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Friday, 30 July 2021
A newsletter that demystifies complex economic jargon and explains how it impacts your everyday life
By Vivek Kaul

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Ilu Ilu Zomato

What convinces is conviction – Lyndon B Johnson.

Lyndon B. Johnson was the 36th president of the United States from November 1963 to January 1969. Before he became president, he was a senator, and as a senator, he practised a technique called “working up”.

Julia Galef describes this technique in The Scout Mindset—Why Some People See Things Clearly and Others Don’t: “When he needed to be able to convince people of something, he would practice arguing that position, with passion, over and over, willing himself to believe it. Eventually, he would be able to defend it with utter certainty— because, by that point, he was certain, regardless of what his views had been at the start.”

Every politician is what Galef calls a professional persuader. Johnson was no exception to this rule. Galef quotes his press secretary, George Reedy, as saying: “He had a fantastic capacity to persuade himself that the ‘truth’ which was convenient for the present was the truth and anything that conflicted with it was the prevarication of enemies.”

Politicians are not the only professional persuaders going around. As Galef writes: “As an entrepreneur, if you can talk with sincere enthusiasm about how your company is “totally killing it right now,” other people might believe it, too. Lobbyists, salespeople, and fund-raisers might play up the strengths and play down the flaws in their cause or product to make it easier for them to sell it to other people.”

When it comes to the investing business, fund managers who manage money and wealth managers who sell financial products are also in the business of professional persuasion.

Ilu Ilu Zomato

And this professional persuasion was visible right through the first 16 days of this month, when fund managers, stockbrokers, investment bankers and everyone else involved with selling a company’s stock to the public for the first time through an initial public offering (IPO), were busy asking prospective investors to buy Zomato. Social-media influencers, the new-age professional persuaders, were also selling the company’s IPO to the world at large in their unique style.

But what was surprising to see was that many individuals who are not in the business of professional persuasion were also at it. WhatsApp, Twitter, Instagram and LinkedIn, were also buzzing. These individuals had managed to convince themselves that after the invention of fire, the wheel, the plumbing system and the washing machine, the Zomato IPO was the best thing that had happened to humankind. They wanted their friends, family and acquaintances to buy into their conviction and buy the IPO.

Okay, I know, I am overstating this. But dear reader, I hope you get the drift. As Galef writes: “Even those of us who aren’t professional persuaders have plenty of things we might like our friends, family, and coworkers to believe: I’m a good person. I deserve your sympathy. I’m trying my hardest. I’m a valuable employee. My career is really taking off [emphasis in the original].” The people I just talked about before this paragraph also added buying the Zomato stock to this list.

They were singing Ilu Ilu Zomato along with the professional persuaders. (For those who still haven’t got it, Ilu stands for I Love You). This ensured that the Zomato IPO was subscribed 38.25 times, which means that for every share that the company wanted to sell, they could have sold more than 38 shares. The retail portion of the IPO was oversubscribed by 7.45 times, and many retail investors turned themselves into professional persuaders, persuading others to join the bandwagon.

So what am I exactly saying here?

I am not dissing the IPO after it has happened. Not at all. All I am trying to say is that if you are not in the business of professional persuasion, there is simply no point in falling in love with a particular stock or, for that matter, any mode of investing.

This is especially true for companies that haven’t started making money yet, as is the case with Zomato. Take a look at the following chart, which plots the income and the loss of Zomato over the last four years.

What does the chart tell us? It tells us that as the income of Zomato increased between 2017-18 and 2019-20, so did its losses. Why was that the case? Ecommerce companies have what is known as a network externality. With every new member who becomes a part of the network, the value of the network goes up.

The humble landline telephone is the best example of this. It was invented by Alexander Graham Bell, who made the first call to his assistant Thomas Watson. If that is how it had stayed, with only Graham Bell being able to make calls to Watson and vice versa, the telephone would have turned out to be a largely useless invention.

Hence, the more the number of people who used the telephone, the more the number of people who wanted to own one. This would increase the value for everyone who owned a telephone. And that’s network externality for you.

Zomato and many other e-commerce companies try to achieve this externality by offering discounts to prospective customers. In the case of Zomato, to be a viable product, it needs both restaurants and prospective consumers on its app. The more consumers order food using the app, more the number of restaurants that would like to associate with Zomato and vice versa.

To build scale, Zomato offers discounts to get consumers on to its app. Nevertheless, this leads to a lot of cash burn, leading to huge losses during the initial years. Hence, as the income of the firm went up, so did its losses. This was reversed to some extent in 2020-21 when the income fell, but the losses came down more.

The network effect over time leads to a monopoly or a few players controlling a large market. As David Evans and Richard Schmalensee write in Matchmakers: The New Economics of Multisided Platforms: “Network effects meant that one firm… would control the market…. These were, therefore, winner-take-all markets.” Ultimately, that’s the play.

Given this, one day, Zomato may make a lot of money, which is why it has been so richly valued. As of 29 July, the market capitalization of the stock stood at Rs 1.11 trillion, which is extremely high for a loss-incurring company.

Of course, the fact that many investors (both retail and institutional) couldn’t buy the shares through the IPO has had a role in pushing up the price of the stock as well. Other than this, the low-interest-rate environment that prevails has pushed people to take on greater risks. Economist Madan Sabnavis of CARE Ratings recently termed this as the pushed to the corner effect “where even conservative households that see negative returns elsewhere feel constrained to invest in stocks.”

But the larger point here is that no one really knows whether Zomato will turn out to be the success that it is expected to be.

Consider the following factors. One, as Galef writes: “The baseline rate of start-up success is closer to 1 in 10.” Two, look at the past. So many IPOs of internet companies happened in the late 1990s and early 2000s, during the dotcom boom; nevertheless, only a few like Amazon survived.

Three, one really doesn’t know whether Zomato will continue to remain popular once discounts start going out of the equation. Four, the success of Zomato also depends on the success of India’s economic story, which has been stagnating in the recent past. The more jobs we are able to create, the more people will earn, and the more they are likely to order food than cook at home.

Of course, this can turn out to be all wrong, and Zomato might go on to become a big success. The point is, there is no way of knowing that right now, despite all the confidence projected by the professional persuaders, real or otherwise. So, Zomato might turn out to be the next Infosys, but it can also turn out to be the next Snapdeal (now, when was the last time you heard that name?).

So should you go against the herd?

Different ideas are in fashion at different points in time. Right now, Zomato is in fashion. The overconfidence around it is simply mindboggling, given that we really don’t know enough about how the future is likely to pan out. As Galef writes: “Sometimes we simply don’t realize how complicated a topic is, so we overestimate how easy it is to get the right answer. But a large portion of overconfidence stems from a desire to feel certain. Certainty is simple. Certainty is comfortable. Certainty makes us feel smart and competent.” The trouble is it is never as it is being made out to be.

In fact, Zomato’s recent success in the stock market might encourage other loss-making unicorns/e-commerce firms to come out with their IPOs. And given the response that Zomato has seen, it is highly likely that professional persuaders will hype up these new stocks as well.

So how do you play it as a retail investor? Go against the herd or with it? At the end of the day, that depends on your risk appetite when it comes to investing. And that’s a very individual thing. How much is return of capital important to you versus return on capital?

If your capability to take on risk is higher, even then, you can’t build a decent holding in Zomato kind of stocks, which are likely to get listed in the days to come through the IPO route, simply because they will get massively oversubscribed.

Over the long-term, any serious investing in such stocks would involve buying these stocks after their IPO is over, and they can be bought directly from the stock market.

Even if your capacity to take on risks is very high, do remember that the future is uncertain and that only one in ten start-ups ultimately make it big. Perhaps the fact that a company has reached an IPO stage means that its chances of making it big are higher. But if that was the case, so many dotcoms which came up with IPOs in the late 1990s wouldn’t have disappeared in the years to come.

What does all this really mean?

This takes us back to the oldest cliché in investing, which I can’t seem to repeat enough, don’t put all your eggs in one basket. Diversify. Don’t bet your life on Zomato and Zomato-like stocks. Buy different stocks. Buy different mutual funds. Stay invested in different asset classes, including fixed deposits. And finally, what applies to the Zomatos of the world, also applies to cryptocurrency.

As Devina Mehra, founder of investment management firm First Global, said in a recent tweet: “There are tradeoffs between managing risks and maximizing returns; not always simple ones. In my opinion, the first priority is to avoid the risk of crippling loss.” Only if you live long enough will you be ready to die another day.

To conclude, love your parents. Love your spouse. Love your partner. Love your friends. But don’t fall in love with a stock or any one way of investing. Because investments at the end of the day are a means to an end and not an end in itself.

Money and wealth should ultimately help you live the life you want to, make the decisions that you want to, and spend time the way you want to. And finally, sleep well at night or even in the afternoon, as I do. Is there a greater pleasure in life?

Disclosure: The writer has no direct investments in Zomato.

Vivek Kaul is the author of Bad Money and was once labelled Twitter’s favourite economist. Were you forwarded this email? Did you stumble upon it online? Sign up here.

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