by Shane Leonard, CFA @shaneleonard121

Every now and then a sinkhole appears and we marvel at it. Fortunately, casualties are rare. In financial markets, rarely are investors so lucky.

Bubbles appear with increasing regularity, though the phenomenon is not new. Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds” was published in 1841.

Delusions in Tech

In the tech bubble of 2000, graduates shunned Wall Street for startups, only to regret it later. Online delivery became a craze that flamed. Wireless local loop and 3G consumed billions of investment, with massive losses ensuing. Major corporations around the world set up venture arms to fight off startups. Leading to a decade lost, winding down their hodgepodge portfolios. So… does it all sounds familiar?

In tech bubbles, there is a common thread. An interesting idea, solving a genuine need, has its business model and potential, extrapolated to the realism of unreality. When reality strikes, the investors are burned, even though the underlying business is doing well, just not nearly as well as the investors dreamed.

History Rhymes

Many of the disappointments of 2000 have become the poster-boys of today. Online shopping is huge, home delivery a success, streaming is the norm, and online advertising has become a powerful revenue stream. Consumers and the technology caught up with the visions of entrepreneurs.

With faith restored, Silicon Valley is a hero once more. An engine for the global economy. The creator of unicorns.

Less than ten

But there are less than ten “cash” unicorns, businesses that have raised $1 billion in a single venture investment round. Alibaba (2005) Clearwire (2006), Facebook (2010), Uber (2014), Flipkart (2014), Xiaomi (2014) and Airbnb (2015).

With each new capital raise, we need to ask, why does any company need to raise that much money privately? Debt is typically cheaper than equity, and the public markets are typically cheaper than private funding. So why the expensive fund raising?

Land grabs v liquidity

Marketplaces have beautiful business models. You provide a venue, buyers and seller do the rest. Often both sides pay you. Your focus is on ensuring both sides are treated fairly and that nothing bad happens on your turf, notably fraud.

Alibaba and eBay are the two largest marketplaces in the world. Both were profitable at IPO. Both are centres of liquidity. As they grew the competition withered. Once these marketplaces had the lion’s share of liquidity, even the offer of “free” could not wrestle the liquidity away. Do you remember Yahoo! Auctions? Alibaba & eBay’s business models have endured booms and busts. They continue to grow & dominate their markets. As Warren Buffett might say, their businesses have a deep and wide economic moat.

Bizarrely, Groupon shares many of these characteristics, but is nowhere as successful. They are a marketplace connecting consumers with sellers. They dominate their chosen cities and categories. Users love what they offer, sellers value the business they can generate. They have a strong gross margin, though not nearly as high as eBay’s. But still they have lost money every year for 5 years, with sales and marketing eating their cash flow.

Groupon’s stock price since IPO

Groupon almost raised a unicorn round in 2011, pulling in $950m. But despite allowing them go on a land grab, hobbling their competitors and dominating the market, Groupon has never been able to turn off the sales and marketing. Without it, the liquidity could evaporate.

Uber as eBay

Uber has the liquidity. Anywhere anytime, they are matching consumer demand with small businesses, their drivers. Satisfaction is high on both sides of the market. The competition is wilting, growth is strong and they dominate.

Investors no longer see the company as a taxi-app. They have faith that Uber can become a logistic company, a platform play.

Uber as Groupon

But Uber lost $470m last year on $415m of sales. It’s gross margin is 50% like Groupon, not 70% like eBay or Alibaba.

It’s engaged in a land grab, city by city, with clones appearing worldwide. Like Groupon it has to put boots on the ground, seed each local market with drivers, run launch campaigns, and endure politicized backlashes in each new market. Their quality and muscle gets them the liquidity. But can they sustain it?

And the answer is?

For now, we don’t have enough data to judge if Uber has the potential to be as remarkable as Alibaba or eBay. With a recent $50bn valuation, investors are assuming it’s land grab will lead to a stranglehold that becomes a cash machine.

The easiest way to know is to look at the details for any of the earliest cities that Uber launched in. If Uber’s growth rates, margins and cashflow in San Francisco or New York mirror an early day eBay, we have an affirmative.

Given the list of smart investors in Uber, we can only assume this is the case. If not, their investment is likely to fall into a financial sinkhole, the error of yet another extraordinary and popular delusion in technology.