Business Performance and Market Pricing

12 min readSep 2, 2024

Introduction

Over the short-term the stock market is a voting machine; over the long-term, it’s a weighing machine. — Ben Graham

Factors such as interest rates, market sentiment, and price momentum can influence stock prices in the short term, but ultimately, it is the underlying business performance and its ability to generate free cash flow that dictate a company’s long-term value.

The Great Mispricing

The financial market to the most part reflects the performance of the businesses that the stock symbols represent. However, it often distorts reality. The dot-com bubble of the late 1990s and the housing market crash of 2008 are prime examples of how the market can sometimes misprice assets, leading to significant disparities between perceived value and intrinsic worth. As Howard Marks often says, the pendulum swings between extremes and it rarely stays in the middle.

One of the factors that causes mispricing is the misunderstanding of how and whether new technologies disrupt existing business models.

Atlassian

Online customer relationship management (CRM) software company Atlassian can be viewed as a classical disruptive business. Its software as-a-service (SAAS) offering Jira is simple to use, easy to customize, and the basic functionalities are free for most small business owners. As it is simple and lacks sophisticated features, large enterprise users do not want them and hence for a long-time ignored by those incumbent CRM vendors.

As user adoption gains momentum, of course Atlassian started to build more advanced feature sets to support more complex workflows.
The SAAS business model is inherently sticky, because it is extremely painful to migrate the accumulated customer data to another vendor.
Many of its early customers who were small have now grown into large enterprises as well, further facilitating the snowball effect of the business growth.

If the business grows so well, why did the market price drop by more than half in Dec. 2022?

Again, the FED’s sharp increase of interest rate from 0% to 4% in 2022 led to a re-pricing of the entire SAAS industry.
The capabilities of the advanced AI exemplified by LLM are so impressive, that the investment community fear that the SAAS business model may eventually be destroyed by AI. Some start-ups can even show that the initial version of the Jira software stack can be automatically generated by AI.

The future is unknown. However, Atlassian’s commitment to customer-centric innovation and its ability to adapt to evolving market needs have been key drivers of its sustained growth. If you believe that the stickiness of Atlassian’s SAAS business model is intact, just as the network effect of Meta’s social network apps, you would be able to see through the current market pricing and see the intrinsic value of the business.

Sleep Number Corp.

Now we turn our attention to a low-tech business in a cyclical industry. Sleep Number Corp. sells adjustable mattresses. The mattress market grows at roughly the same rate as the economy, which is not much, yet Sleep Number was able to grow in the past 20 years at about 10% per annum, by stealing market share from other manufacturers.

Sleep Number Corp’s performance is closely tied to the economic cycle, with sales typically surging during periods of economic expansion and declining during downturns. This cyclical pattern is particularly evident in its correlation with the housing market, as mattress purchases often coincide with new home purchases or renovations.

Despite the ups and downs for the demand for mattresses, one could say it is a fairly stable and predictable business with a relatively simple business model. Yet its market price has gyrated to the extreme during the economic bottom as well as the top. A couple of contributors to the sentiment swings:

There is inherent leverage built in the business model. Due to the low margin nature of the products, any expansion requires borrowing on the short end of the yield curve. When shrinking demand coincides with increasing interest rates, the company’s balance sheet gets squeezed, causing fear of bankruptcy.
As the population’s concern over sleep quality increases, innovative sleep monitoring and sleep enhancing products emerge. Can Sleep Number Corp. maintain its competitive edge in a low-margin business?

As shown in the chart above, overextended borrowing during the good times in 2020 led to a deteriorated balance sheet when demand shrank in an increasing interest rate environment in 2023. If history rhymes, I would like to believe that Sleep Number Corp. shall demonstrate a replay of 2000 and 2008 price reversal.

Summary

Market prices change in reaction to short-term revenues or earnings releases, product or market news, economic or interest rates, either positively or negatively. Whether or not these metrics or events correctly reflect the fundamental business operations, it is up to the investors to decide. The key factors driving business dynamics rarely change.

The Real Decline

“This time is different”. This is the most dangerous 4-word phrase in investing that has caused great harm to one’s portfolio. Yet, occasionally, when the technology paradigm shifts from under, a long-lasting business can be materially and permanently damaged.

Intel

Intel is an admirable business empire that jointly created the Silicon Valley as we know it today. It has dominated the desktop computer CPU market since the 1980’s and still commands over 70% of the server CPU market today. Through the past 40+ years, Intel has brought to market tremendous innovations in areas such as silicon manufacturing, computer architecture, and software compiler technologies. In most of the areas directly related to its core CPU market, Intel has spearheaded technology innovation.

However, partly due to its success in the desktop CPU market, Intel has completely missed two disruptive technologies that are today on the brink of toppling the very existence of Intel. They are mobile low-power CPUs and graphic process units (GPU). This is the classic Innovator’s Dilemma playing out twice in a single company.

ARM introduced extremely low-power CPU core technology targeted for mobile computing at a time when laptop computers were still a tiny market and smartphones did not come to existence yet. Such a small market was naturally ignored by Intel management. When it realized the potential of the mobile CPU market and introduced its own Atom CPU in 2008, it was not able to compete with the then dominant ecosystem surrounding ARM’s cores.
Ever since the proliferation of personal computers (PC), GPU has always been a niche market, drawing interest from the hard-core gamers only. Intel happily allowed nVidia to co-exist with its CPU’s as a coprocessor for those use cases. While nVidia continues to invest in its customer ecosystem and cultivate the software development environment CUDA, the GPU development efforts inside Intel fail to gain momentum. Today, nVidia’s market cap is 31 times that of Intel.

Intel’s failure to capitalize on the mobile CPU and GPU markets has had far-reaching consequences. The company has ceded significant market share to ARM and Nvidia, resulting in a decline in its market position and financial performance.

Intel will continue to thrive in the desktop computer CPU market, but as the world moves towards mobile and AI, Intel becomes increasingly irrelevant. As the chart above shows, its market price dwindles as the company fails to deliver growth expectations, and as failed investment initiatives pile up, the bottomline deteriorates as well.

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This time is different. The market price prediction of Intel’s business at Sep. 2022 turned out to be prudent.

GoPro

When GoPro announced its first 35mm HERO at the Action Sports Retailer trade show in 2004, it was a disruptive innovation to the camera market. As the rest of the camera market was obsessed with higher resolutions and dynamic range, GoPro quietly focused on other product attributes few cared about initially, such as mobility, battery life, ruggedness and waterproofness.

As Christensen predicted in Innovator’s Dilemma, as the demand in pixel-count eventually saturated, other product attributes started to emerge and drove customers to GoPro cameras. GoPro saw its revenue increase 7-fold from $230M in 2011 to $1.6B in 2015. Its market price shot up shortly after its IPO in 2013. See the revenue and price chart below.

However, the technology for cameras evolved so quickly, that GoPro itself became a victim of technology disruption, this time by smartphones. Smartphone cameras improved rapidly, thanks to advancements in sensor technology, image processing algorithms, and computational photography powered by machine learning. Since you need to carry a phone anyway, and it has a good enough camera, why would you carry a separate GoPro HERO?

GoPro has remained a niche market product ever since, and perhaps will never escape it.

Walgreens

The innovative drug store chain has enjoyed three-decades of continuous expansion and financial success from the 1990’s to the 2010’s. Its strategy of aggressive expansion into high-traffic urban areas, focus on pharmacy services, and utilizing technology to achieve customer convenience, have helped propel it to become the second largest drugstore chain in the US, with $130B in annual revenue.

However, since 2015, shares of Walgreens have been down 80%. While it got a temporary boost from Covid vaccinations and test sales during the peak of the pandemic, it is facing the ultimate question today: is retail pharmacy broken? Reimbursement rates for prescription drugs have fallen; competition from Amazon and grocery stores are rising; while the push into primary care with the acquisition of VillageMD did not yield the expected growth.

Is this time different? Can Walgreen revitalize its growth engine, or has the train for online drug subscription and online primary care left the station without Walgreen?

Summary

This time may truly be different. When the inevitable forces of disruption kick in, short-term damages in business operations may actually become permanent. Hence short-term market pricing may indeed accurately predict future business performance. Understanding the difference requires a deep insight into the core business, regarding the value it brings to its customers and the technology stack it relies upon to deliver that value.

The Disruptors

“The next big thing always starts out being dismissed as a ‘toy’”. — Chris Dixon.

Disruptive products often offer a simpler, more affordable, or more convenient solution compared to existing alternatives. They may initially target a niche market or a specific customer segment that is underserved by traditional offerings.

Most of the toys are cheaper, easier to break down and have poorer performance than the real thing, but once in a while a toy product like Tesla comes along. Tesla entered the electric vehicle market with the Roadster that accelerates from 0 to 60 mph with 3.7 seconds. The Roadster demonstrated that electric vehicles could offer performance, efficiency and style, paving the way for Tesla’s future success.

What attributes do disruptive products have then? Companies with disruptive products tends to be

in a new markets that have no established incumbents, or
in an existing market that has unique attributes valued by a small group of customers, but lacks attributes demanded by the majority of the customers;

That have

inherent sticky attributes that drives continuous revenue growth;

That benefits from

a tidal wave of technology paradigm shift, which improves performance metrics at a faster pace than sustaining technologies.

Nubank

Having a bank account and credit card is a symbol of having grown up and being in charge of one’s own financial matters. To get one, one has to go through a lengthy process of paperwork and perhaps pay several visits to a bank’s branch location. Nubank made all of this extremely easy and pleasant for Brazilians. With a few clicks on the phone, one can be up and running and taking control of their finances.

Traditional banking institutions initially underestimated the potential of Nubank’s digital-first approach, dismissing it as a novelty rather than a serious competitor. However, the company’s focus on customer experience and its ability to leverage technology to offer convenient and accessible banking services quickly resonated with consumers. With Net Promoter Score (NPS) over 90, customers at Nu Bank grew like weeds. Just recently the total customer count surpassed 100 million.

As shown in the chart above, revenue has been growing at ~50% per annum. The market had high expectations upon IPO in 2021, but lost faith shortly after; the market eventually had to catch up, and perhaps overshoot again.

Roblox

Roblox originally started as a physics simulation engine. Since the release of its first game in 2006, it has been charging an unconventional path in the intersection of several markets, including education, online massively-multiplayer games, and real-time communication.

Chid Play — Roblox initially focused on users under the age of 13, with cartoonish lego-like avatars for all players. It was dismissed as a primitive childish game. Why would a professional gamer care about blockish characters running around in low-resolution backgrounds? After consistent growth, users above the age of 13 now consist of more than 60% of the total user base as of Q2 2024.

Just Games — Active users shot up during the Covid pandemic. People are stuck in their houses with nothing better to do after all. As user-engagement drops post-pandemic, Roblox was dismissed as just another gaming platform. In fact, Roblox’s platform is built on a scalable 3D spatial computing engine that enables real-time communication and interaction in virtual environments. This technology has applications beyond gaming, including education, virtual events, and social experiences.

As shown above, Roblox revenue has been growing at a healthy 25% PA. The market expectations have not resumed to the post-pandemic highs, as the Wall Street is still having a hard time putting a label on what exactly is the market for Roblox.

Summary

Real disruptors are almost always dismissed as toys. People underestimate the reality of emerging new markets, or the power of the underlying technology paradigm shifts, or both. Herein lies the opportunity for analysts who seek to understand the real drivers of the business models.

Conclusions

A good investor is ultimately a good business analyst.

The market sometimes misprizes the value of a business due to short-term events, and sometimes correctly predicts the value of a business that is permanently impacted. A good investor should see through the buzz and seek for a deep understanding of the business fundamentals, which include the underlying technology paradigms and the market competition dynamics.