First published: 16/03/2017
One of my earliest (& fondest) memories of my time at Fidelity is the new analyst induction program. During my first year, in 2004, some 35 of us new joiners congregated in Boston for training and to meet some of the most senior portfolio managers - greats such as Will Danoff (who manages the US$100bn Fidelity Contrafund) and Joel Tillinghast (Portfolio Manager of the Fidelity Low-Priced Stock Fund).
The highlight for me was meeting the great Peter Lynch. Peter made three statements that left a clear imprint on my investment philosophy:
a) Stocks always follow earnings and cash flow - focus on them and you will get the stocks right;
b) The person that turns over the most rocks wins the game;
c) In this business, if you are good you will be right six times out of ten - you are never going to be right nine times out of ten - learn to deal with it!
This note deals with his second point. It struck me that I mostly talk about the stocks/rocks that are in my portfolio. Very rarely do I talk about the other 90% that we research that aren’t part of the portfolio. Today I’ll address that with one of my erstwhile favourites which recently exited the fund - Facebook.
Facebook will be well known to you all. It’s a stock I have eulogised in these pages a number of times before (‘Bits & Atoms - March 2016’, ‘What is good, what is great’ - May 2016). Since my May 2016 note, Facebook has added another US$90bn in terms of stock valuation.
The Fund has been involved in Facebook since its initial public offering in 2012, with a brief period of no ownership while we took time to understand and digest the US$19bn Whatsapp acquisition. The attraction of Facebook is simple:
a) 1.8bn users - 24% of the world’s population spending on average 45 minutes a day on the platform
b) Network effects - these are Facebook’s moat, as you need to be on Facebook if you want to connect to your friends/relatives and it remains a repository of your life’s history - the moat only increases with time and more users
c) An intelligent and motivated CEO/owner in Mark Zuckerberg - he has the smarts and flexibility in the organisation to innovate and navigate the ever changing social media landscape. It’s a company which theoretically fits in perfectly into our framework of sustainable pricing power.
So what has changed my mind?
For starters, I don’t view my job as only to buy the best companies. It’s equally important to consider the price paid versus the value received and to own stocks in the portfolio where there lies a positive gap between our view of the company’s fundamentals and what the market is currently pricing in. Facebook, with a market cap now of US$394bn, trades at a price earnings multiple of 30 times 2017 GAAP (Generally Accepted Accounting Principles) earnings, and it made $11bn of cash flow for equity shareholders last year.
By comparison, the world’s largest company by market cap, Apple - at US$720bn (and a portfolio holding) trades at 15 times 2017 consensus earnings and generated US$53bn of free cash flow for shareholders last year. So with Apple, for 1.8 times Facebook’s market cap you get a company which generates about five times as much cash flow. As you may know, I follow the not so popular investment maxim - ‘profit is an opinion; cash is a fact’
However it is not only the valuation that matters. What really worries me - and prompted my exit - are my following views:
Firstly, everyone loves Facebook and it appears in almost every hedge fund/managed fund portfolio. Infact of the 53 sell side analysts covering Facebook only two rate it a sell. The investment thesis is clearly well understood and well known. Going back to a core principle, I fear I am struggling to understand where my views substantially differ from what may already be priced into the stock.
More tangentially, I have been re-reading on the economic history of United States under President Ronald Reagan - a historical figure that the current President Donald Trump would like to emulate (interestingly Reagan, like Trump, was a Democrat before he became a Republican).
One of the milestone events that caught my attention was that in 1982, a year after President Reagan’s election, the largest corporation in American history - AT&T was broken up into eight different entities & its monopoly over the US telephone system effectively dismantled.
Social media and the telephone share a very important characteristic - the moat of network effect. Network effect is the (generally) positive effect that each incremental user has on the value of that product or service to all other users. For example, the more people who own telephones, the more valuable is the telephone to each owner. Social media follows the same analogy - the more people on Facebook, Instagram or WhatsApp the more valuable the platform to all existing & future users.
Facebook’s moat actually goes a step further in that not only does it gain from network effects (like AT&T) but it also has unique access to our digital identity and all the actions (photos/articles we like & share) we perform on its various platforms.
What makes it so unique could also be its Achilles heel.
In fact Michal Kosinski, a researcher at Cambridge University, in 2012 (http://www.pnas.org/content/110/15/5802.full ) proved that on the basis of an average of 68 Facebook "likes" by a user it was possible to predict their skin color (with 95% accuracy), their sexual orientation (88% accuracy), and their affiliation to the Democratic or Republican party (85%). This is mind blowing data and gives Facebook unique power.
There has already been significant controversy around whether this user data was used to influence either the Brexit vote or the US presidential elections (read this article - https://motherboard.vice.com/en_us/article/how-our-likes-helped-trump-win for more details). What is true is that Facebook’s algorithms have the ability to influence our opinions and in many cases even our emotions. This is great power & with great power comes great responsibility.
While the CEO and Facebook management have clearly articulated how seriously they take this issue, I fear that at current valuations the margin of safety in valuations is limited as fellow investors are not thinking enough about the issues I have highlighted above.
If history is any guide, market power has been resolved either through new competition (unlikely) or the heavy hand of the government. And it is this area which every Facebook investor should be applying more thought to.
Government regulation & its impact is difficult to forecast with accuracy - Just look at what happened to the banking sector post the financial crisis or closer to tech land, Microsoft, which went through a near lost decade (in terms of stock price performance) post the European Commission anti-trust ruling in 2004.
Putting all this together, the issue of market concentration in technology in general and Facebook in particular sounds like an area which requires a lot more thought and where the risk/reward is probably not appropriate at this point to spend the fund’s risk capital.
Facebook remains a unique company and I continue to remain flexible in my approach. We continue to do work on the industry which includes understanding the impact of prospective regulation. If further work shows that the worries I have articulated here are unlikely to come to pass, and that the market is undervaluing Facebook’s future growth prospects, then the stock will be back in the portfolio. For now, however, I prefer to watch from the side lines.
After all, the privilege of running a global fund is that the opportunity set is significant and there are so many other rocks to turn!
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