Facebook: Why it may be a BUY!!

I have decided to initiate a long position in Facebook. Facebook stock has fallen dramatically in price over the last few months. This precipitous fall can be largely attributed to an escalating scandal around Facebook’s alleged mismanagement of user data, concern about the effects of this ‘breach of trust’ on user engagement, and fear of a brewing regulatory backlash against Facebook’s business model. In this post, I will attempt to evaluate some of the significant risks in Facebook, and then explore why I think it is a buy. There are two questions to consider: (i) Is it available cheap? and (ii) is it a good quality business?

Good Price?

Data scandal

There are a few reasons why the scandal - and ensuing concerns - may be overblown. Whilst I am not delusional enough to believe that Facebook is not at fault, I suspect that the extent to which it has mismanaged data is being exaggerated: a headline about how Facebook is selling your personal information will obviously attract more attention than a headline which says that some of Facebook’s practices could potentially be considered to be unethical. Indeed, I think that this scandal will pass. There are two reasons for that. Firstly, the rate at which people moved past the VW emissions scandal suggests that people have a tendency to be forgiving if companies resolve ethical issues. Thus, the impact of the data scandal on user engagement may be less significant than it is perceived to be - provided Facebook resolves issues. Secondly, any regulation arising from the data scandal will only benefit Facebook. It is likely that regulation will legitimise and entrench the data economy. Rules will make it harder for start-ups to enter the space occupied by Facebook (that is the space of a social network, which generates cash by selling targeted advertising products). 

Despite my confidence that the current scandal will not necessarily weaken Facebook’s hand, there are two reasons to be more reserved when one is dismissing the impacts of the data scandal. Firstly, Facebook, which - unlike VW - relied upon the network effect to build its platform, may be unwound by the same forces. Secondly, Facebook may be subject to steep fines for its misuse of data. 

Changing user habits

Whilst the scandal is certainly not to be ignored, as a long-term investor, I am more concerned about Facebook’s ability to retain and monetise user engagement across its different platforms. There are ‘shorter-term’, and longer-term concerns in this regard. 

In the short-term, as people are shifting from posts to (1) personal messaging, (2) stories, and (3) video content, Facebook must rapidly alter its business model. Facebook has already begun to address these issues - Facebook has started placing advertisements in Instagram’s stories feature, and has also launched IGTV (Instagram TV) so users can share video content. The success of these two changes is difficult to assess, but I am inclined to believe that Facebook can deal with these two changes (2 & 3). The shift to personal messaging is more concerning. I struggle to understand how Facebook will be able to deliver targeted advertisements without making people feel that their privacy is being invaded. However, there are at least two positives in this regard as well. Firstly, Facebook has an established personal messaging offering in WhatsApp (they have the users). Secondly, the monetisation of WeChat in China - which I do not fully understand - suggests that Facebook should be able to find a creative solution to this issue as well (they should be able to monetise this existing user base). Overall, I think that Facebook should be able to create more value, as it begins to monetise Instagram, and potentially WhatsApp. They will have to be careful not to over-advertise though, as this may put-off users.

In the longer term, there are two concerns I have. Firstly, with generational changes, people tend to move from one social network to another. For example, people moved from Facebook to Instagram, and may make another shift as time goes on. Thus, generational changes may pose a risk to Facebook: children may not want to use the same social networking platforms as their parents. Secondly, there may be a technological shift - a step change - in the way people share information. However, this is (i) probably very far in the future, and (ii) something Facebook will be able to adopt and adapt to - if it is not leading this change.

Management concerns

The mismanagement of people’s data raises questions about the company’s value system. This may be partly responsible for the decline in share price. However, there is reason for hope. Facebook - by reducing the number of polarising, and provocative posts - is watering down users’ feeds. The reduced availability of ‘juicy’ content could negatively impact user engagement. This may be evidence of Zuckerberg and co. sacrificing the short-term for the long-term. Getting rid of such content may indeed enable the company to grow in a more ‘clean’ manner. Thus, this helps to restore my confidence in Facebook’s management.

Overall
From a valuation perspective, whilst I have not tried to use a D.C.F model, I am fairly confident that Facebook is cheap. A high-growth company with substantial earnings is trading at only 19x P/E.

Good Quality Business?

If I am going to make a long-term investment, I want to buy a good quality business at a good price. So far, I have considered the challenges facing Facebook, and explained why I think that they are less significant than people might think. These factors are very important, as they explain why my view on the company is different to that of the current consensus - the risk-factors considered and my evaluations of these factors explain why I think Facebook may be available at a good price. But, if I am going to make a long-term investment, I must now decide whether it is a fundamentally good business. 

There are two reasons why I think Facebook is a good quality business. Whilst neither is particularly insightful, I think they provide a rudimentary base for thinking about Facebook. Firstly, Facebook’s platforms serve a fundamental purpose. People - being the social creatures they are - need to have a means to communicate with each other from afar, and companies must advertise in order to promote their offerings. Secondly, with a growing world population, rising amounts of free time and increasing internet penetration, the potential market is continuously expanding. Thus, I think Facebook is a good quality business.

Conclusion

I think that there is a range of possible futures for Facebook. I also think that amidst the flurry of recent bad news, people have become overly negative on Facebook. Facebook is not a risk-free investment by any means, and there is a chance that I am being over optimistic. But, I think that despite being challenged, it is a good long term investment. Indeed, it is made more so by the fact that they are investing capital in other projects as well (eg: Oculus, e-commerce). 

Facebook will test my emotional resilience in the time to come. I hope I will live up to the challenge. 

Investor Series - Interview #2

This is the second interview of my Investor Series, and am sure you will find it insightful. In this video, I interview Vinay Agarwal. He is a Director at First State Investments. Vinay manages funds that invest in Asia and the Indian sub-continent.

I stated upon releasing my first video that I intended to focus more on content than production values. With this interview you will find that I have overdelivered on the latter half of that promise. However, going forward, I will need to make sure that the production values do not suffer so much that they detract from the content.

Investor Series

In this video, I interview Vinod Nair. He is a Managing Partner at Altavista Investment Management. I hope this video will prove to be the first of a useful series. I intend to focus more on content than production values.

Investor Howard Marks on Luck, Risks and the Job that Got Away -- Knowledge@Wharton

In this post, I have picked out a few quotations I found interesting from a K@W post. I hope you will find these nuggets of wisdom as insightful as I do! If you take one thing away, let it be that “Success in investing is not a function of what you buy. It’s a function of what you pay.”

Price is king

Investing is ultimately about buying a company for less than you think it is worth, or at least less than what you think it will be worth in the future. That being said, it is probably best to buy great businesses at great prices, because you can then hold your position 'forever'.

The official dictum was if you were buying the stock of a good enough company, it didn’t matter how high a price you paid.” But it did matter, Marks noted, and people were paying about five times what the stocks were worth. “By 1973, the people who held those stocks had lost 90% of their money.”

Citibank had invested in “the best companies in America and lost a lot of money.” Then it invested in “the worst companies in America and made a lot of money,” Marks noted, adding that “it shouldn’t take you too long to figure out that success in investing is not a function of what you buy. It’s a function of what you pay.”

"Not-Loser's Tennis" & "No-called-strike Baseball"
In investing, you don't need to try to hit a winning shot all the time. You just need to stay in the game long enough, that when a winning opportunity you like presents itself, you can take advantage of it. In fact, you never need to hit that winning shot at all; you could even just stay in till your opponent (the market) makes a mistake. This is why investing is such an advantageous game. 

It’s not a crapshoot like — if you’ll pardon the expression — venture capital, where you invest in 10 companies but if one of them turns out to be Google, you’re a success.”

He plays “not-loser’s” tennis. “If you think you can see the future and the world is going to go according to your decisions, go for winner’s tennis. But if you think the world is full of randomness and uncertainty, spend your time trying to avoid losers.” 

If we can make a large portfolio of investments where none of them [strike out], then we’ll have … no bad ones to pull down the average.”

Self-fulfilling Prophecies
Low business confidence - or fears of a recession - can trigger a recession, and high business confidence can cause a boom. Self-fulfilling prophecies occur regularly on the stock-market. 

Sometimes I think confidence is the only thing that determines economic outcomes. Confidence is largely self-fulfilling.

The Stupidity of Spending the Future Today
Borrowing is simply a means for consuming tomorrow's money today. The thing is, (i) you have to pay for this right, and (ii) there is a chance that tomorrow's money will never materialise!

Credit is one of the reasons the world is in trouble now. Countries like Greece, France, Italy, Portugal and Spain have to practice austerity now because that’s what happens when you spend money you don’t have.

The Bermuda Triangle of Valuation (Learning from Damodaran)

As I have mentioned in previous posts, I did a course about Valuation over the summer. This post follows a similar post about the dangers of valuation models. In my previous post - also inspired by an Ashwath Damodaran talk - I explored the importance of 'stories', which necessarily drive every valuation. I would like for this post to serve as a cautionary note for myself - and any readers - about the common errors we might make when valuing a company. I have attempted to capture the main points Damodaran makes in his talk.

The Bermuda Triangle of Valuation is:

• Bias and Preconceptions
• Uncertainty
• Complexity

Bias and Preconceptions

• It is important to distinguish between Pricing and valuation. Most people think of a number first and build a valuation to fit the number. Value cannot precede valuation, because models can only tell you what you want to here. If you want to buy, you will keep fiddling with the inputs till the model says it is a buy. Thus, it is probably useful to question how each input number was derived.

• You start out with an opinion, and then your valuation simply confirms what you learned. The more you know about a company the more biases there are in your valuation. That being said you need to know the business to develop a story.

• If you know the managers of the company, you know too much to value the company effectively. If you get too close to the company, you are less effective.

• When everyone is saying something in the market, it is hard to step back and objectively disagree. The less confident you are the closer your valuation gets to the market. 

• Suggestion bias. If I say I think its worth 15, but value it anyways, you will probably arrive at a similar price.

• When you see decimals in a valuation, the valuer is using decimals to intimidate you. Decimals mean nothing, because you cannot be that precise about the value of a company.

• Small changes have significant effects. Thus, it is important to question each input.

• Don’t let comparable multiples tell you what the price is. If you pick the comparable, you are making several assumptions!

• Several people deny bias. Denial is no good (Stop lying to yourself). Instead, you must think of ways to structure processes that help reduce bias. 

• Ask people to be transparent about where they come from. What was there hypothesis? What were their findings (attempt to disprove the hypothesis?) The hypothesis is full of bias, so you can then take the findings with a pinch of salt. That being said, its much easier to point out the (often small) issues with a hypothesis than it is to create a hypothesis yourself.

• Where M&A is concerned, you don’t ask the deal maker if the deal makes sense; they have bias!

Uncertainty - We often ignore this as we don’t know how to deal with it.

• Every input involves assumption. We make estimates. The difficulty of making estimates is variable. We want companies where it is possible to make estimates. The harder it is to make an estimate, the greater the uncertainty is. Uncertainty is an opportunity, and so the pay-off to doing valuation is greatest when there is greater uncertainty. However, we must be aware that our numbers are only one possibility.

• Estimation uncertainty (Micro uncertainty) can be refined through cashflows and KPI estimates.

• Economic uncertainty (Macro uncertainty) can be accounted for through the discount rate.

• Spending more time doing valuation doesn’t make uncertainty go away.

• Continuous uncertainty is much easier to deal with than discrete uncertainty (bankruptcy, nationalisation). We must deal with discrete uncertainty. This is because these improbable - but not impossible - occurrences, can result in insurmountable difficulties for companies.

• Things we can do to deal with uncertainty:
• Less is more: Aggregate things instead of breaking them down, when you make forecasts and assumptions. That being said, looking at the lines for historical data allows you to spot significant changes, and can help guide your research.
• Make sure your valuation is not at war with itself; be clear what your assumptions are.
• Make sure your assumptions affect all the relevant inputs, (eg. inflation affects interest rates, discount rates, and growth rates)
• Be realistic.
• Even if you disagree with the market, try to understand what the market is telling you.
• Law of large numbers: Use averages to compare. But, blind averages may conceal significant anomalies.
• Don’t use the discount rate to account for fear.
• Use distributions instead of fixed figures. Considers the different possible outcomes. Draw a bell-curve?
• Don’t look for precision. You will be wrong 100% of the time! You are only looking for a ball-park figure to confirm what your story will look like in numbers.

Complexity - As valuations and models are complex, we may lose sight of what exactly it is we set out to achieve.

• Companies are 'tentacled octopuses'. This complexity may make it difficult to understand a company's business.

• Data accessibility means we have more data. However, this means we must filter the useless noise, and hunt for the jewels.

• Legal/accounting complexity also raises issues.

• Build simple models.
• In complex models with lots of variables, input fatigue sets in. (You may start putting random numbers in.)
• So, the model becomes a blackbox. You don't know what went in and don't know why a given output came out.