150,000 customers and $40 million a year in revenue, but it loses money. Its board says that if it prevails it will become the dominant market provider. There are precedents such as Microsoft, Google and Trade Me, where a natural monopoly evolved and made shareholders rich.
But at more than $3 billion, the market has priced Xero as if it has already reached those elevated heights. It hasn't and it might not.
Products such as Microsoft Exchange increase their utility the more users they acquire, but is this true of accounting software? I think it is more like Microsoft Explorer, a program that works well but if I am the only person who uses Chrome I am not disadvantaged by my isolation. The business has $45 million in costs compared to $37 million in customer revenue.
But unless they can get more customers they will be unable to sustain their overheads without drastic changes.
Xero is aiming for the stars, passing first through the cloud. Early investors have done well but what is driving the current frenzy? Is it a cold rational expectation of future growth, or greed and animal spirits? By contrast, Meridian Energy is a stable business that last year made $295 million after tax and has $6 billion in fixed assets. It has been valued at $4 billion.
For Xero to catch up to Meridian in profitability it must gain vast economies of scale. Even if it increased revenue tenfold it would struggle to catch Meridian; yet both enjoy similar market capitalisation.
This means Fama's investors may believe there is a 50 per cent chance Xero will increase its revenue 20 times; this would make it a $6 billion company; discounted by half to account for risk.
Schiller, however, might say investors know nothing about the business and are blindly following the herd.
Martin (New Zealand)
11:34 AM Sunday, 27 Oct 2013
Nice one.
Nice one.
I thought this was the case at $2.70,imagine how I feel by trying to be rational. Damien, FOMO (fear of missing out) is the cousin of greed.
I thought this was the case at $2.70,imagine how I feel by trying to be rational. Damien, FOMO (fear of missing out) is the cousin of greed.
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Cmada (New Zealand)
11:34 AM Sunday, 27 Oct 2013
I believe this article might have more credence if you got even the most basic of technological references right: It's Microsoft's Internet Explorer. Somehow I don't think you can understand the dynamics and drivers behind a growth tech stock if you can't differentiate basic software offerings. Not to mention you didn't quote the latest revenue & customer numbers.
Yes Xero has quite a significant price premium at the moment, but it's there because some big names have invested large amounts of money into the company by buying shares up large.
Yes Xero has quite a significant price premium at the moment, but it's there because some big names have invested large amounts of money into the company by buying shares up large.
Once they did a NZ$180m capital raising and caused the valuation of Xero to increase, indexes & managed funds etc who index to the NZX50, 20, 15 & SciTech all have to buy, not to mention others who become aware of the Xero story from all the publicity. When you combine extremely high demand with low stock liquidity (a large portion of the stock is held by large interests and staff who rarely sell shares), you get the basic dynamics of supply and demand.
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Manfred (Auckland Central)
11:36 AM Sunday, 27 Oct 2013
There were quite a few people who put all their savings into one of the finance companies that went under in the last five years. I'm not saying that Xero will go under. That jury is still out. However, if people want to "bet" on Xero, then that's fine as long as they know what risk they are taking. In Xero's case I'm not convinced that everybody knows what they are buying when they acquire shares.
And then it is also a matter of your own investment style and principles. I for one am looking for undervalued companies that are profitable, have a growth story, a good ratio of net tangible assets to share price, little or no debt, and ideally even pay a dividend. Using these criteria Xero is currently not a buy for me. But that is my approach and it works for me. Everybody else needs to find the style that works for them and perhaps Xero is what they are looking for.
And then it is also a matter of your own investment style and principles. I for one am looking for undervalued companies that are profitable, have a growth story, a good ratio of net tangible assets to share price, little or no debt, and ideally even pay a dividend. Using these criteria Xero is currently not a buy for me. But that is my approach and it works for me. Everybody else needs to find the style that works for them and perhaps Xero is what they are looking for.
My take on this is: The important piece is to try to stay away from greed and use as much information as possible and reasonable to make a sound investment decision. If you do you can limit your risk and still have decent return on investment after tax, much higher than any savings account (or even property) can offer.
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Bunter (New Zealand)
11:36 AM Sunday, 27 Oct 2013
It's Shiller, not Schiller.
Fama wouldn't argue that individual stocks aren't occasionally mispriced, only that it's very difficult to consistently identify such stocks in a way that allows excess returns to be made. And Shiller would agree - for every truly mispriced stock, there are dozens that look mispriced but turn out not to be. One doesn't find many $100 notes lying around on the footpath waiting to be picked up.
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Kiwi Londoner (England)
11:36 AM Sunday, 27 Oct 2013
For share prices to truly reflect all of the information required to inform such pricing, insider trading would have to be legal.
Friedrich von Schiller, was, perhaps, a more astute observer of human character, remarking that "anyone taken as an individual, is tolerably sensible and reasonable- as a member of a crowd, he at once becomes a blockhead". An apt description of the functioning of bull markets, and even more true of those investors who see something especially gilt-edged in information technology.
Friedrich von Schiller, was, perhaps, a more astute observer of human character, remarking that "anyone taken as an individual, is tolerably sensible and reasonable- as a member of a crowd, he at once becomes a blockhead". An apt description of the functioning of bull markets, and even more true of those investors who see something especially gilt-edged in information technology.
Xero's future lies in a buy-out by a major IT, outsourcing or consultancy company that either sees a complementary product or wishes to neutralise competition.
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Robin Ducker (New Zealand)
11:36 AM Sunday, 27 Oct 2013
I think the theory with Xero's growth strategy is similar, if not identical to Metcalf's Law. This states that the value of a utility is equal to the sum of the users squared - and this applies to both users, ie. customers as well as investors.
If it not difficult to see how this law works and why it should work that way....the more people that join, the more people want to join because its value to them increases. Does Xero qualify to have this law apply? Well, as a cloud application the answer is a yes, provided they have the scalability to respond to the market. As I understand it this is what the investments are aimed to provide.
If it not difficult to see how this law works and why it should work that way....the more people that join, the more people want to join because its value to them increases. Does Xero qualify to have this law apply? Well, as a cloud application the answer is a yes, provided they have the scalability to respond to the market. As I understand it this is what the investments are aimed to provide.
Of course I understand the case the author is making but this is apples and oranges. Utilities are great places to run to in a crisis and will if they are well managed always make money at any time but the profits will be modest. Xero is, lets face it, a clear example of risk Vs reward. On the face of it there are a lot of people betting big money on the reward part, and having well positioned and motivated investors must help them.
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TM (New Zealand)
11:36 AM Sunday, 27 Oct 2013
I too share the concern about this business - however it is a great success story either way - employing a lot of people, making a few very wealthy and it may well be bought out and so all end happily. However the issue for me is simple, as I use small business software every day.
The cost of acquiring new customers is huge - more than the gain in a years revenue - and as soon as they stop adding them faster than losing them - which will happen more and more as the service offer drops, the model doesn't work. The SME market is fickle, businesses go broke, get smaller or larger and hence change software.
This product is fine - but is not a one stop shop - i.e. doesn't have point of sale or payroll built in - unlike QuickBooks which is an excellent product. Before the problems really manifest themselves, lets all hope Microsoft or Oracle come calling with the chequebook.
The cost of acquiring new customers is huge - more than the gain in a years revenue - and as soon as they stop adding them faster than losing them - which will happen more and more as the service offer drops, the model doesn't work. The SME market is fickle, businesses go broke, get smaller or larger and hence change software.
This product is fine - but is not a one stop shop - i.e. doesn't have point of sale or payroll built in - unlike QuickBooks which is an excellent product. Before the problems really manifest themselves, lets all hope Microsoft or Oracle come calling with the chequebook.
Just remember, the founders have cashed out - nothing to lose here, and also comparisons with Trademe and Misrosoft are wrong - they made money early and did not just burn through cash.
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11:36 AM Sunday, 27 Oct 2013
> but if I am the only person who uses Chrome I am not disadvantaged by my isolation.
>
Sadly, this is not entirely true. I recently attempted to register for information on the Victoria University of Wellington website using Google Chrome. I encountered a server error. After sending an email, I was told by the VUW IT department, "I'm sorry we don't support Google Chrome".
>
Sadly, this is not entirely true. I recently attempted to register for information on the Victoria University of Wellington website using Google Chrome. I encountered a server error. After sending an email, I was told by the VUW IT department, "I'm sorry we don't support Google Chrome".
There's safety in numbers for all software.
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11:36 AM Sunday, 27 Oct 2013
The other question is, can they scale their customer base without their costs correspondingly increasing linearly. The ideal for a software company is that more customers give zero or close-to-zero increases in costs. From what I hear, Xero is far from that Nirvana.
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the old chook (New Zealand)
11:37 AM Sunday, 27 Oct 2013
Low income people gambling on the pokies = bad!
High income people gambling on the share market = good!
???
High income people gambling on the share market = good!
???