There has been tremendous interest in the recent IPO's of ride-hailing giants Lyft (LYFT) and Uber (UBER). Finance history suggests these firms will deliver poor risk-adjusted returns to investors. This article will contextualize the historical relationship between firms with high market caps and low operating profitability.
Most finance students learn about the Fama-French Three Factor Model. The model observes that small-cap stocks tend to outperform large-cap stocks, and low market-to-book stocks tend to outperform high market-to-book stocks. Adding these observations to the Capital Asset Pricing Model better describes stock market performance than beta alone. It is no wonder that size and value are two of my "5 Ways to Beat the Market"; including these historical factors of market outperformance better describes equity market returns.
In 2012, nearly 20 years after Fama and French's seminal paper, Robert Novy-Marx published The Other Side of Value: The Gross Profitability Premium, which showed that a simple measure of profitability had roughly the same power as book-to-market in predicting the cross-section of average returns. In his research, profitable firms generated significantly higher total returns than unprofitable firms, despite having significantly higher valuation ratios. Novy-Marx is one of the most intelligent people I have personally met in my lifetime, but a simplification of this conclusion is probably intuitive to many Seeking Alpha readers - more profitable firms deliver higher equity returns over time.
In 2013, Fama and French would publish A Four-Factor Model for the Size, Value, and Profitability Patterns in Stock Returns, which would use profitability to further describe returns. As long-time readers know, I often lean on the dataset of Dartmouth professor Kenneth French, a member of this famed finance duo, in my articles. Within this dataset, he forms portfolios based on size and operating profitability. The return dynamics within these portfolios gives us our titular link back to Uber.
In this dataset, operating profitability, is operating profits (sales minus cost of goods sold, minus selling, general, and, administrative expenses, minus interest expense) divided by book equity. Below I show a matrix of the annualized returns of 25 portfolios subdivided by size and operating profitability. This monthly dataset streches from mid-1963 through March of 2019.
There are a couple of important takeaways from these realized returns. First, the lowest returns in each size cohort row are the companies with the lowest operating profitability. Second, returns tend to decline as you move from small to large companies - the oft-discussed size premium. Third, the absolute worst performing cohort bisects these two trends - the largest companies with low operating profitability.
Uber fits in that bucket. Under this simplified version of operating profits, Uber's are decidedly negative as excerpted from the company's S-1 filing for the recent IPO and detailed below.
With a market capitalization of $69B (as of Thursday), Uber also fits neatly into the largest size cohort with the five subportfolios in the largest slice of the dataset ranging from average constituent size of $56B to $81B. The company sees itself as a dominant transportation company, but it already has a larger market capitalization than the largest domestic automaker - General Motors (GM) $53B, the two largest domestic airlines combined - Delta Airlines (DAL) at $36B and Southwest Airlines (LUV) at $28B, and the second largest standalone railroad - CSX (CSX) at $63B.
Uber bulls will contend that that the company's scale will cause profits to rise faster than expenses. That is a challenging assumption. They can raise prices, but it will challenge the elasticity of demand in places where there are free or cheap alternative transportation options. Marketing costs will fall as market penetration continues to rise. Labor and insurance costs seem unlikely to abate though. The share of revenue going to the driver seems like it is relatively close to its floor amidst episodic calls for driver strikes.
Eventually, Uber will replace the driver with autonomous vehicles. At that point, the company goes from a capital-light, spread-based subscription business favored by tech companies to a capital-intensive transport company. The company sees itself as a dominant transportation company, but it already has a larger market capitalization than key transportation leaders in other parts of that industry. It has been a disastrous start for Uber as a public equity. Finance history on companies with high market capitalizations and low profitability suggests below market returns are likely to continue.
My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.