As companies like Apple and Alphabet went from companies too small for an index fund to its top components, such that 6% of all S&P 500 index investing dollars go into these two companies alone, it has been an underappreciated benefit that these two companies have been immensely profitable, sitting on hundreds of billions of dollars in cash and earning tens of billions of dollars per year in cash profits, respectively. Even though the companies are “new” by historical standards regarding where they were twenty years ago, they have not introduced a systemic risk because the profits were there.
It appears that Uber and Lyft will have their initial public offering within the next year, based on filings, and there are introductory estimates that Uber’s valuation will be $120 billion.
What does this mean? Uber will certainly become a member of the S&P 500. For reference, the smallest company in the S&P 500 is Newfield Exploration Corp., valued at around $3 billion. If Uber were to enter the S&P 500, it could be one of the thirty largest components, depending upon the number of shares that are made available to the general public as float. For additional reference, Philip Morris International is the 34th largest component, and has a market cap of $128 billion. It is a bit more complicated than that, because again, S&P 500 size determinations are chosen by committee that takes into account the number of shares that are on the market, which is currently undetermined.
The concern with Uber is that, from 2015 through the present, it has lost roughly $15 billion cumulatively, with some quarters posting losses in excess of $1 billion. That is unusual. There aren’t many companies that are this large and losing money during an uptick in the economic cycle, and this is exacerbated by the fact that Uber relies upon a labor force of individuals who are math illiterate when it comes to insurance, depreciation, and gas costs for their vehicle and fail to realize that they are earning a take-home pay of less of less than minimum wage in a fair number of circumstances.
Future regulations are more likely than not, and as a result, I would expect that Uber’s labor costs are likely to rise in excess of inflation over the medium-term, a cost which may not be able to be passed along to the customer or else that likely would have occurred by now.
For now, Uber is still small enough compared to the index as a whole, which is valued at around $25 trillion, such that a $120 billion entrant cannot inflict much systematic risk. Really, the risk with Uber is that it becomes even more overvalued and has a valuation that increases 3-4x fold in the aftermath of its IPO and then becomes 2-3% of the index. If that were to occur, it would almost be certain to stand in line for a substantial future drop, as the ride-sharing market has so many frictional costs that enduring billion-dollar profits will be incredibly hard to find.
I mention this to remind you that the S&P 500 Index is only as strong as the underlying companies that reside within them. If you look at the thirty largest companies right now, they are all the most dominant global firms that earn billions of dollars in profits. That’s why it does well. But if Uber were to join their ranks, a company with a recent record of billion-dollar losses would join their ranks.
If Uber were to enter the S&P 500 with a $120 billion valuation, it would be small enough that any future underperformance could be absorbed by the rest of the index. The only way I see any type of direct harm to index investors would be if Uber and Lyft were to increase four or five-fold shortly after their IPO, stay there for a year or two, join the S&P 500 Index, command a proportionate share of index dollars, and then revert thereafter to historical valuation norms that would resort in a steep drop.
As is, I would not want to be putting 0.5% or 1% of my S&P 500 dollars into Uber. I have deep concerns about unprofitable companies trading at valuations in the hundred billion dollar market-cap range. Outside of cyclical businesses, Amazon is the only example where the results have not been disastrous, and Amazon was a unique experience because the lack of profitability was due to wildly high capital spending that eventually proved profitable, which is unlikely to be the case with Uber.
An index fund is only as strong as its underlying parts. The underlying parts are only strong to the extent that they do not contain a meaningful amount of grotesquely overvalued assets. With the forthcoming Uber, and to a lesser extent Lyft, IPOs, I believe that some real junk will re-enter the S&P 500. At present valuations, the effect is absorbable, but if the index were to consist of a few dozen Ubers or if Uber were to dramatically increase in valuation with its status quo business model, adverse consequences would observably diminish returns.