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What maths is involved in making returns from a basket of ‘unicorn’ stocks?

What maths is involved in making returns from a basket of ‘unicorn’ stocks?

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We had so much fun taking pot-shots at unicorns last autumn that, here on The Value Perspective, it seemed only right to make a New Year’s resolution to hold our fire for a while. For anyone now fearing for our sanity, we should point out ‘unicorn’ is gaining currency among investors as a way of describing unlisted start-up businesses that have reached a paper valuation of at least $1bn (£700m). 

As you will see from articles such as Hit and myth and Storage issues, we remain unconvinced such businesses are quite the unqualified investment opportunities others believe them to be. We were, as we say, going to lay off them for a while but then we read about the pony dressed as a unicorn that slipped its handlers and went on the run in California for a few hours – and, well, how could we resist? 

The only question was whether to go with the metaphor of something looking like a unicorn in reality being a pony or to pursue the more literal idea of a unicorn running amuck – but then the matter was taken out of our hands when we saw the following chart from J.P. Morgan, entitled ‘Many unicorns finding it hard to survive in the wilderness’.

Source: Bloomberg, Techcrunch, JPAM, February 16, 2016 “Current” shows most recent price index for companies public for more than 950 days

After all, why would we look a gift horse (or gift pony or gift unicorn) in the mouth? The chart shows all the unicorns that have thus far had an IPO and the money they have since made – or, in the great majority of cases, lost – for those who bought in at the time. As we have noted before, unicorns tend to be very expensive – right up to the moment the market gets involved and cuts them down to size. 

Little wonder then that Bill Gates was recently quoted in this FT article as saying he would not know whether to go long or short “a basket of unicorns” at the present time. “I might go short in the two-year timeframe,” added the Microsoft co-founder, “but not in the longer timeframe because all it takes is for one or two of those to join the pantheon and your short would make you go bankrupt.” 

Extreme example 

The possibility that one or two unicorns could “join the pantheon” is of course what keeps so many investors interested and certainly, if you are holding a basket of the creatures, you have got to be hoping it contains the next Facebook or Google – or preferably both. So what sort of numbers would be involved in such a scenario? Let’s do the maths on an extreme example. 

Say you wanted to invest $100 evenly across 100 unicorns in the hope of achieving a return of 10% a year over the next decade – in effect turning your $100 into $259. You then lose all your money on 98 of the unicorns – how hard would your two success stories have to work? Well, in order to hit that magical $259 after 10 years, your remaining $2 would have to increase 12,969%. 

With the average unicorn currently valued at around $3.5bn then, over the course of the next decade your two companies would both have to have grown into $450bn behemoths – meaning both businesses would have to be the same size as Google. 

But perhaps we are being overly harsh about the unicorns’ chances of success and so let’s say that only 80 rather than 98 go on to bite the dust. That would mean that, instead of two companies each worth $450bn at the end of 10 years, we would need to have 20 companies worth just the $42bn each – that is, 20 businesses each around the size of Netflix. 

Now, clearly there are people with track records in investing in tech start-ups who might feel confident of pulling off such a trick but would you? Certainly, here on The Value Perspective, we are not interested in those sorts of odds, preferring another path in the hope of achieving 10% compound returns – that is, investing in equities and, more specifically, in the cheapest parts of the equity market.

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