Shortly after Didi Chuxing’s US IPO, the ride hailing company saw its mobile app banned from app stores by Chinese regulators. And as of late August, it witnessed its share price plunge by over 50% from a previous high[1]. But it is not our intention to chip in on any network data security issues, as existing articles have sufficiently covered that ground. Instead, we seek to understand whether tech companies should sacrifice short-term profits in favour of aggressive business expansion.
It’s key to talk about why such questions merit further analysis. In the past, under the traditional economy, professional investors often shunned companies that weren’t profitable. But we see the opposite takes place in today’s new economy: companies such as Amazon and Tesla, i.e. those that are still in their investment phase and yet to be profitable, are clearly the frontrunners in terms of global market value.
The concept of profits no longer seems relevant, as many new tech companies invariably decide to pump capital into developing new businesses as well as research and development. The redder a company’s balance sheet, the higher its stock price. Apparently, such is the trademark of a new trend.
It resembles Didi’s business development strategy. According to its IPO prospectus, Didi’s domestic ride-hailing business began turning profits in 2019, with moderate year-on-year growth in 2020 despite the pandemic’s blow[2]. Meanwhile, the company continued to plough money into new businesses and new technology research, which resulted in Didi making losses as a whole for the past three years2.
Didi’s new business ventures and R&D efforts covered a diverse variety of projects. In its foray into new business lines, the ride-hailing company has launched operations in overseas markets and began offering food delivery services. In China, Didi started providing bicycle and electric bicycle rental services in 2018, and rolled out a domestic logistics freight unit and a group-buying arm in June last year. Meanwhile, the tech conglomerate has ventured into financial services, and has been focusing its research firepower in the development of electric vehicles and autonomous driving systems.
But to understand whether persistent reinvestment in a loss-making company should be considered a positive trait, we think it’s key for investors to differentiate the nature of investment projects in the old and new economy, and how investments are treated differently by accounting standards. In the past, investments could mean production plants and machinery, which were all tangible. Their values might change over time, but they didn’t tend to change abruptly, and were more transparent as these assets were bought and sold in the second-hand market. Accounting standards therefore treated such items as investments, instead of costs.
But in today’s new economy, with most investments being intangible assets – ranging from software, or new medical or engineering patent rights – it can be difficult to pinpoint exactly how much these assets are worth, or to buy and sell them in any market. Accountants, erring on the side of caution, would usually treat these expenses as costs and deduct them from profits. But if we think about it, a successful software or patent can command much higher value than tangible assets, even though they aren’t treated as investment items like factory buildings and machinery. Instead, they are considered as expenses, which ultimately have an impact on a company’s profit margins in the balance sheet.
But of course, not every investment will turn out to be a success. Indeed most of the research expenditures should probably be treated as part of the costs. So the question as to which ones are successful and which aren’t, will ultimately rest on each investor’s individual insights and experiences. If an investor is of the view that a given investment or R&D efforts would work in favour of the target company, he/she should consider these expenditures as investments rather than costs.
In our experience, several factors can be used to gauge how successful an investment is. First, is the company in question a pioneer in the industry it’s operating in? It usually points to relatively little competition, meaning that there’s a higher chance of it succeeding in said industry. Second, how big is the industry the target company is operating in? The larger the industry, the easier it is for the company to take advantage of economies of scale. The internet has a global reach, which enables leading companies, such as Facebook and Netflix, for example, to tap on not only the domestic market, but also international consumers. Finally, investors should be convinced of the target company’s ambition to grow, the ability of those at the management level to execute business strategies, and its approach to attracting talents – only companies with these qualities will be well placed to act on the opportunities arising out of the first two scenarios.
[1] Source: Sina Finance, as of Aug 2021
[2] Source: Didi Prospectus, as of June 2021
Disclaimer
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.
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