Over the past couple of years, the number of loss-making public companies has grown dramatically. Private equity and venture capital investors eager to capitalize on buoyant market sentiment have been all too happy to launch loss-making companies into the public realm.
Meanwhile, investors anxious to get a slice of the action have been more than happy to buy into these businesses when they hit the market, paying what seems like excessive multiples for companies hemorrhaging cash and growing losses.
Losses for growth
There are situations where it may make sense to acquire a loss-making business. Accounting quirks can rob a company of profitability, even if it is generating positive cash flow. In another scenario, a company like Amazon (AMZN, Financial) can remain loss-making for years as it tries to grab market share and invest heavily to meet growing consumer demand.
These examples are relatively rare. More often than not, loss-making companies are suffering under the weight of competition and marketing costs. These are lousy business models disguised by high valuations.
Not creating value
Some company managers, analysts and investors claim that a company is creating value when losing money, using the excuse that it is trying to capture market share or entice consumers to recurring subscriptions with heavy discounts. However, far from creating value, this is actually eroding value in most cases. There is typically a transfer of wealth away from the investor to the company. This money either goes to consumers to grow the company's market share, or to making company executives into millionaires or billionaires. Sometimes it's both, as is the case with highly successful companies like Amazon, and sometimes, the company is throwing money at an idea that will never work out.
Warren Buffett (Trades, Portfolio) discussed this topic in his 2000 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual letter to investors. At the time, he was referring to the companies that had consumed shareholder capital in the dot-com bubble, but these thoughts are just as relevant today with the number of loss-making companies increasing:
"This surreal scene was accompanied by much loose talk about "value creation." We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get."
As he went on to explain and his letter, these IPOs are nothing more than a wealth transfer:
"What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company's promoters. At the bottom, the "business model" for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen."
I am not going to pick out any individual companies that may be an example because that might suggest the issue is unique. It is not. Investors should always keep an eye on loss-making companies and understand how they are funding the losses.These losses are often funded first by debt, and when this avenue runs out, shareholders have to put more money into the business.
Even though it may not appear like a wealth transfer at first, when a company issues more shares, each existing shareholder's claim on the enterprise is diluted. Investors will have to put in more cash to maintain their claim on the company (and share of potential profits). If there is no end in sight to losses, investors will have little to no visibility on when they will earn a return.