Everything should be made as simple as possible, but not simpler. Einstein
How simple or complex should an investment thesis in Facebook be?
John and I made an investment in Apple a little over two years ago. It was the first time that I felt like I had departed from the Buffett religion of value investing. My thinking was very simple. Apple’s products had become a brand so strong that its customers would continue to buy their technology as long as Apple’s technology kept pace with its competitors, which I assumed Apple could do. As it happens, Buffett’s value investing tent widened shortly thereafter and we were glad to see we hadn’t wandered to far off the reservation.
Facebook is certainly another departure. The future prospects of Facebook may appear virtually unknowable. This statement alone would have eliminated the company from my investment universe 5 years ago. What has changed?
I have struggled over the past week to find an adequate way to articulate this point with any sort of significant value-add. This won’t be long and it won’t be complex.
Buffett has often invested in people. I have mentioned this recently, that Buffett most often invests in business models, but occasionally will invest in seemingly poor business models, but great people. Think of his famous investment in Nebraska Furniture Mart (“NFM”. Try to imagine whether Buffett would have invested in Mrs. B. on Day One (the first day of NFM). She had little capital ($500 from her brother and eventually sold her own furniture to pay off some inventory debts), no permanent showroom, eventually her suppliers black-balled her because she was undercutting other local retailers who were buying from these same suppliers (with a low mark-up strategy) and the list goes on.
“In 1937, the Nebraska Furniture Mart was founded in the basement of her husband’s shop. Her belief in selling at tiny margins created rough going early on with the manufacturers boycotting Mrs. B at the urging of local competition, who generally operated on higher markups. Traveling by train to Kansas City, Chicago and New York, she became a proficient furniture bargain hunter by buying from large furniture stores at 5% over their cost, and still making a profit using her low markup sales strategy.”
The simple answer is no. He wouldn’t have invested in NFM. However, Buffett watched how well Mrs. B executed at NFM from his office in Omaha and was consistently impressed with her accomplishments. Through execution and leadership, she turned a business with little prospects of success into a giant in Omaha (sidenote: my parents drove 8 hours to shop at Nebraska Furniture Mart because the prices were that good).
Perhaps not a direct analogy, but in similar and a larger scale, I believe that Zuckerberg has done something related with Facebook. It would have been very difficult to convince me in the early days of Facebook that a long-term investment in “The Facebook” would be a wise decision. However, if you have any inclination to make an investment in Facebook, it is worthwhile to go back and read of the problems and obvious pitfalls of Facebook from its early days. Two resources here are Corner of Berkshire thread on Facebook and a fun book called, Chaos Monkeys.
Both of these sources cite innumerable reasons why Facebook could or should have been a poor investment. The key isn’t that these people were wrong about the challenges facing Facebook. The key is how right the skeptics were about the daunting challenges facing Facebook. The conclusion I have drawn from Facebook’s short history is how well Facebook has consistently solved or side-stepped these challenges.
To name a few without dissecting each or the subsequent solutions:
- Facebook is a fad, Myspace and Friendster were popular until they were not.
- Facebook banner and side-bar ads are horrible and their monetization efforts are very poor (Chaos Monkeys digs deep into this problem and how Facebook solved it).
- Google + has a huge ability to crush Facebook with its massive installed user base of Gmail accounts
- Shift from desktop to mobile will crush Facebook early efforts at monetization.
- Shift to photo-based social sharing.
- Teens are leaving en masse and related, Facebook is only for Old People.
The list goes on and on….yet Facebook is now one of the most profitable business at scale I have ever seen. Why? I don’t believe any of the naysayers were wrong in doubting Facebook’s ability to do what they have done. Instead, I think Facebook’s leadership, and I will single out Zuckerberg, did an incredible job at executing.
I have pointed out in the past that Buffett’s like business models more than people in his investments, however, I think Facebook provides both. The business model of networks and incredibly high margin advertising dollars combined with the execution and skill of Zuckerberg is an equivalent of Mrs. B running a much better business than selling furniture at extremely low margins.
One short-hand way to look at execution is to compare the evolution and growth of Facebook vs. Twitter. Facebook had a two year head start in its founding, but in a world that moves as fast as today, we can basically say that they started around the same time. Yet, today Facebook made $24B in operating cash flow last year, while Twitter is only worth around $23B and basically broke even last year (if you are very generous with your calculation of the stock option grants). It’s astounding to see the difference in execution between these two companies.
As mentioned above, Zuckerberg has effectively managed each of the “problems” and succeeded each time when failure was obvious. Why is this, I think there are a few reasons. Zuckerberg is truly an owner-operator in the Buffett model. Facebook is his canvass, similar to how Berkshire is Buffett’s canvas, so Zuckerberg will do anything to make sure it succeeds and he doesn’t need his shareholders approval or care in the short-term even what even his users might think. This gives him a huge advantage when competing against “hired guns” at other companies who are merely managing their businesses. (Check out Twitter’s management history for a classic comparison)
Facebook’s financials are quite impressive. Last quarter alone, FB generated operating margins of approximately 50%. After adjusting for the tax impact of the new tax law, FB earned $2.21 per share in the final quarter of 2017. For 2018, FB will probably earn around $24B with a current enterprise value of approximately $475B (net of $40B in cash), this equates to a P/E ratio of only 19. Give or tax a few billions in earnings, we can round it up to 20x P/E for a business that grew revenues at 40% in 2017.
One problem I have with the current financials of Facebook is they are almost irrelevant as a snapshot in time. They are awesome right now, really no other words can describe the level of profitability and growth when looking at Facebook’s financials. However, it isn’t the snapshot of today’s numbers that needs to be answered, it is whether or how long those numbers can continue in the future.
If you think Facebook is going away, Facebook isn’t a good investment at any price. If it is a bad business or has poor leadership, they will spin their wheels with what cash they have coming in the door to try to prevent their terminal decline. This is not just a lesson on Facebook, but a general investing lesson. Paying a low multiple for a business, like Sears, would have been a disastrous long-term investment over the past decade. I feel more comfortable paying a higher price for a hugely profitable business with a management team who has demonstrated consistent excellence (this second point is even more important than the first) than justifying an investment in a poor business with reference to a low P/E ratio.
I think Facebook and other technology companies are teaching value investors a new lesson, one that some are learning faster than others (John was ahead of the curve on this lesson with Tencent).
- With staying power and long-term thinking (typically accomplished through majority voting ownership), some young and extraordinarily talented CEOs are able to accomplish a lot.
- The scale growth of the business with limited equity capital or operating expenses has led to hugely profitable businesses.
- The combination of young and talented Owner-Operators with hugely profitable businesses allow such businesses to transition and evolve to maintain their dominance at each step along an industry’s maturation process.
Facebook, Google and Tencent all have these attributes, along with a few others companies (Atlassian is another that comes to mind). It is difficult, yet helpful to look beyond the typical value investing parameters to see what the best businesses in the future will be. I recently bought shares in Facebook because I think the business model, scale, operating cash flow and excellent leadership make it dynamic enough to adapt and grow in the future.
Matt Brice is the portfolio manager at The Sova Group and can be reached at email@example.com. Disclosure: Matt Brice and The Sova Group clients own shares of Tencent, JD, Apple and Facebook.