Principle 6

This is a continuation of my reflections on 'Factfulness' by Hans Rosling. Whilst I finished reading the book almost a year ago, I was unable to complete my series of posts. Through these posts, I am attempting to draw principles which are applicable to the world of investing, from the eye-opening book.

The Size Instinct 

Learning 1: The Size Instinct and Noises.

In Factfulness, Rosling says that by "Paying too much attention to the individual visible victim rather than the numbers can lead us to spend all our resources on a fraction of the problem." He also says that "We tend to assume that all the items on a list are equally important, but usually just a few of them are more important than all the others put together."

In today's world, there is an unprecedented level of access to information. In some sense, this should make investing harder. Theoretically, as more information is readily available in the public domain, the market value should converge to the fair value more quickly; hence, there are fewer market inefficiencies that can be exploited. Whilst this has occurred, the above description of the efficiency resulting from easy access to information is not complete. This is because with our unprecedented levels of access to information we have also gained an unprecedented level of access to noise. 

Thus, it is very important not to be non-discriminatory when we are trying to follow current events. Indeed, several newspapers print over twenty pages every day. They simply do not have the time to produce high-quality, balanced, in-depth analyses every day. Instead, some print eye-catching headlines, and produce superficial and provocative recounts of ongoing events. Whilst these stories may be entertaining, they elevate these noises to a pedestal of significance. Hence, reading these stories could lead you to make poorer investment decisions. So, be more discriminatory when you are reading, and choose your sources of information carefully. That way, you will be better able to keep things in proportion and focus on those things that are really important. As a solution, Hans Rosling suggests the 80/20 rule; the idea is that one should focus on trying to understand those 'items on a list', that account for 80% of the total. 

Whilst we must strive to filter through the noise, I must strike a cautionary note. We must remember that our pre-existing views and biases may influence our classification of "noise". Indeed, this could be dangerous as it may lead you to ignore literature which would force you to test - and defend - your perspective. Thus, it is important to actively seek out literature and people with an alternative views. This will likely help you make better investment decisions.

Learning 2: The Size Instinct and Market size.

Rosling states that "The world cannot be understood without numbers. And it cannot be understood with numbers alone." This is certainly true in the investment world. Indeed, several fundamental value investors would argue that "investing is more art than science". This is because it is about "Narrative and Numbers"; any numbers we use in a financial model are the output of assumptions, which must be set in a story. Whilst numbers are very important, using just numbers can lead you to make grave mistakes in valuation. For example, you may say that because a company has grown at 15% p.a. it will continue to do so. However, if you have not thought carefully about your story, you may forget to account for the capital expenditure needed to produce that growth. Or, you may say that a company (in the USA) , which has been growing at 60% p.a. , will grow at 6% to perpetuity. To do this you would have to fail to realise that this would mean that it would account for the entirety of the US economy - which grows at roughly 3% - at some point in the future. 

We have said that numbers are very useful; however, some types of numbers are more useful than others. Indeed, Rosling says that "Amounts and rates tell very different stories," and that "Rates are more meaningful". Whilst this may not necessarily be true in all circumstances, it is true for investing. Even value investing, which is about 'present' value, can't help dealing with the future. Thus, before one decides what a company is worth, one must try to determine its future: "What is happening to the market as whole? Within this market, how is this company's market share going to change? "  Present market share - whilst it is still important - is less important than future marketshare. How the environment in which a firm operates is changing is of utmost importance. This is because, as I have said before, understanding structural changes in an industry offers opportunities, or - at the very least - helps avoid losses. 

Thus, when you are next using numbers, make sure to (i) base them on a story; and (ii) try to use rates and changes as opposed to absolute quantities.

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.