Michael J. Mauboussin is Chief Investment Strategist at Legg Mason Capital Management in the United States. He is also the author of bestselling books on investing like Think Twice: Harnessing the Power of Counterintuition and More Than You Know: Finding Financial Wisdom in Unconventional Places. His latest book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing is due later this year. In this interview he speaks to Vivek Kaul on the various aspects of luck, skill and randomness and the impact they have on business, life and investing.
How do you define luck?
The way I think about it, luck has three features. It happens to a person or organization; can be good or bad; and it is reasonable to believe that another outcome was possible. By this definition, if you win the lottery you are lucky, but if you are born to a wealthy family you are not lucky—because it is not reasonable to believe that any other outcome was possible—but rather fortunate.
How is randomness different from luck?
I like to distinguish, too, between randomness and luck. I like to think of randomness as something that works at a system level and luck on a lower level. So, for example, if you gather a large group of people and ask them to guess the results of five coin tosses, randomness tells you that some in the group will get them all correct. But if you get them all correct, you are lucky.
And what is skill?
For skill, the dictionary says the “ability to use one’s knowledge effectively and readily in execution or performance.” I think that’s a good definition. The key is that when there is little luck involved, skill can be honed through deliberate practice. When there’s an element of luck, skill is best considered as a process.
You have often spoken about the paradox of skill. What is that?
The paradox of skill says that as competitors in a field become more skillful, luck becomes more important in determining results. The key to this idea is what happens when skill improves in a field. There are two effects. First, the absolute level of ability rises. And second, the variance of ability declines.
Could you give us an example?
One famous example of this is batting average in the sport of baseball. Batting average is the ratio of hits to at-bats. It’s somewhat related to the same term in cricket. In 1941, a player named Ted Williams hit .406 for a season, a feat that no other player has been able to match in 70 years. The reason, it turns out, is not that no players today are as good as Williams was in his day—they are undoubtedly much better. The reason is that the variance in skill has gone down. Because the league draws from a deeper pool of talent, including great players from around the world, and because training techniques are vastly improved and more uniform, the difference between the best players and the average players within the pro ranks has narrowed. Even if you assume that luck hasn’t changed, the variance in batting averages should have come down. And that’s exactly what we see. The paradox of skill makes a very specific prediction. In realms where there is no luck, you should see absolute performance improve and relative performance shrink. That’s exactly what we see.
Any other example?
Take Olympic marathon times as an example. Men today run the race about 26 minutes faster than they did 80 years ago. But in 1932, the time difference between the man who won and the man who came in 20th was close to 40 minutes. Today that difference is well under 10 minutes.
What is the application to investing?
The application to investing is straightforward. As the market is filled with participants who are smart and have access to information and computing power, the variance of skill will decline. That means that stock price changes will be random—a random walk down Wall Street, as Burton Malkiel wrote—and those investors who beat the market can chalk up their success to luck. And the evidence shows that the variance in mutual fund returns has shrunk over the past 60 years, just as the paradox of skill would suggest. I want to be clear that I believe that differential skill in investing remains, and that I don’t believe that all results are from randomness. But there’s little doubt that markets are highly competitive and that the basic sketch of the paradox of skill applies.
How do you determine in the success of something be it a song, book or a business for that matter, how much of it is luck, how much of it is skill?
This is a fascinating question. In some fields, including sports and facets of business, we can answer that question reasonably well when the results are independent of one another. When the results depend on what happened before, the answer is much more complex because it’s very difficult to predict how events will unfold.
Could you explain through an example?
Let me try to give a concrete example with the popularity of music. A number of years ago, there was a wonderful experiment called MusicLab. The subjects thought the experiment was about musical taste, but it was really about understanding how hits happen. The subjects who came into the site saw 48 songs by unknown bands. They could listen to any song, rate it, and download it if they wanted to. Unbeknownst to the subjects, they were funneled into one of two conditions. Twenty percent went to the control condition, where they could listen, rate, and download but had no access to what anyone else did. This provided an objective measure of the quality of songs as social interaction was absent.
What about the other 80%?
The other 80 percent went into one of 8 social worlds. Initially, the conditions were the same as the control group, but in these cases the subjects could see what others before them had done. So social interaction was present, and by having eight social worlds the experiment effectively set up alternate universes. The results showed that social interaction had a huge influence on the outcomes. One song, for instance, was in the middle of the pack in the control condition, the #1 hit on one of the social worlds, and #40 in another social world. The researchers found that poorly rated songs in the control group rarely did well in the social worlds—failure was not hard to predict—but songs that were average or good had a wide range of outcomes. There was an inherent lack of predictability. I think I can make the statement ever more general: whenever you can assess a product or service across multiple dimensions, there is no objective way to say which is “best.”
What is the takeaway for investors?
The leap to investing is a small one. Investing, too, is an inherently social exercise. From time to time, investors get uniformly optimistic or pessimistic, pushing prices to extremes.
Was a book like Harry Potter inevitable as has often been suggested after the success of the book?
This is very related to our discussion before about hit songs. When what happens next depends on what happened before, which is often the case when social interaction is involved, predicting outcomes is inherently difficult. The MusicLab experiment, and even simpler simulations, indicate that Harry Potter’s success was not inevitable. This is very difficult to accept because now that we know that Harry Potter is wildly popular, we can conjure up many explanations for that success. But if you re-played the tape of the world, we would see a very different list of best sellers. The success of Harry Potter, or Star Wars, or the Mona Lisa, can best be explained as the result of a social process similar to any fad or fashion. In fact, one way to think about it is the process of disease spreading. Most diseases don’t spread widely because of a lack of interaction or virulence. But if the network is right and the interaction and virulence are sufficient, disease will propagate. The same is true for a product that is deemed successful through a social process.
And this applies to investing as well?
This applies to investing, too. Instead of considering how the popularity of Harry Potter, or an illness, spreads across a network you can think of investment ideas. Tops in markets are put in place when most investors are infected with bullishness, and bottoms are created by uniform bearishness. The common theme is the role of social process.
What about someone like Warren Buffett or for that matter Bill Miller were they just lucky, or was there a lot of skill as well?
Extreme success is, almost by definition, the combination of good skill and good luck. I think that applies to Buffett and Miller, and I think each man would concede as much. The important point is that neither skill nor luck, alone, is sufficient to launch anyone to the very top if it’s a field where luck helps shape outcomes. The problem is that our minds equate success with skill so we underestimate the role of randomness. This was one of Nassim Taleb’s points in Fooled by Randomness. All of that said, it is important to recognize that results in the short-term reflect a lot of randomness. Even skillful managers will slump, and unskillful managers will shine. But over the long haul, good process wins.
How do you explain the success of Facebook in lieu of the other social media sites like Orkut, Myspace, which did not survive?
Brian Arthur, an economist long affiliated with the Santa Fe Institute, likes to say, “of networks there shall be few.” His point is that there are battles for networks and standards, and predicting the winners from those battles is notoriously difficult. We saw a heated battle for search engines, including AltaVista, Yahoo, and Google. But the market tends to settle on one network, and the others drop to a very distant second. I’d say Facebook’s success is a combination of good skill, good timing, and good luck. I’d say the same for almost every successful company. The question is if we played the world over and over, would Facebook always be the obvious winner. I doubt that.
Would you say that when a CEO’s face is all over the newspapers and magazines like is the case with the CEO of Facebook , he has enjoyed good luck?
One of the most important business books ever written is The Halo Effect by Phil Rosenzweig. The idea is that when things are going well, we attribute that success to skill—there’s a halo effect. Conversely, when things are going poorly we attribute it to poor skill. This is often true for the same management of the same company over time. Rosenzweig offers Cisco as a specific example. So the answer is that great success, the kind that lands you on the covers of business magazines, almost always includes a very large dose of luck. And we’re not very good at parsing the sources of success.
You have also suggested that trying to understand the stock market by tuning into so called market experts is not the best way of understanding it. Why do you say that?
The best way to answer this is to argue that the stock market is a great example of a complex adaptive system. These systems have three features. First, they are made up of heterogeneous agents. In the stock market, these are investors with different information, analytical approaches, time horizons, etc. And these agents learn, which is why we call them adaptive. Second, the agents interact with one another, leading to a process called emergence. The interaction in the stock market is typically through an exchange. And, finally, we get a global system—the market itself.
So what’s the point you are trying to make?
Here’s a key point: There is no additivity in these systems. You can’t understand the whole simply by looking at the behaviors of the parts. Now this is in sharp contrast to other systems, where reductionism works. For example, an artisan could take apart my mechanical wristwatch and understand how each part contributes to the working of the watch. The same approach doesn’t work in complex adaptive systems.
Could you explain through an example?
Let me give you one of my favorite examples, that of an ant colony. If you study ants on the colony level, you’ll see that it’s robust, adaptive, follows a life cycle, etc. It’s arguably an organism on the colony level. But if you ask any individual ant what’s going on with the colony, they will have no clue. They operate solely with local information and local interaction. The behavior of the colony emerges from the interaction between the ants. Now it’s not hard to see that the stock market is similar. No individual has much of a clue of what’s going on at the market level. But this lack of understanding smacks right against our desire to have experts tell us what’s going on. The record of market forecasters has been studied, and the jury is in: they are very bad at it. So I recommend people listen to market experts for entertainment, not for elucidation.
How does the media influence investment decisions?
The media has a natural, and understandable, desire to find people who have views that are toward the extremes. Having someone on television explaining that this could happen, but then again it may be that, does not make for exciting viewing. Better is a market boomster, who says the market will skyrocket, or a market doomster, who sees the market plummeting.
Phil Tetlock, a professor of psychology at the University of Pennsylvania, has done the best work I know of on expert prediction. He has found that experts are poor predictors in the realms of economic and political outcomes. But he makes two additional points worth mentioning. The first is that he found that hedgehogs, those people who tend to know one big thing, are worse predictors than foxes, those who know a little about a lot of things. So, strongly held views that are unyielding tend not to make for quality predictions in complex realms. Second, he found that the more media mentions a pundit had, the worse his or her predictions. This makes sense in the context of what the media are trying to achieve—interesting viewing. So the people you hear and see the most in the media are among the worst predictors.
Why do most people make poor investment decisions? I say that because most investors aren’t able to earn even the market rate of return?
People make poor investment decisions because they are human. We all come with mental software that tends to encourage us to buy after results have been good and to sell after results have been poor. So we are wired to buy high and sell low instead of buy low and sell high. We see this starkly in the analysis of time-weighted versus dollar-weighted returns for funds. The time-weighted return, which is what is typically reported, is simply the return for the fund over time. The dollar-weighted return calculates the return on each of the dollars invested. These two calculations can yield very different results for the same fund.
Could you explain that in some detail?
Say, for example, a fund starts with $100 and goes up 20% in year 1. The next year, it loses 10%. So the $100 invested at the beginning is worth $108 after two years and the time-weighted return is 3.9%. Now let’s say we start with the same $100 and first year results of 20%. Investors see this very good result, and pour an additional $200 into the fund. Now it is running $320—the original $120 plus the $200 invested. The fund then goes down 10%, causing $32 of losses. So the fund will still have the same time-weighted return, 3.9%. But now the fund will be worth $288, which means that in the aggregate investors put in $300—the original $100 plus $200 after year one—and lost $12. So the fund has positive time-weighted returns but negative dollar-weighted returns. The proclivity to buy high and sell low means that investors earn, on average, a dollar-weighted return that is only about 60% of the market’s return. Bad timing is very costly.
What is reversion to the mean?
Reversion to the mean occurs when an extreme outcome is followed by an outcome that has an expected value closer to the average. Let’s say you are a student whose true skill suggests you should score 80% on a test. If you are particularly lucky one day, you might score 90%. How are you expected to do for your next test? Closer to 80%. You are expected to revert to your mean, which means that your good luck is not expected to persist. This is a huge topic in investing, for precisely the reason we just discussed. Investors, rather than constantly considering reversion to the mean, tend to extrapolate. Good results are expected to lead to more good results. This is at the core of the dichotomy between time-weighted and dollar-weighted returns. I should add quickly that this phenomenon is not unique to individual investors. Institutional investors, people who are trained to think of such things, fall into the same trap.
In one of your papers you talk about a guy who manages his and his wife’s money. With his wife’s money he is very cautious and listens to what the experts have to say. With his own money his puts it in some investments and forgets about it. As you put it, threw it in the coffee can. And forgot about it. It so turned out that the coffee can approach did better. Can you take us through that example?
This was a case, told by Robert Kirby at Capital Guardian, from the 1950s. The husband managed his wife’s fund and followed closely the advice from the investment firm. The firm had a research department and did their best to preserve, and build, capital. It turns out that unbeknownst to anyone, the man used $5,000 of his own money to invest in the firm’s buy recommendations. He never sold anything and never traded, he just plopped the securities into a proverbial coffee can(those were the days of paper). The husband died suddenly and the wife then came back to the investment firm to combine their accounts. Everyone was surprised to see that the husband’s account was a good deal larger than his wife’s. The neglected portfolio fared much better than the tended one. It turns out that a large part of the portfolio’s success was attributable to an investment in Xerox.
So what was the lesson drawn?
Kirby drew a more basic lesson from the experience. Sometimes doing nothing is better than doing something. In most businesses, there is some relationship between activity and results. The more active you are, the better your results. Investing is one field where this isn’t true. Sometimes, doing nothing is the best thing. As Warren Buffett has said, “Inactivity strikes us as intelligent behavior.” As I mentioned before, there is lots of evidence that the decisions to buy and sell by individuals and institutions does as much, if not more, harm than good. I’m not saying you should buy and hold forever, but I am saying that buying cheap and holding for a long time tends to do better than guessing what asset class or manager is hot.
(The interview was originally published in the Daily News and Analysis(DNA) on June 4,2012. http://www.dnaindia.com/money/interview_people-should-listen-to-market-experts-for-entertainment-not-elucidation_1697709)
(Interviewer Kaul is a writer and can be reached at [email protected])
Aswath Damodaran is one of the world’s premier experts in the field of equity valuation. He has written several books like Damodaran on Valuation, Investment Fables, The Dark Side of Valuation and most recently The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit, on the subject. He is a Professor of Finance at the Stern School of Business at New York University where he teaches corporate finance and equity valuation. . In this interview he speaks to Vivek Kaul.
How did you get into the field of valuation?
I started in finance as a general area and then I got interested in valuation when I started teaching. Valuation is a piece of almost everything you do and I was surprised how ill developed it was as a field of thought. It was almost random and not much thinking had gone into thinking about how to do it systematically.
A lot of valuation is basically compound interest when you discount the expected cash flows. So how much of it is math and how much of it is art?
Much of it is not the compound interest or the discount factor it is really the cashflows you have to estimate. So most of it is actually is in the numerator. It is about figuring out what business you are in. Figuring out how you make money. Figuring out what the margins are. What the competition is going to be. So numerator is where all the action is and it is actually very little to do with mathematics. It is more an understanding of business and actually getting it into numbers.
Can you give us an example?
So if you are trying to value Facebook getting the discount rate for Facebook is trivial. It is easy. It is about 11.5%. It is about the 80th percentile in terms of riskiness of companies. The trouble with Facebook is figuring out, first what business they are going to be in, because they haven’t figured it out themselves. How are they going to convert a billion users into revenues and income? And second, if they even manage to do it, how much those revenues will be, what will the margins etc. And those are all functions where you cannot think just Facebook standing alone. It is going to compete against Google. It is going compete against Apple. It is going to compete against other social media companies. So you have to make judgement calls of how it is all going to play out. It is numbers but the numbers come from understanding business. Understanding strategy. Understanding competition. Understanding all the things that kind of come into play.
You just mentioned that the discounting rate for expected cash flows from Facebook was at 11.5%. How did you arrive at that?
I have the cost of capital for by every sector in the US.
So this is the cost of capital for dotcoms?
This is actually the cost of capital for risky technology capitals. So basically I am saying is that I could sit there and try to finesse it and say is it 11.8% or is it 11.2%. But it doesn’t really matter. Getting the revenues and margins is more critical than getting the discount rate narrowed down.
This 11.5% would be from a combination of equity and debt?
For a young growth company it is almost going to be all equity. You don’t borrow money if you are that small and when you are in a high growth phase it is not worth it. It is almost all equity.
I recently read a blog of yours where you said that you have sold Apple shares even though they were undervalued. Why did you do that?
There are two parts to the investment process. One is the value part to the process. And the other is the pricing part to the process. To make money you need to be comfortable with both parts. You want to feel comfortable with value and you have to feel comfortable that price is going to converge on the value. In the case of Apple for 15 years I was comfortable with my estimate of value and I was comfortable that the price would converge on value. In the last year the Apple stockholder base has had a fairly dramatic change. There has been influx of a lot of institutional investors who have coming in as herd investors and momentum investors who go wherever the price is hottest. You have also got a lot of dividend investors who came in last year because they expected Apple to start paying dividends.
What happened because of that?
So you got this influx of new investors with very different ideas of what they expect Apple to do in the future. They are all in there. And right now they are okay for the moment because Apple is able to keep them all reasonably happy. But I think this is a game where I have lost control of the pricing process because those investors turn on a dot. Like they did, when the stock went from $640 to $530 for no reason at all. You look at any news that came out. Nothing came out. So why is the stock worth $640 and eight weeks later $530? But that’s the nature of momentums stocks. It is not news that drives the price anymore, it’s the herd. Basically if it moves in one direction, prices are going to go up $20. If it moves in the other direction, it is going to go down $30. And I looked at the pricing process and said I have lost control of this part of the process. I am comfortable with the value still. But I am leaving not forever. If these guys keep pushing it down, sooner or later they are going to push it to a point where these guys leave and then I can step in buy the stock. So it’s not permanent but I think at the moment it has become a momentum stock.
You have talked about the danger of purely relying on stories while investing. But that’s how most investors invest. What are the problems with that?
Even momentum investors want a crutch. Basically stories give them a crutch. You have decided to buy the stock anyway because everyone else is doing it. You don’t want to tell people because that doesn’t sound good so you look for a story to convince yourself that you area really doing this for a good reason. The power of the story is very strong, I am not denying it. But I am saying that if there is a story my job is to bring it into the numbers and see if that story holds up to scrutiny.
You can talk about user base. Facebook the story is that they have lots of users. My job is to take those billion users and talk about what that might mean in revenues and margins and operating income and cash flows. And not just say that there are lot of users therefore the company must be worth a lot. If a Chinese company says we are going to be valued. There are a billion Chinese. Okay. What does that mean? You have a billion Chinese but how much will be you able to sell? How much will they buy your product? So I think you need to get past the macro big story telling because it is easy to fall into saying that hey this company is worth a lot.
Can smaller investors make money by piggybacking on investment decisions of big investors?
If you look at institutional investors they do things so badly why do you want to piggyback on them.
Someone like a Warren Buffett and Rakesh Jhunjhunwala in the Indian context?
You could but I think by the time you get the information it is usually too late. It is not like you are the only one who finds out that Warren Buffett has bought a stock. Half the world has found out. So when you get to lineup to buy the stock, everyone else is buying the stock and price has already moved up.
George Soros once said that most money is made by entering a bubble early. What are your views on that?
Everybody is guilty of hyperbole when it comes to bubbles and Soros is no exception. Soros has never been a great micro investor. He has made his money on macro bets. He has always been. He has never been a great stock picker. For him it is got to be massive macro bubbles, an asset class that gets overpriced or underpriced. You’re right if you can call macro bubbles you can make a lot of money. John Paulson called the housing bubble made a few billion dollars. So he is right and he is wrong. He is right because if you can call a macro bubble you can make a lot of money. He is wrong because if you make your investment philosophy calling macro bubbles, you better get lucky, because everybody is calling macro bubbles and most of them are going to be wrong.
You have talked about buying the 35worst stocks in the market and holding that investment and making money on it. How does that work?
It’s called the classic contrarian investment strategy where you buy the biggest holders and you hold them for a long period. There is evidence that if you hold them for a long period that they tend to be the best investments. But it comes with caveats. One is that if you buy the 35 biggest losers they often tend to be low priced stocks because they have gone down so much which increases the transaction cost of your trading. The other is that it is very dependant on your time horizon. It turns out that if you buy the lowest price stocks for the first 18 months they actually underperform. It is only after that they turnaround. This means that if you buy these stocks you are going to get about 18 months of heart burn and stomach aches. And for many people they don’t have the patience to stay in. So they often buy the worst stocks after reading these studies. About 12 months in they lose patience they sell it. It is very dependant on both those pieces of puzzle falling in.
How much role does media play in influencing investment decisions of people?
Media and analysts are followers. None of the media told us last week that Facebook was going to collapse. Now of course everybody is talking about it. So basically when I see in the media news stories I see a reflection of what has already happened. It is a lagging indicator. It is not a leading indicator. I have never ever found a good investment by reading a news story. But I have heard about why an investment was good in hindsight by reading a news story about it.
I am not a great believer that I can find good investments in the media. That’s not their job anyway.
(The interview was originally published in the Daily News and Analysis(DNA) on June 2,2012. http://www.dnaindia.com/money/interview_ive-never-found-a-good-pick-by-reading-a-news-story_1696935)
(Vivek Kaul is a writer and can be reached at [email protected])
When the whole world was going gaga about Facebook’s Initial Public Offering (IPO), there was one man who did not fall for all the hype, looked at the numbers of the company, asked some basic questions and concluded “they don’t know how they are going to make money.” Looks like, he was proved right in the end. The stock was sold at a price of $38 per share, and has fallen since then. Aswath Damodaran was the man who got it right. “In hindsight everybody will tell you that they were bearish on Facebook. Nobody will admit to buying the shares,” points out Damodaran. He is a Professor of Finance at the Stern School of Business at New York University where he teaches corporate finance and equity valuation. In some circles he is referred to as the “god of valuation”. In this interview he speaks to Vivek Kaul.
Let us start with Facebook, you have been critical about their IPO pricing?
The trouble with Facebook is figuring out, first what business they are going to be in, because they haven’t figured it out themselves. How are they going to convert a billion users into revenues and income? And second, if they even manage to do it, how much those revenues will be, what will the margins etc. They don’t know how they are going to make money. Whether they are going sell advertising to these users? Whether they are going to sell products to these users? Services to these users? I think all they know right now is that they have a lot of users.
But if they have no idea of what to do with their users, how did they make the $4billion in sales that they did last year?
They are selling. 12% of that came from selling stuff for Zynga (The maker of popular games such as “FarmVille” and “CityVille,”). The remaining 88% did come from very subtle advertising. The question is that whether they can scale that up? Because right now it is kind of invisible. You can’t see it because it is relatively small. But if they want to generate the kind of revenues they want, you are going to see it on your Facebook page. And it is going to be very very clear that they are using what they know about you to pick those ads. And I am not sure people will be comfortable with that knowing that they are seeing not just your profile but your interactions. So they can see how old you are. What political party your support? What sports you like? It is all going to go. And that’s their selling point.
So it will be some sort of invasion of privacy?
It is not some sort of invasion of privacy. It is an invasion of privacy. The question is can they do that without people getting pissed off and saying I am leaving Facebook and going elsewhere. And that I think is the big unknown. Because let’s face it, they have not just a billion users, but they know more about these users than any other company on the face of this earth. If you want a company to find 35million people who fit a specific demographic characteristic, the place to go is Facebook. They can show it to you. The only question is that if you did advertise through Facebook to those 35million is this the kind of forum were they are inclined to click on an ad.
How does it compare with Google?
In case of Google it is a much more direct business model. It’s search. You click and that’s it, everybody could see what they were doing. Facebook is a much more subtle model. On Facebook you are talking to your friends, which is a private conversation between you and your friends, but when you see these intrusive ads on the side, you realize you are not just talking to your friends, you are talking to your friends and somebody at Facebook is monitoring you at the same time. That’s a very tricky challenge. So they have made the $4billion, but at the value (the market capitalization of the Facebook stock) they have they have to make $35billion. And that’s a very different game because that would mean a lot more ads on every page directly focused in on what the users are doing.
In face very frankly I didn’t realize there are ads on my Facebook page for a long time…
It is pretty subtle right now because they don’t have that much advertising. If you think of revenue of $4billion spread out across a billion users, you are going to see a very few ads because it is still on the sides. And sometimes it doesn’t even look like an ad. Right. It’s a Facebook friend with GM. You click on it and before you know it you are looking at GM’s product offerings. So it is very subtle right now. But it can’t stay subtle for them to make the kind of revenues they have to make to justify their price now. The kind of scary thing here is that Mark Zuckerberg has said that he wants to build a social enterprise and not a business enterprise.
What does he mean by that?
What he means by that is he built Facebook so that people could talk to each other. He didn’t want ads on it. For a long time he refused to take ads on Facebook until he was told that if you can’t take ads there is no other way to make money in this. So I am not sure how willing he is to go the distance because it is going to be a fight. It’s going to be a fight against not other social media companies but against the big players. The Googles and The New York Times of the world. This is a tough game to fight and you got be willing to act like a business and I am not sure is willing to yet.
You called the business model of Facebook, a Field of Dreams. Why is that?
Yeah. You ever seen that movie? Field of Dreams.
In the movie Kevin Costner moves to the American Midwest and he is walking through this cornfield. And hears this voice and it says “if you build it he will come”. He being Shoeless Joe Jackson, a baseball player from a 100 years ago. On the faith that these old baseball players will show up, he builds this baseball field in the middle of Iowa and everybody asks him, why are you building this huge baseball field in the middle of nowhere? And he tells them, if I build it they will come. And that in a sense is what social media companies are doing right now. They are building this place where there are lots of users and they are telling people trust us if we build this, they will come. They being advertisers, product sellers, they will come. But in the Field of Dreams they did come but I am not sure in these companies that they will.
Talking about the current price of Facebook how do you see it? Yesterday is closed at around $33.(The interview was conducted on Thursday, May 24,2012) Has it fallen enough?
I think it fell enough in those two days that you are going to get a consolidation. The next run on them will tell how far they might go back. The low 30s are close enough to my intrinsic value that I wouldn’t call them massively overvalued. I think there is enough potential in the company. If it dropped to $15 then it’s pretty much a bargain. At $31-32 its pretty close to intrinsic value
The intrinsic value you calculated for Facebook was $29?
So why was the stock valued at such a high price of $38 per share when it was sold to the public?
It wasn’t valued. It was priced.
So why was it priced at such a high price?
Remember they weren’t pricing it on a blank slate. They could see transactions happening in the private share market where people were buying and selling Facebook shares. And there the prices were going at about $42-43. So they said if people are buying and selling at this price, these are real transactions.
What sort of stock market was this?
For the last two years Facebook has been on what’s called a private share market where people who owned shares of Facebook were allowed to trade.
So is it like over the counter?
Not even over the counter. They are actually beyond the counter. These are private companies that are not incorporated. So this is a completely unregulated share market. Like Goldman Sachs could sell shares. Players in this market are pretty big institutional investors they are not individual investors. Transactions here have particular merit because these are two informed investors transacting and they are coming to a price. And investment bankers saw that price and they said if they are paying $42, then we should be able to sell it at $38. And they also got onto the phone and they called institutional investors. They tried to gauge demand until Thursday evening (May 17,2012). And that’s why they set the price at 4 o’clock on Thursday because that’s how late they were pushing this off to make sure that there was enough demand.
Wasn’t this a throwback to the days of the dotcom bubble?
This is how all pricing is done in IPOs. IPOs are always priced they are never valued because essentially your job as an investment banker is to sell at that price. What was unusual here was that demand and supply that they gauged collapsed. They didn’t realize how thin the market was until one hour into the offering when they saw the price collapse. It started at $38, it went to $43, and then very quickly it kind of collapsed. My theory is when you price things you are building in market perceptions, what you think will happen etc. You are basing it in on momentum. That’s a very fragile thing. You don’t want mess with it. Even people who are buying based on pricing and momentum like to tell themselves that they are buying based on value. So they look for a good story and they don’t want to have their face rubbed at the fact that they are buying because everybody else is paying the price.
In case of Facebook it was quite the opposite…
If you look at what the investment banks and Facebook insiders did in the last week they almost rubbed the investors faces in this. They rubbed it in the sense that they kept hiking up the offering price, saying we know you are suckers. At the same time the insiders were selling the shares in the week leading up to the offering. If I had been the investment banker I would have spent the last week talking about the user base, and advertising because that would have given the momentum investors a crutch. I am purely buying it because of advertising revenues. Instead it was all about pricing. They made it very transparent that they were not valuing the company. It was all demand and supply. I have a feeling that if you point to midday on Friday (May 18,2012) and say that was the time when the momentum on social media companies, not just on Facebook, shifted. And if you look at what has happened since it is not just Facebook which has seen its price collapse. It’s Groupon. It’s LinkedIn. It’s the entire sector. And I wager that there are IPOs lined up to go to investment banks of social media companies, that are either being pulled right now or being dramatically repriced.
You have said in the past that Facebook has huge corporate governance issues. Can you elaborate on that?
It has got voting shares and non-voting shares. Zuckerberg has got the voting rights. It is also incorporated as a controlled corporation which basically means that you don’t have to follow the corporate governance rules (like the Sarbanes Oxley Act) that publically traded companies need to do. They can have insiders on the board.
Is that allowed?
If you are controlled corporation it is. And Facebook has been very open about that they are going to be a controlled corporation.
How does regulation allow for something like that?
As long as you make it public. If it is a controlled corporation investors have to make a judgement as to whether they care. In case of Facebook initially it looked like they didn’t care. Right from the beginning Facebook has been very open that they are not really going to be a publically traded company and that really they are a private business that wants the capital that public markets give them. But it is going to be Zuckerberg’s company.
So they won’t give out much information?
They might give out the information but you will have no say in what they do. So if they do an acquisition…
Did they overpay for Instagram?
They paid. I don’t know whether they overpaid. But the paid and there was no accountability. Zuckerberg basically decided to pay a billion (dollars) then he told the board that I have bought the company and I have paid a billion. This is not the way a company should be bought. A CEO shouldn’t be deciding what to pay overnight and you shouldn’t be telling the board of directors after you have bought a company that I just bought a company for a billion and I just want you to know.
This is like how mom and pop shops down the road operate…
It is a way a dictatorship operates. Facebook is a corporate dictatorship.
So who influenced Zuckerberg to do what he is doing?
Google set the framework that Facebook is using right now. The voting shares, non-voting shares. Sergey Brin and Larry Page are the models that Zuckerberg is using.
Can you elaborate on that?
Until Google came along, US companies generally did not have two classes of shares. Voting shares and nonvoting shares were for a long time banned by the New York Stock Exchange. So most companies didn’t even try. So if you look at Apple, you look at Microsoft they had only one class of shares. Google essentially did two things. They did their IPO through an auction rather than through investment banks. And secondly they decided to have voting and nonvoting shares. If institutional investors had risen at that point of time and said we are not buying these shares because we don’t have enough voting rights, then Google would have been forced to go back to drawing board and then come back. Institutional investors were okay with Google doing that. Once they opened that door every social media company you look at LinkedIn and Groupon, they follow what Google did.
So these shares are listed on NASDAQ?
Yes. NASDAQ allows for voting and nonvoting shares that is the part of the reason for listing on it. The New York Stock Exchange because it is in competition with NASDAQ has now also started relaxing, they want the money, they want the listings. So they will take Facebook even if it’s voting and nonvoting shares. So this will be a race to the bottom.
So the shares sold to the public were nonvoting shares?
They are low voting shares. The shares that Zuckerberg owns have 10 times the voting rights, which means he has 57% of voting rights with 35% of the shares. And he will always make sure that remains above 50%.
So he can go ahead and buy anything without requiring clearance from the board?
Google for instance recently issued new shares which have no voting right at all. So that is the third layer. You have ten voting rights shares. One voting rights shares. And no voting rights shares. Zuckerberg can go out and raise as much capital as he wants. If he issues no voting rights he will always have 57%. He going to lock in that voting percentage.
But how is something like this allowed in a developed market like the US?
I don’t think it should be banned. Let the investors decide for themselves. Lots of countries you have two classes of shares. Its par for the course. And you just price it in.
It’s just that it hasn’t happened in the US for a long time?
I think you will wake up one day and see I wish I had voting rights. But you chose to be a part of this game. I am not feeling sorry for the institutional investors in Google who are crying about the fact that Google does things they don’t like. You bought the stock you live with it.
(The interview was originally published in the Daily News and Analysis(DNA) on May 28,2012. http://www.dnaindia.com/money/interview_facebook-is-a-corporate-dictatorship_1694603)
(Interviewer Kaul is a writer and can be reached at [email protected])
So let me be a killjoy this Monday morning and say that Facebook is a bubble. And like all bubbles it will burst.
The price of the Facebook share closed at $38.23 at the close of trading on Friday. At this price the company was worth around $104.6billion.The basic question that crops up here is that whether Facebook deserves such a high price? “It’s exceedingly dangerous to pay a $100 billion valuation for a company that hasn’t figured out a way to make money,” Aswath Damodaran, a professor at Stern Business School at New York University told Barrons Online. Damodaran is one of the world’s premier experts on valuation.
Facebook versus Google
Facebook earned 43 cents per share in 2011. At its Friday closing price of $38.23, the company has a price to earnings ratio of around 88.4 ($38.23/43cents). Now compare this to Google, which is the closest comparison we can make with a stock like Facebook. Google had an earnings per share of $33 in 2011. The market price of the company closed at $600.4 on Friday, implying a price to earnings ratio of 18.2 ($600.14/$33). This makes Facebook around five times as expensively priced as Google (88.4/18.2). Price to earnings ratio is equal to the latest market price of the share of the company divided by its earnings per share.
Even if we were to look at the expected earnings for the current year, Facebook is expensively priced. Analysts expected Facebook to earn around 50 cents per share in 2012. This means that the forward price to earnings ratio of the company is at 76.5($38.23/50cents). Google’s forward price to earnings ratio for 2012 works out to 14, making Facebook more than five times as expensive as Google.
Let us get into little more detail here. Both Google and Facebook have around 900million users. “There isn’t much scope for growth here, really – we’re beginning to run out of connected adults on the planet,” points out venture capitalist Mahesh Murthy on his Facebook page.
Google had sales of $39.98billion with a profit of $10.83billion. From almost a similar number of users Facebook had sales of $3.71billion and profits of $1billion. Hence Google makes average revenue of around $44per user. At the same time Facebook makes average revenue of around $4 per user. It is rather ironic that even though Google has average revenue per user 11 times that of Facebook and also earned a profit which was nearly 11times, the price to earnings ratio of Facebook is 5 times that of Google.
So what are investors paying for?
Investors are essentially paying for the future growth of Facebook. As Kevin Landis chief investment officer at Firsthand Capital, a Facebook holder told Barrons Online “The investment thesis is pretty simple. Facebook knows more things about more people than does Google, and those people have stronger emotional connections and loyalty because that’s where their friends are…So given a few years to figure it out, Facebook could end up being worth more than Google, which has a market value of $200 billion.”
One advantage with more user data is that Facebook can help advertisers reach their targeted audience better. When companies advertise in mass market mediums like newspapers or television channels they have no clue of whether they are reaching their target audience. But with Facebook they can be sure.
At least the story being bandied around by analysts who are bullish on the stock. But companies aren’t buying this yet. In fact General Motors, a company with one of the largest advertising budgets in the United States, recently pulled its ads from Facebook, cancelling its $10million Facebook advertising budget.
As Matthew Yeomans wrote in a recent column on www.guardian.co.uk “GM clearly believes Facebook users aren’t engaging in banner and targeted advertising and, in that analysis, the company is probably right. Frankly I’ve never met a single person (apart from those who work in the digital advertising industry) who believe online banner ads are effective”.
This is something I totally agree with. What makes it even worse on Facebook is its cluttered look. In fact I only realised that my homepage on Facebook page has ads when I went looking for them. In comparison the Google.com page has a very clean look and with a white background the targeted ads are easily available.
Given this Facebook might find it a little difficult to grow its revenues. As Murthy puts it “This (the valuation of Facebook) might make sense if there was room for Facebook to grow. Where is that? More ads per user? Would we really like that? More charges per ad? Advertisers are already smarting at FB’s rates. Will you pay for apps on their store? Will you pay for premium listings? Not many will, I believe. The point is that FB will find it hard to grow its revenues per user – which is around $4 per year now.”
In fact the revenue growth of Facebook is slowing. Its revenues for the first quarter of 2012 stood at $1.06billion in comparison to $1.13billion in the fourth quarter of 2011. The primary reason for the same is the fact that more and more users are accessing Facebook from their smartphones. And smartsphone screens do not lend themselves well to advertising. Facebook admitted to this in a recent filing with the Securities and Exchange Commission, the stock market regulator in the United States, where it said “we do not currently directly generate any meaningful revenue from the use of Facebook mobile products, and our ability to do so successfully is unproven.”
The bubble signs
Other than the basic doubt on the business model (i.e. how does the company plan to make money) of Facebook, there are other signs also of why the company is in bubbly territory. Too many analysts are bullish on it.
Towards the end of the dotcom bubble in 1999, even though the stock market had gone up too soon too fast, most the stock recommendations from the analysts remained a buy i.e. the analysts of Wall Street were commending investors to buy stocks even at very high levels.
According to data from Zack Investment Research only about 1% of the recommendations on some 6000 companies were sell recommendations. The remaining 99% was divided between 69.5% buy recommendations and 29.9%hold recommendations(i.e. don’t buy more shares but don’t sell what you already have).
Analysts typically do not like issuing sell recommendations (or in the case of Facebook asking investors not to buy the stock) because that did not put them in the good books of the company involved. This would mean that the company would stop sharing information and deny the analyst access to its top people. And what good is an analyst who has no access to information on the company he is covering.
Henry Blodget one of the premier analysts during the days of the dotcom boom is quoted as saying in Andy Kessler’s Wall Street Meat “You’ve got to understand. If I stop recommending stock and the shares keep going up, there is hell to pay. Brokers call you up and yell to you for missing more of the upside. Bankers yell at you for messing up their relationships. There is just too much risk in not recommending these stocks.”
Facebook is in a similar situation. Analysts are predicting that Facebook will grow its profits by 38% and its revenues by 35% on an average over the course of the next three years. This is groupthink at its worst.
Another thing that happened during dotcom bubble was the fact that the valuations of the dotcom companies with no business models were worth much more than companies which had genuine businesses in place which had been generating revenue for years. Priceline.com sold its shares at $16 and ended its first day of trading at $69. The website basically resold airline tickets and did not own any airplanes, but was worth more than the entire tangible airline industry put together.
Valuations had reached crazy levels. eToys a tiny seller of toys on the web with revenues of $25million was listed on the stock exchanges at a market capitalization of three times the value of Toys “R” Us, a company with tangible business and stores throughout the United States generating a revenue of $11billion.
While the situation is nowhere as crazy now as it was back then but it is a tad similar. At its current market capitalization of around $104.6billion, Facebook is worth as much as PepsiCo, a company which has been in the business for years. PepsiCo has a sales of $67billion with profits of around $6billion. While people may call PepsiCo an old economy stock but it can be pointed out that the company still has huge scope to expand across large parts of Asia and Africa where the annual per capita consumption of cold drinks continues to remain low.
In comparison there is not much scope for Facebook to grow from its current levels as far as number of users is concerned.
Warren Buffett one of the greatest investors of our times did not invest in any of the dotcom stocks in the late 1990s. His returns fell for a few years and he was also the laughing stock of the market. But when the bubble burst and billions of dollars of investor money were lost, Buffett was the last man standing. What he wrote in his annual letter to the shareholders of Berkshire Hathaway for the year 2000 after the dotcom bubble burst is worth repeating here:
By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street – a community in which quality control is not prized – will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
And for all we know Facebook might just be a passing fad. I would like to conclude with something a gentleman by the name of Marc Effron, the President of The Talent Strategy Group, and author of One Page Talent Management, told me a few months back, when I asked him if Facebook was just a passing fad. “The first thing that comes to my mind when you say Facebook is MySpace,” he replied.
(The article originally appeared at www.firstpost.com on May 19,2012. http://www.firstpost.com/investing/facebook-is-a-bubble-and-it-will-burst-316100.html)
(Vivek Kaul is a writer and can be reached at [email protected])