Everyone seems to be talking about Xero – and I’ve been fielding a lot of ‘should I invest?’ queries. So here is what will now be my standard reply:
Do your research.
This is a low dollar early stage investment that would normally be offered to an Angel or Venture Capital investor. That means the risks and potential returns are higher, and that investors should be very well informed and financed.
1: Read about the business
Read the prospectus (offer document). All of it. Make sure you understand where the value of the company is going to come from, what will happen to the money raised, and what the risks are.
Read Mark Clare – who has blogged about Xeros IPO over on Valuecruncher. Read other analysts comments as they emerge.
Read a book about the dot com boom and bust. Pick any one. There is value there, but only a few win.
2: Assess the business
You’ll need to drive a spreadsheet for this.
Form an opinion about the size of the potential market for Xero’s product, and then form another opinion about their ability to capture that market in the face of competition that is not standing still. How long will it take to make money? How much will it take to get there in time? Money? Could this make $100m a year, and so be a billion dollar company? what are the underlying assumptions to get there?
What is the probability of Xero becoming a billion dollar company ($100m ebit a year)? a hundred million dollar company ($10m ebit per year). A $50m or less company? ($5m ebit or less). Worthless (they spend all the capital and close down). Assign probabilities to each of these based on what you read and know.
Remember that the current Xero product may fail – so will the team be able to redirect to another more profitable line and still become big? VC’s sometimes (not that often) invest in great teams that have average products.
3: Assess the investment
What sort of multiples of earnings would this get on a US market? (Look up INTU)
Who are the logical trade buyers? What sort of earnings multiples would they pay? How much money do their competitors stand to lose if Xero executes well? (They’d be willing to pay that). How much money could a larger competitor make out of migrating their customers to Xero’s product? (they’d pay that much).
Remember that there may well need to be another financing round between your investment and maturity – so your percentage of that hundred or billion dollars would be squeezed down. Assess how much capital Xero will need in 18 months time to keep going for the following 18 months until profitability, and guesstimate what percentage of the company, if any (loans instead perhaps?) will need to be sold to get that.
The work out what percentage return will you make if this becomes a a hundred million dollar company? a billion dollar company? $50m? $0?. Take your probabilities from above and multiply out to get your very own expected return.
It had better be greater than 12%. Hell – it had better be great than 20-50%, because you have a very real chance of losing everything. Remember your money could be safely put with someone like Gareth Morgan and earn 8-12%, without a chance of losing it.
One more thing. You may feel that the demand for these shares will be supernatural, resulting in a massive initial hyped up appreciation of share price, and you may like to take a punt, and exit quickly. Do that only if you see real evidence of the required frothiness amongst your peers and bigger investors. Be very wary though – many others may have the same idea.
Still with me? Now invest only if you already have a diversified portfolio of stocks and fixed interest investments, can afford to hold this investment for a while, and walk away from it if you have to.
If you didn’t manage to get through the analysis above, or to do your own version of it, then you will not be an informed investor. The informed investors are the ones that win in the markets – something Warren Buffet is very good at. The uninformed are either investing on emotion, or on someone else’s advice. Neither are recommended – stock tipping is about the same as horse tipping (though quite different from cow tipping), while investing on emotions is … dangerous. If you don’t want to do the research but still want to invest in stocks that’s not a problem – go to someone like GMI and get them to buy you a diversified portfolio of stocks and bonds.
Will I invest in Xero?
Right now it is too hard. Not only would I actually have to do the above research, but I’d also need to open a NZ trading account to invest in stocks, which seems difficult. The forms are long, involved and on paper – requiring such antiquities as stamps and envelopes. Plus I don’t really trust a market where you cannot easily short. I’d rather spend my research time on companies and industries I know, and give the diversified portfolio bit to someone else (GMI in this case). Right now I am long eBay and AAPL, and short EQR and MSFT.
<update – En avant has some comments on the deal>