WHY ARE INVESTORS ATTRACTED TO LOSS-MAKING COMPANIES?

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INTRODUCTION

Convincing investors that investing in your company would be an attractive prospect might be one of the most difficult things to do. Going back to basics, let’s answer the question, why do investors invest in a company? The obvious answer to that is they want return on their investment and returns make you rich in this capitalist world.

But, in this ever-changing and competitive world one cannot stick to the basics and be worry free. This brings us to the question – what has changed that investors are now investing in companies that are not generating any profits? The answer to that would be the era of growth investing. Essentially there are two paradigms of investing – value investing and growth investing, which we’ll be discussing below.

VALUE INVESTING

Warren Buffet, CEO of Berkshire Hathaway, one of the most famous investors and world’s sixth richest person is also a value investor. So, what is value investing? Picking stocks that appear to be trading for less than their intrinsic or book worth is referred to as value investing.

Investors with a keen eye for profits seek out the companies that seem to be undervalued in the market, but are backed by a strong potential, claiming that stock prices are not the real determining factor of their actual worth.

They believe that the market overreacts to both positive and bad news, resulting in stock price movements that are out of line with a company’s long-term fundamentals. The market’s response provides an opportunity to prosper by purchasing stocks at a discount—on sale. Value investing is still very much relevant and is used by many renowned investors as a successful investment.

GROWTH INVESTING

Growth investing is not a new concept. In fact, it has been in practice for many years and more so in this new era of startups. It is an approach that is focused on increasing an investor’s capital by investing in growth stocks i.e. small companies or start-ups whose earnings are expected to grow exponentially. With the rapid growth of the tech sector, investors have started valuing growth and they tend to be comfortable even if firms aren’t making huge margins. Companies no longer play the short-sighted game and have learnt to take risks by investing in loss-making entities, as sometimes they reap much more financial returns in the future. Analyzing the revenue generated and profits made by the company is inadequate and orthodox, albeit safe way of doing business. Hence here are a few reasons why a loss-making company can be an attractive target :-

  1. Growth

Tech Stars Co-Founder David Cohen said, “Going for profitability too early often means limiting growth.” Now, it is more important to have revenues higher than profitability. This principle is clearly reflected in the success of Zomato and Jio. They initially offered ridiculously high discounts and have grown their market share which gradually over the years can easily be converted into a profitable venture since they have a loyal customer base.

 2.  Future Potential

Some companies try to look at future potentials of the companies rather than what they are contributing in the present or how much cash they are burning currently. This can be in case of newer ventures like Artificial intelligence, E-Wallets, drones etc. Even the Union Cabinet recently cleared the PLI scheme to make India a drone hub by 2030. So, sometimes you have to take risks on how these companies will attract clients in the future to get a first mover’s advantage.

3.  Huge valuations of Intellectual Property Rights

This might be one of the few reasons which don’t involve big risks for the investors as some companies despite being loss-making have some intellectual property rights like copyrights or patents which have huge valuations in the market. So, it is not hard to understand that even though they might be loss-making, investing in them is usually a clever idea as you are not betting on them but you are betting on their valuable Intellectual property rights.

4.  Market Goodwill

Some companies have huge market goodwill despite being loss-making. Nokia is one such example. So buying such companies is more about the use of the goodwill than about their assets and debts. Generally, the investor backs such companies to cash in on the goodwill of such companies which has been built over the course of multiple years and which can be turned around with the right management. So, high market goodwill can make a loss-making entity extremely attractive.

5.  Eliminating Competition

Sometimes, despite being a loss-making entity, companies have a huge potential of growth. So to the other profitable entities in the same sectors, these loss-making companies might seem like a very captivating target to alleviate any future competition in the present itself. They would prefer to spend more money than to lose it later and remove the competition.

CONCLUSION

The ‘money’ in the investing world no longer depends on the present but is more of a bet on the future on what the companies would offer in the future. Bigger players are ready to wait and play long term game to earn big. Investing in loss-making entities might be a risk but since the oldest mantra is HIGHER THE RISKS, HIGHER THE RETURNS, they may provide exceptional returns.