Over the last 2 decades, the “tech” sector has come to dominate the economy. In the process, as the tech sector matured, it broke into several subsectors, each with its own unique investing considerations.
In this industry primer, I will look at one specific subsector of tech: e-commerce. Let’s see what makes it unique and how investors can look at this sector to ensure the highest chance of good returns.
What Are E-Commerce Companies
In this article, I will define e-commerce as retail companies doing the majority of their sales online or supporting the online sales ecosystem. This means I will exclude companies making some online sales but still relying on their brick-and-mortar shops. I will, however, discuss at the end the competition risk from every company turning into an online seller.
A Different Industry Structure
Most retail companies have relied on the same business model for almost 2 centuries: buy products and sell them in a physical shop, if possible, ideally placed geographically. This required a lot of personnel to fill up the shelves, assist customers, check goods out, etc. It also required large expenditures on facilities in the right locations.
Each shop’s sales were limited to at most a few tens of kilometers radius around the shop building.
Traditional retail is a very capital-intensive business, with the need to own large shops and inventories. It’s also a very low margin business, as customers seek out the lowest prices and stores compete largely on price.
This led the sector to slowly based itself on 2 possible models to optimize costs:
- Specializing in one product category only (like clothes retailers, for example)
- Scaling up to be the shop for everything (the Walmart model)
E-commerce changed things drastically for retailers, with a few key differences in how e-commerce operates:
- There’s no geographical limit to a shop’s reach. At once, retailers can sell to a whole country from one centralized online shop.
- Lower physical CAPEX, with industrial warehouses in low-cost areas replacing much nicer looking and much more expensive physical shops in prime locations.
- Inventory and supply-chain optimization through real-time tracking of orders and centralization of inventory.
- The ability to have “long-tail items” in stock, like rare books selling just a few thousand copies per year for early Amazon, unlike traditional bookstores.
- The struggle for the best retail location for foot or vehicle access is replaced by a struggle to get online attention and traffic.
In many ways, this made e-commerce more similar to direct marketing catalog businesses than to traditional retailers. Traditional retailers were slow and inefficient at adapting to this new threat.
The Rise of Marketplaces
At first, e-commerce had to iron out multiple technical difficulties, including building safe and trustworthy online payment systems. This caused an initial disappointment in online sales, one of many factors driving the bursting of the tech bubble.
As the technical obstacles were solved, e-commerce emerged as a real threat to traditional retailers. A leaner cost structure allowed for lower prices. Better inventory meant more satisfied clients. The ability to reach an entire market in an entire country helped create economies of scale as well.
Currently, e-commerce is a $1T market in the US and $5T globally.
Marketplaces operate a business with two separate sets of “clients”, the sellers bringing products to the marketplace and the buyers, with the marketplace operating as the unavoidable middleman.
Marketplaces are very hard to get started, as you need sellers to get users, and you need users to attract sellers. But once the initial push is done, they solve the hardest part of e-commerce: bringing online traffic. Sellers on Amazon have immediate access to hundreds of millions of eager buyers.
The Internet’s global scale induces a “winner-take-all” logic where just a few actors end up dominating a whole sector.
To this day, e-commerce is still dominated by the few early successful marketplaces that managed to carve themselves a durable niche: eBay for second-hand items, Amazon for consumer products, Etsy for gifts and handicrafts, AliExpress for China-made goods, etc.
Stand-alone websites provide an alternative to marketplaces. These websites might rely on software providers (Shopify, for example) and payment processors like PayPal and Stripe.
These usually rely on bringing in traffic through ads and other marketing strategies like SEO (Search Engine Optimization). This makes them independent from marketplaces but highly dependent on other tech companies, like social media (Facebook) or search engines (Google).
Still, being able to control your own traffic and gain buyer loyalty to your brand instead of a marketplace, with competitors just one click away, can be a very durable way to build an e-commerce business. So we should expect that both marketplaces and stand-alone sellers will persist in the e-commerce ecosystem.
Investing in E-Commerce
E-commerce businesses are able to scale to size and at a speed impossible for brick-and-mortar retailers to match. This is why a company like Amazon went from an online bookstore to dominating the Western world’s retail trade in such a short time.
As a result, e-commerce businesses have to grow fast, outpacing their competitors in the winner-take-all game. It often means price wars and expensive marketing spending to acquire a lot of consumers fast.
The consequence is that successful e-commerce might be unprofitable for a very long period of time: Amazon only started to show a profit because of its “side business” of cloud computing.
Due to this focus on growth instead of immediate profitability, an investor in e-commerce have to rely on different financial metrics than earnings or free cash flow.
One of them is the customer lifetime value (LTV or CTV). This is the estimation of the value of buyers from their first visit to the website. Because the acquisition of new users is expensive, the first purchase is usually not enough to cover the marketing cost. If the client keeps coming back, the marketing cost will be worth it in the long term.
Another metric used a lot by marketplaces is Gross Merchandise Value (GMV). It allows for measuring the value of all the goods and services sold on the marketplace, including by third-party sellers. A stagnant or declining GMV is a massive red flag for an e-commerce company, especially a marketplace.
If possible, the average order value (AOV) is another interesting data to analyze. A rising AOV could indicate increasing trust or satisfaction from the user.
As for all not-profitable-yet growth stocks, cash on hand and how long it will last at the current spending levels is a very important metric. So a careful study of the balance sheet and cash flow statement is key to accurately predicting possible troubles or shareholders dilution in the future.
Lastly, Internet metrics like “website traffic checkers” or Google Trends data can help us see if an e-commerce company is getting more popular or is benefiting from an overall trend in the market.
Possible Investment Strategies
One method for investing in e-commerce that has proven very lucrative has been to invest early in promising companies. The benefit is obviously the ability to invest before a company grows 100x in size. The downside is that picking the right company is very hard. For example, very few people believed in Amazon in 2000 when the dot com bubble had burst and the company was bleeding money.
It is a strategy that is somewhat outdated in countries with a well-developed e-commerce sector. It is especially hard to imagine how a newcomer could dethrone Amazon in the West or Alibaba in China. The “next Amazon” is probably NOT the next anything.
This, however, can be an option for younger markets, like South America, Southeast Asia, the Middle East, or Africa (companies like MercadoLibre or SEA have been the focus of investors interested in that idea).
Investors using this method will need to be ready to hold their investments through periods of extreme volatility, counting on long-term growth and ignoring short-term fluctuations.
Another option is to bet on the dominant actors. While this might sounds “boring”, investors in dominant players like Amazon or Shopify gained from excellent performance up to late 2021. The recent underperformance of these stocks might indicate that an extended period of stock price decline is forthcoming or that the 2020-2021 pandemic effect had pushed e-commerce stocks too high too quickly.
And this brings me to the last possible strategy to invest in e-commerce, using cyclicality. The tech sector in general, including e-commerce, is prone to getting periodically overvalued and then undervalued.
Investors in e-commerce after the bankruptcy wave of 1999-2000 would have consistently outperformed markets in the two decades after. This is, of course, if they had sold before the bubble burst. The same situation occurred again during the 2020-2021 vertical climb of tech stocks related to the pandemic.
So it is possible that once the current “tech crash” is over, the sector will again offer great buying opportunities to hold for a decade or two, or at least until the next tech bubble?).
Threats to the E-Commerce Sector
Traditional retailers have finally started to react to the threat of e-commerce. Companies like Walmart have leveraged their pricing power and existing logistical networks to quickly become large e-commerce actors (25% of US grocery e-commerce) after ignoring the sector for years.
So it is possible that traditional retailers are ready to stage a comeback, leveraging their shop networks as logistical centers and delivery points and capitalizing on their existing user base. This could drastically reduce pure e-commerce companies’ ability to keep growing at the rate they did over the last 30 years.
In addition, every SME is now an online seller as well, developing their expertise and network in small niches to beat the larger generalist actors. Many customers in specialist niches would rather buy from a specialist retailer than from Amazon.
The trend of the hybrid e-commerce/physical shop model has not been missed by e-commerce leaders either, with, for example, Amazon acquiring Whole Foods in 2017.
One last threat stems from the “winner-take-all dynamic. This can lead successful companies to fall under the scrutiny of anti-trust regulations. For example, Amazon has been exposed to this risk both in the US and abroad, and Alibaba is coming under fire from Chinese regulators.
Conclusion
E-commerce is now a central part of the retail industry and is unlikely to ever go away. Even if it might never fully replace traditional retail, it is a sector investors should not ignore.
E-commerce, along with all Internet sectors, has a structural tendency to have a few companies turning into quasi-monopolies, usually a very profitable setup for investors who choose the right company at the right time.
The e-commerce market is maturing, and in developed countries, the turn to a hybrid model and slowing growth should be expected. In developing markets, companies replicating the business model of developed countries’ giants are likely to do well, even if it might tricky to pick the winner at an early stage.
In any case, attention to fundamentals and caution regarding the cyclicality of tech investing will be useful to protect investors from a general downturn in the sector. We seem to be in the midst of such a downturn, even if it is hard to tell when it will be over.
Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.
