The death of profit: Why investing feels broken, and markets no longer make sense

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Patrick Dovigi is doing the unthinkable. His company, GFL Environmental Inc., hauls trash in bright green trucks across Canada and the United States. Yet the 41-year-old Canadian is something of an industry wunderkind, having made the garbage business look glamorous – at least to investors.

GFL went public in March, 2020, and in the 18 months since, its share price on the Toronto Stock Exchange has almost doubled. The whole sector has performed well, but GFL’s return has trounced those of its major rivals, and the company is now valued at more than $15-billion.

A key part of GFL’s appeal is its consistent growth. Since founding the company in 2007, Mr. Dovigi has acquired more than 100 smaller rivals and transformed GFL into North America’s fourth-largest player. For his prowess, Mr. Dovigi was paid $37-million last year, making him one of Canada’s highest-paid CEOs, but some of his compensation was paid in stock options, and those alone are worth $214-million at current prices.

The irony here is that GFL doesn’t make money. In fact, the company loses a lot of it. Over the past three fiscal years, GFL’s net losses have totalled $1.9-billion. Yet Mr. Dovigi is hell-bent on consolidating the fragmented waste management industry, and he has no qualms about paying for deals with fresh debt that eats into GFL’s bottom line. Moody’s has rated the company’s debt as junk and called out its “aggressive debt-financed acquisition growth.” But that hasn’t slowed Mr. Dovigi down. Profit? For him, that’s a long-term problem.

It’s a common mindset lately. For all its hype, Uber Technologies Inc. UBER-N has never made money – actually, it’s lost US$19-billion over the past five years. Streaming giant Spotify Technology SA SPOT-N has lost €2.6-billion ($3.8-billion) over the same period. There are now so many high-profile money-losers that Goldman Sachs recently created a Non-Profitable Technology Index, and its value soared when the pandemic hit.

Money-losing companies are also getting acquired for astronomical sums. This past December, Salesforce.com Inc. acquired Slack Technologies for US$28-billion, even though Slack, developer of the ubiquitous workplace messaging app, lost $1-billion over three years. And in August, payments specialist Square Inc. bought Australian buy-now-pay-later lender Afterpay for US$29-billion, even though Afterpay has yet to make a cent.

This euphoria for money-losing companies emerged in the aftermath of the 2008 financial crisis, when disruptors like Facebook and Netflix prioritized scale and global reach over profits. Because they were so successful at it, many investors became desperate to latch onto the next big thing, and by the middle of the last decade, private startups were often considered sexier investments than many publicly traded companies, no matter how much money they lost.

But in 2019, after a decade-long bull run, it finally seemed there was a reality check coming. Few of these money-losers had existed in a world of rising interest rates, and with the global economy heating up, central banks had started to hike rates, taking some of the wind out of growth stocks. With the future looking less certain, institutional investors started asking more questions. Famously, WeWork tried to go public in the fall of 2019, but the deal failed spectacularly after IPO filings showed US$2.8-billion in losses over the previous 18 months, plus a slew of governance issues (as chronicled in a new tell-all book called The Cult of We).

The pandemic, though, has made this era of sober second thought seem like little more than a blip. With interest rates back near zero, and with trillions of dollars in bonds once again yielding next to nothing, growth at any cost is back in favour. Investors are once again willing to underwrite years of losses in hopes of backing the next Amazon or Shopify.

“When we started writing the book, we thought WeWork was the bookend to this crazy era in Silicon Valley,” says Eliot Brown, a Wall Street Journal reporter and one of The Cult of We’s co-authors. “We literally had to rewrite the epilogue a couple of times.”

It’s now not only acceptable for a company to bleed money as it acquires or spends heavily to achieve scale; it’s actually encouraged. Investors are so taken with the prospect of technological revolution that private backers are stretching the limits of reasonable investments and valuations – a mindset that’s also bleeding into public markets. “We’ve completely normalized this concept of no profit,” says Mr. Brown.

Somehow, the only thing more tantalizing these days than investing in a company that makes $1-billion a year in profit is finding one that loses it.

The dominant ethos emanating from Silicon Valley over the past decade can be summarized by a simple phrase first coined by venture capitalist Marc Andreessen: Software is eating the world.

When he first used the term in a Wall Street Journal op-ed in 2011, Mr. Andreessen, who co-founded early internet browser Netscape, was angry that the broad stock market was rather dismissive of startups. Back then, many investors likened the new wave of companies – the Zyngas and Facebooks – to those that famously crashed during the dot-com bubble. “Today’s stock market actually hates technology, as shown by all-time low price-to-earnings ratios for major public technology companies,” he wrote, citing the fact that Apple was trading at a mediocre PE ratio of 15.2. The revolution was coming, he opined, because “more and more major businesses and industries are being run on software and delivered as online services – from movies to agriculture to national defence.”

Because software is so easy to access, many startups eschewed early profits in exchange for national or global reach. Some, such as Facebook, sought scale by making their products free to use, while others made theirs extremely affordable. One of Uber’s defining features was its cheap rides, even though the fare rarely covered the true cost of the trip – which meant Silicon Valley money subsidized the rest.

Looking back, it now seems obvious that software really was eating the world, but it took some time for Mr. Andreessen’s thesis to become a mantra. Facebook was originally ridiculed for paying US$1-billion for Instagram in 2012 because the photo-sharing app had hardly any revenue. But after a few years as a publicly traded company, Facebook’s profit potential became undeniable. In 2020, the company made US$29-billion, up 58 per cent from a year earlier.

Once investors caught on, money started pouring into venture capital funds. There was also a growing consensus that traditional investment vehicles like mutual funds were dying because they couldn’t compete with low-cost exchange-traded funds. Almost by default, then, money managers with expertise in alternative investments – private equity, venture capital, real estate – had a certain shine to them, and in no time there was so much money flowing into VC funds that they started to change the way they supported their portfolio companies.

“The amount of capital out there has made it acceptable to lose money for a longer period of time, in the hopes that eventually you tip the market and become a near monopolist, or at least a duopoly,” says Martin Kenney, a professor at the University of California, Davis. Prof. Kenney first wrote a comprehensive paper on the trend in 2018, with co-author John Zysman, called Unicorns, Cheshire cats, and the new dilemmas of entrepreneurial finance. In it, they noted that more and more startups were undercutting incumbents and other rivals on price and service because they were backed by billions of dollars worth of private capital that plugged their annual holes.

SoftBank, led by Masayoshi Son, embodies this model. Five years ago, the Japanese investment firm laid out plans for its US$100-billion Vision Fund, then deployed the cash with the specific goal of flooding its investments with so much of it that they’d outlast their competitors. Famously, SoftBank invested US$4.4-billion in WeWork after spending less than 20 minutes touring its offices, according to Forbes.

In Canada, the situation was radically different. Save for a few homegrown funds, tech was largely a backwater in a country dominated by natural resources and financial services. Aside from Shopify’s US$131-million IPO in 2015, there wasn’t much progress until early 2019. That’s when the tech sector finally seemed to gain some momentum, fuelled in part by the expectation that more U.S. startups, such as Airbnb Inc. and Uber, would finally go public. That March, Montreal’s Lightspeed Commerce Inc., which sells payment software for restaurants and retailers, pulled off a $240-million IPO on the TSX.

At first it seemed the party wouldn’t last long. By September, WeWork’s plans to go public blew up. A month later, GFL made its first attempt to go public in one of Canada’s largest ever IPOs, but ultimately pulled the deal because it couldn’t shore up enough investor demand. Where private investors had been willing to write cheques that continually boosted corporate valuations, public investors were suddenly more discerning.

CURRENT MARKET VALUE

US$125.5-BILLION

380%

US$28.3-BILLION

PERCENTAGE GAIN SINCE IPO

221%

US$73.3-BILLION

119%

US$44.5-BILLION

38%

U.S. LISTED COMPANIES

PELOTON

SPOTIFY

DOORDASH

SNAP INC.

INTERACTIVE

TECHNOLOGY

INC.

INC.

SA

US$189-MILLION

US$262-MILLION

NET LOSS IN LAST FOUR QUARTERS

US$576-MILLION

US$752-MILLION

CURRENT MARKET VALUE

US$125.5-BILLION

380%

US$28.3-BILLION

PERCENTAGE GAIN SINCE IPO

221%

US$73.3-BILLION

119%

US$44.5-BILLION

38%

U.S. LISTED COMPANIES

PELOTON

SPOTIFY

DOORDASH

SNAP INC.

INTERACTIVE

TECHNOLOGY

INC.

INC.

SA

US$189-MILLION

US$262-MILLION

NET LOSS IN LAST FOUR QUARTERS

US$576-MILLION

US$752-MILLION

CURRENT MARKET VALUE

US$125.5-BILLION

380%

US$28.3-BILLION

PERCENTAGE GAIN SINCE IPO

221%

US$73.3-BILLION

119%

US$44.5-BILLION

38%

U.S. LISTED COMPANIES

PELOTON

SPOTIFY

DOORDASH

SNAP INC.

INTERACTIVE

TECHNOLOGY

INC.

INC.

SA

US$189-MILLION

US$262-MILLION

NET LOSS IN LAST FOUR QUARTERS

US$576-MILLION

US$752-MILLION

Then the pandemic hit, and suddenly digital businesses were all the rage. In July, 2020 – after what turned out to be a short-lived stock-market freefall – Toronto-based Dye & Durham Ltd., which provides software for legal and business professionals, finally went public (its first attempt, in 2018, had failed), and the deal was a smash. The company’s share price quickly tripled, opening the floodgates for more deals. When Montreal’s Nuvei Corp., which handles online payments, attempted its own public offering two months later, investors were so desperate to get their hands on it that the deal size was boosted to US$805-million, making it the TSX’s largest-ever tech IPO.

By the end of 2020, tech companies on the TSX and the TSX Venture Exchange had raised $8.1-billion, setting a full-year record. That record fell in just the first five months of 2021. As for tech IPOs specifically, there have been 14 of them on the TSX in just over a year, after a decade of almost none.

Of the newly listed companies, only four turn a profit.

No matter how much the underlying businesses have changed, one of the fundamental principles for funding startups remains the same: Many of them will fail. “One thing that hasn’t changed in the last decade, even though there’s way more money and appetite for investments, is that 80 per cent of the returns generated in this industry still come from 10 per cent of investments,” says Chris Arsenault, a co-founder of Montreal-based VC firm Inovia Capital, which has invested in companies such as Lightspeed and Sonder. “That was the case 30 years ago, that was the case 10 years ago, that is the case today.”

But the industry has certainly evolved. For one, more founders now want to build empires – even in Canada, where there’s a cultural aversion to tall poppies. “The entrepreneurs we’re backing are way more ambitious,” Mr. Arsenault says. “They’re seeing patterns of success.” Five years ago, founders and VCs alike were much more content to sell out early in case another life-changing offer never came their way. “Now we’re past that.”

Because there’s so much money sloshing around, founders can easily find the capital they need to backstop bigger ambitions. Global funding to startups soared to US$292-billion during the first half of 2021, almost four times the amount invested in the first half of 2016, according to CB Insights, which tracks private financing. Private backers are practically begging startups to take their money because they want to fund the next big thing before their rivals do. It’s the SoftBank model on steroids.

In March, New York–based VC giant Tiger Global raised US$6.7-billion, and it has already funded 170 startup deals in 2021, more than double its total last year, according to PitchBook. Meanwhile in Canada, Calgary-based fintech startup Neo Financial Technologies Inc. announced $64-million in new funding last week, after raising $50-million just 10 months ago. CEO Andrew Chau told The Globe that searching for additional funding wasn’t even on their radar, but they were bombarded with requests. In normal times, startups are the ones begging for money.

With funding rounds flowing like water, valuations are soaring. It used to be that unicorns, or startups worth US$1-billion or more, were rare and therefore idolized. But since the start of the pandemic, at least 14 Canadian companies have attained that status, including FreshBooks, Clio and Benevity. Toronto-based fintech Wealthsimple recently raised its second round of capital in just seven months, boosting its paper valuation more than three-fold, to $5-billion – even though it has struggled to make money.

This insanity is now prevalent on public stock exchanges too. “In 2019, the crazy was confined to the private markets,” says Mr. Brown, co-author of The Cult of We. “In 2021, the crazy is alive and well in the private and the public markets.”

Public investors used to rely on age-old metrics such as PE ratios, yet many of them aren’t very useful for companies that don’t make money. They’re also particularly weak markers of success for early-stage tech companies, which tend to have hefty software development expenses. So public investors are now much more comfortable looking at potential profit once the company has some scale and therefore more pricing power.

To achieve such scale, many public companies have been hunting for deals. Lightspeed, Canada’s 2019 IPO darling, has spent US$2-billion on acquisitions over the past year. VerticalScope, which buys websites for communities of enthusiasts – everything from beekeeping to snowboarding – and went public on the TSX in June, has made more than 200 deals and plans to use its recent IPO proceeds to buy even more.

Employing an aggressive acquisition business model isn’t necessarily a bad thing – some of Canada’s premier companies live by it, including Alimentation Couche-Tard and Constellation Software. But cost discipline and stellar integration of acquired businesses are crucial.

Constellation, run by billionaire recluse Mark Leonard, is effectively a conglomerate of software companies that continually buys smaller firms. Putting many unprofitable startups to shame, the company reported US$436-million in net income last year (and that’s the official bottom line, not “adjusted profit,” a metric many young companies advertise because it conveniently leaves out costs such as interest on debt).

Constellation doesn’t publicly disclose acquisition multiples, but Howard Leung, an analyst at Veritas Investment Research, estimates it pays an average of 0.8 times a target’s annual sales (after accounting for any cash acquired). Lightspeed, meanwhile, paid 15 times the projected current-year revenues for its two most recent deals. That helps explain why Lightspeed reported a 220-per-cent quarterly revenue jump over the previous year – but a net loss that doubled to US$49-million.

So far, however, investors don’t seem to give a damn. Lightspeed’s stock is up 71 per cent this year and 859 per cent since its IPO. GFL, which employs a similar model in waste management, has seen its shares almost double on the S&P/TSX composite index since its IPO.

Lately, though, there has been a public warning or two. Mark Barrenechea, the CEO of Waterloo-based Open Text Corp., started waving the caution flag last month on an analyst call. ”Growth at any cost is bad cholesterol,” he said. OpenText has historically been a serial acquirer – a profitable one – but lately its targets have become quite expensive because everyone is bidding for the same ones. “We have found the value expectations to be too high,” Mr. Barrenechea told The Globe at the time. “We’re not going to jump in and pay any price.”

So how does this end? Canada’s cannabis industry might hold some answers. A few years back, after the federal government promised to legalize recreational pot use, there was a rush of money into the sector, and shares of unheard-of cannabis companies went on a tear.

The lofty valuations kicked off a buying frenzy. In early 2018, Aurora Cannabis Inc. acquired two major rivals, Cannimed Therapeutics and MedReleaf, for a total of $4.4-billion. All three companies were unprofitable. Canopy Growth, the industry kingpin, acquired players as far away as Lesotho and Colombia. Intrigued by the fervour, wine and spirits giant Constellation Brands invested $5-billion in Canopy in August, 2018, thinking it was getting in early on a global powerhouse.

But profit expectations proved to be wildly inflated across the industry, and the Canadian market is now oversaturated with bud. Scores of management teams have been fired, including Aurora’s, and Constellation, which paid $48.50 per Canopy share in 2018, now holds stock that trades for $17.61 apiece.

Yet extrapolating this experience to all money-losing companies is tricky. In fact, widespread market corrections have been called before (like in late 2019, when WeWork’s IPO failed), but nothing has proven capable of calming the insanity – not even a global pandemic. If anything, the fervour has only spread to more markets: startups to stocks, housing to cryptocurrency.

What’s often lost in any debate about the froth is that there’s something fundamental that unites, and fuels, all these markets: ultralow interest rates.

Bond yields have paid next to nothing for so long that investors have had to look elsewhere to earn reasonable returns. Investors are now also borrowing at record levels to put money into the stock market (known as margin debt). In August, a record US$911-billion was borrowed specifically for investing purposes in the U.S., up 196 per cent over the past decade, according to FINRA.

Low rates have also allowed companies to borrow or refinance their existing debt for much cheaper (something GFL has taken advantage of to fund its U.S. expansion). They’ve also enabled governments to borrow for next to nothing and unleash trillions of dollars worth of economic stimulus, some of which has found its way into financial assets.

The cure for the insanity, then, ought to be rising rates. Yet every time central banks have started hiking over the past 10 years, a new calamity seemed to hit.

This reality, coupled with the potential for widespread industry disruption, can make investing a dizzying endeavour. Investors are left wondering: “Is it crazy? Or is it just something I don’t understand?” says Ben Preston, who leads the global sector research team at Orbis Investments, a contrarian money manager. “It’s very much a psychological journey.”

Add to that the fear of missing out, and it can get toxic fast. “If you’re wrong for a little while, you can write it off,” says Mr. Preston. But if you miss out on an extraordinary gain, such as Shopify’s rise, “you feel a little stupid.” And that can lead to irrational behaviour.

If what is transpiring feels completely untethered from reality, it isn’t necessarily so. There are lots of companies making a ton of money. In July, Apple, Alphabet and Microsoft reported combined quarterly earnings of US$57-billion, or roughly US$5-billion a week. In Canada, equity strategists at Bank of Montreal recently noted corporate earnings have rebounded so quickly coming out of the pandemic that the bank’s 2021 profit estimates for publicly traded companies have been raised by a record 26 per cent since the beginning of the year.

At the same time, many of the growth stocks that soared during the first year of the pandemic have cooled. The once-almighty Ark Innovation ETF, which skyrocketed 148 per cent in 2020, is down 6 per cent for the year, and many companies that have recently gone public have watched their share prices crash. Tesla’s stock is flat for the year. Meanwhile, stodgy Canadian bank stocks are up an average of 26 per cent.

And yet, venture capital is still being thrown around willy nilly, and acquisitions of unprofitable companies aren’t showing any signs of cooling. Who cares about profit when there’s the world to gain from getting in early on a brand new industry? Online gambling was recently legalized, and this summer Toronto-based Score Media and Gaming, which operates the popular app theScore, was sold to Penn National for US$2-billion, even though theScore makes no money.

Some of these bets will undoubtedly pay off. But when there’s so much upheaval, it’s hard to tell whether something is a fad or not. “Many individual companies are deserving of their current high multiples – we absolutely concede that somewhere in the global growth basket sits the next Amazon,” asset management giant GMO wrote in a note to clients this summer. “Unfortunately, they’re also ALL being priced that way, and for us, that is a bridge too far.”

For software companies, a top concern has to be that technology will advance so quickly that their product becomes obsolete in just a few years. Blockchain technology, for one, is reconfiguring how legal contracts and the infrastructure underpinning the financial system works. “If your software is about transaction verification and transaction security, that is something that blockchain is probably going to disrupt,” says Veritas’s Mr. Leung.

For crypto, which is now attracting gobs of retail-investor money, the prospect of regulation, which now seems inevitable, could radically change things. For electric vehicle makers, the worry has to be that the old guard catches up. Case in point: Earlier this month Ford Motor Co. poached the head of Apple’s burgeoning EV division.

There’s another factor that applies to every sector, and though it’s somewhat intangible, it cannot be ignored. Historically, the weight of the insanity has forced a correction, provided there isn’t enough underpinning the froth. “At some point, the fundamentals matter,” Mr. Leung says.

Sometimes it takes a few quarters, sometimes a few years – and that can be maddening for those who’ve been mystified by the madness from day one. But at some point, investors grow skeptical. The trouble is, it can be impossible to tell when that will happen – and by then, the early backers have usually vanished, leaving the carcass for the suckers who bought them out.

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