Archives For May 2012

 

I don’t believe Facebook requires much by way of introduction. I’m not sure history can show us a more heralded (by the media anyway) public offering fueled by tremendous optimism about the business only to be replaced within days by a string of bad news stories, leading to widespread pessimism about its future, and accompanied by a steep drop.

This is classic Shleifer Effect stuff. But it’s a different kind of business than ones I’m used to evaluating and owning…it’s a far cry from a value situation. This is classic big story growth stock. That’s why I have to disclose this confession: I bought a small piece of this business today.

I’m working on some other projects and don’t have the time to go into much detail right now, but I’ll try to get back to it soon.

Suffice it to say that I see a business with a lot of opportunity for growth by tapping an asset of enormous value, its user base. They make some money now, and I believe the company will find ways to squeeze something viable (nay, thriving) out of those 900 or so million users.

While I remain skittish of social networking businesses (see this post where I mention Facebook in reference to MySpace), I believe there is a durable competitive advantage. In other words, I don’t foresee (despite many people that believe differently) something like Twitter or an upstart making serious inroads to steal Facebook market share and/or force it into a pricing war that reduces its profitability.

I also believe it has a profitable economic model in that its gross margins can (and do) exceed its expense structure (and this despite a lot of expenses expanding for growth) and its earnings can (and do) exceed its requirements for reinvested capital.

But then there’s that pesky problem of price. When measuring it against earnings, it’s high. Very high. Even after the major fall. How am I rationalizing this to myself then, you must ask.

Pessimism. Tremendous, and I believe, unwarranted pessimism that is leading to irrational behavior. Granted, this same pessimism could burgeon further from here. My purchase might lose value. At this point, based on my evaluation of what I see, that would create another buying opportunity. I would take advantage of it.

So, I will no doubt inspire righteous ire by quoting Warren Buffett below in my justification for buying Facebook. But these models are complex and nuanced, so here is one upon which I’m depending more and more…

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’”

Most of the resources I’m paying attention to for news about Facebook come from Henry Blodget’s BusinessInsider.com. Again, I’m not actively trying to attract the outrage of my value investing compatriots, but I find a lot of signal inside the layer upon layer of noise that comes out of Business Insider.

Facebook Stock Is Breaking Down Again (May 30, 2012)

How Morgan Stanley Clients Got Screwed On Facebook — And How We Can Fix The System (May 31, 2012)

On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide what you need to understand the retail business of Amazon.com. You can watch it here. I’ve included some transcribed remarks below with a little color commentary.

For some context, this corresponds with the steepest part of the dot-com collapse. Amazon’s stock price had been in free-fall for 18 months, declining from $106 in December 1999 to $14 when he sat down with Charlie. And its drop wouldn’t end until shortly after 9/11 when it hit a $6 bottom.

Bezos Can Distinguish Between Stock Price and Business Fundamentals

Charlie Rose (CR): Two years ago you were Time Magazine’s man of the year. What are you this year?

Jeff Bezos (JB): It’s internet poster boy to internet pinata in 12 months! Not an easy thing to do.

CR: Let’s talk about it. How’s the business?

JB: Actually, the business is better than ever. This is one of those things that is so hard for people who are seeing it from the outside to really understand and internalize. but if you look at 1999, which is the year that the stock was booming, we had 14 million customers shop with Amazon. In the year 2000, when the stock was busting, we had 20 million people shop with Amazon.

…But I do think it’s typical for people to separate the stock prices of internet companies (which have obviously come way, way, way off their highs) and the fundamentals of those companies which are actually getting better and better.

CR: What are the fundamentals of Amazon, and how are they getting better?

JB: For example, in Q4 of 99 when our stock was at or near its peak, we had an operating loss of 26 percent of sales. A year later, when the stock was near its 52-week low, we had an operating loss of seven percent of sales. So the operating losses got much, much better. The number of customers…got much, much better. You can basically go through and look at every important operating metric in the company and they’ve all improved.

[Paul: As we discussed here, there are some very capable CEO’s – leaders of important and successful businesses – that seem incapable of separating stock price and the performance of the business. At the very least, they have an emotional and financial tie to the market’s price…a tie they have a difficult time unraveling.]

Growing the Business

CR: …why stray from books?

JB:  Charlie, one of the reasons that we’ve expanded into these new categories is because our customers have asked us to do it.

CR: What kind of relationship do you have with Sony, for example?…Do you have the kind of relationship that an authorized dealer does so you can offer Sony products competitively?

JB: Well we do offer products competitively, but in some cases that doesn’t necessarily mean that we’re buying them directly from the suppliers. We started our electronics business two years ago, and we’re now direct with over 340 different electronics suppliers. We have by far the largest selection of electronic items…in the world…We have over 125,000 items…compared with a huge electronics superstore that might have 5,000 items. We’re so new in the business, over time and patiently, we hopefully get relationships with every manufacturer.

[Paul: This is remarkable to think about. In 2001 Amazon was already an important player in  electronics retail. But big players like Sony weren’t yet dealing with them directly. Amazon makes it a priority to offer the highest selection possible at the lowest price available. One can only imagine the costs they were eating by sourcing through electronics distributors, paying those mark-ups while simultaneously selling cheap. 

This has been the Amazon modus operandi…buy your way into the market even if it means taking losses while you help customers learn the habit of buying from you. Then, when you have the customer buying power behind you, go direct to manufacturers for procurement, get better pricing, and enjoy improving margins. 

Remember that: growth is expensive for Amazon. It always has a lot of clean-up duty after opening new stores and expanding into new geographies. It hurts corporate profitability. But then, inevitably, Amazon owns the category, has power to buy cheap and in bulk, and becomes profitable while continuing to sell at the low price point.]

E-commerce Is All About Scale…  

CR: Looking at the experiences you’ve had over the past three years, was part of the business plan simply to grow faster? [Bezos nods his head, yes.] Would you change it? In hindsight…would you have had a different business model or strategy?

JB:  I don’t think so. I think we have…made the right set of trade-offs. One of the things that you have to know about e-commerce is that it’s a scale business. What that means is that it’s very, very difficult to be a small- or medium-sized e-commerce company.

The difficulty there is because there are big fixed cost investments. You have to write a bunch of software, and it’s just as expensive to write that software if ten customers use it as it is if 20 million customers use it…It’s difficult to build software that scales and is feature rich…[But] we like things to be hard because then you can get competitive advantage from it.

…And We Had to Manage The Land Rush

CR: The biggest mistake you’ve made so far?

JB: …We started investing in a series of smaller- and medium-sized e-commerce companies. Of all the companies that perhaps, in hindsight at least, could have know better, it’s probably us. Because we did know that the fixed costs in the business are high.

CR: So what happened?

JB: One of the things we were very convinced of, and indeed was definitely true in the earlier days, is that there was a land rush phase to the internet. And so, when we saw product categories that we thought were important to our future at some point, but they weren’t the ones we were going to do first…Pets.com, wine.com, etc….there were a bunch of things that we were invested in that didn’t work out. We knew we weren’t going to do those things anytime soon, but we wanted placeholders  in those industries so that later, perhaps, we could fold these industries back into Amazon.com. So that was driven by…a land rush mentality…It’s hard to put a precise date on it, but I believe that for the first four years of our existence, that land rush mentality was correct. And the only reason we exist today is because we…behaved that way. But that started to transition after a certain point, and we didn’t see it at the time it transitioned. And it took us a couple years too long.

…That’s part of what created the land rush…the huge market cap of the internet sector. So all these companies could get funded. And that’s what created one of the imperatives for moving so quickly. Because there were so many start-up companies getting $60 million or more in venture capital. And those companies with that much capital, if that financing environment had continued for any extended period of time…many of those companies might have been able to build the scale to be successful.

[Paul: This makes even more sense in light of a “systematically eliminate risk” comment below. Amazon was broadly criticized for all the investments it made that went bust. The assumption was, I think, that Amazon was spreading its dollars as a way to capitalize on the mania of so many dot-coms being valued higher and higher by the market. Not at all, says Jeff Bezos. Amazon was making the investment with a specific objective in mind…control the expansion of various categories and wield your influence or risk another company getting scale (number of customers, sophisticated e-commerce software, and distribution capabilities) and threatening your chance at achieving ubiquity (more on that topic in a later post). 

And what’s old is new again. Amazon hasn’t really changed their view on preventing viable competitors by bear-hugging them. But because their scale is so much larger, they feel more confident in their ability to just compete upstarts out of business. For those that pose a larger threat – e.g., Quidsi and Zappos – Amazon co-opts by purchasing. You can read a bit more about that here.]

The Amazon.com Model

CR: [Something to the effect of…] Does the Amazon.com economic model work?

JB: I think the model has been demonstrated. If you look at our U.S. books, music and video business, that business has been profitable for quite a while now…And our electronics business, I think one day, is going to be one of our largest and most profitable businesses.

[Paul: I’ll write more on this at a later point. Sometime around 2000, Amazon proved that it could turn a profit quite easily. The secret? Just stop growing. As I mentioned above, there are some incredible inefficiencies inherent to growth. When you start selling electronics, it takes time to be a big player. So you don’t get to source directly from giants like Sony. But you must have the selection, so you buy it from an expensive middleman and endure losses so you can continue earning customers by selling at the low price point. Then, one day, you reach the tipping point…you have scale, you can purchase directly (and with negotiating power), and you iron out inefficiencies. Now you have customer loyalty, the ability to sell at low prices, and low costs to produce gross margin dollars. Voila! Profitability and competitive advantage!]

Moore’s Law & Its Derivatives: The Internet As Superior to Physical Retail

JB: One of the things that’s totally different about e-commerce versus physical world commerce is that real estate doesn’t obey Moore’s Law. Moore’s Law says that microprocessor performance doubles for the same price point every 18 months. That’s held true for more than a decade. What you’re finding now is disk space is getting twice as cheap every 12 months. And bandwidth is getting twice as cheap every nine months. So if you take the bandwidth doubling every nine months and assume it holds constant for the next five years, that means that we can spend the same amount of money on bandwidth per customer that we spend today five years from now but use 60 times as much bandwidth. That’s a big, big deal.

Innovation

JB: I am a dyed in the wool optimist. We live in an era of incredible invention, and what drives the economy is invention…A long time ago people thought it was raw materials that drove the economy, and whichever country had more gold was the richest country.

That’s not true anymore.

What drives economies is the education of the people and the innovation that they can then create. And I see a world which – in part because of the internet – is about ready to explode with innovation everywhere.

…It used to be that if you were a genius and you lived in India, it was a little bit harder for you to make an economic contribution to the world. What you do now is create the next great software, and you do it from wherever you are, and you communicate with the world community of software engineers. This is a big deal. And so if you believe fundamentally, and I do , that innovation is what drives world prosperity, I say hang on to your seat.

[Paul: Bezos is often derided as a technocrat. Everyone respects his intelligence, but many see him as just a metric-driven geek who brings no passion to building a vision for the business. Watching and hearing this statement would cause those critics to think twice. Jeff Bezos is driven by big ideas and has passion about enabling the masses with platforms that fuel innovation.]

Confidence to Say…Check & Mate

CR: What could destroy that dream for you? What’s the terror?

JB: [Responding unflinchingly and without breaking eye contact.] When I first met John Doerr, who’s the person at Kleiner-Perkins who invested in Amazon.com, one of the things he said really stuck with me. It was, “What start-up companies do is they take their precious early capital dollars and systematically eliminate risk.” That’s what they do; the successful ones.

What people often get wrong, when you’re a start-up company, 99 percent of whether you make it to be a more established company is luck. This company, Amazon, we’ve worked incredibly hard. We’ve cared for our customers. I’d put us up there against any other company in how much we have bled and sweat for our customers. but we had the planets align for us so perfectly in those early days in terms of the timing and many other things; decisions that we made that were poor decisions that turned out to be the right decision anyway.

In the early days, that’s when the company’s destiny is really not in its own control. At this point in time, with the brand name that we have…we have so many assets now, now it really is under our control. We don’t worry about externalities now. What we worry about now is that we don’t do our job. And I’ll tell you one of the things in this period that I kind of like is that it’s a lot easier in the year 2001 for Amazon.com as a company to be humble, working our butts off, than it was in 1999 when the world believed we couldn’t lose.

CR: [Paraphrased] There are two schools of thought. One is that Amazon will become the most spectacular retailer of all time. The other is that Amazon may become the most spectacular failure of the internet era. What’s the odds of the first being true versus the second?

JB: Let’s put it this way: we get to decide, nobody outside the company can decide that.

[Paul: I don’t see many ways to interpret this confidence. Bezos is saying that – AND THIS IS WAY BACK IN 2001! – absent screwing up internally, we’ve already won.  We’ve eliminated the worst risks. We’ve eliminated luck as a variable in this. The model is that bullet-proof. It’s our to screw up.]

 

Marc Beniof’s words (as noted in a post yesterday, here) sent me thumbing through a few more books in my library. What have other CEO’s had to say about their stock prices?

From the excellent book, Built From Scratch, by Home Depot co-founders Bernie Marcus and Arthur Blank, come the following quotes. (Which, by the way, in no way diffuses my enthusiasm for this book. When studying retail, it is as important to read this as Sam Walton’s Made in America. No question!)

The Home Depot has always been a high-multiple stock. Part of the explanation for it is that the financial community trusts us. (page 183)

Anticipating a hit to earnings from a bad acquisition in 1984, the early days, CEO Bernie Marcus went to the Wall Street throne to plead his case for not punishing the stock price:

 We arranged a series of meetings in New York in which Bernie and Ron Brill, every hour on the hour for a full day, came clean with fund managers and analysts who covered our company. Standing before each group, Bernie stood up and bluntly announced, “I am the CEO of this company, and I am a schmuck,” in precisely those words. “We screwed it up…”

After that, Bernie told them about the corrective measures that had been put in place to prevent a repeat in the future. He assured them that the growth and profitability would continue. And they believed Bernie.

 …We disappointed the Street for the first time…Suddenly, analysts said we didn’t know what we were talking about. It was the nadir of the business. (page 184)

Finally, the following quote calls into question whether the tail was wagging the dog. How much did attention from Wall Street influence their decision to expand in the Northeast? Don’t get me wrong. I understand that stock price plays a big role in a company’s ability to raise capital for growth needs. There is a reality to wanting the stock price to be high versus low. I get it. But the slippery slope of this mentality can be frightening.

 

During the first three years of our Northeast invasion [store expansion beyond its Southeast base], 1988-91, our stock just went crazy. Getting a presence to that part of the country exposed us to Wall Street in living color. For the first time, analysts and brokers saw how busy the stores really were. Seeing is believing; our stock price once again was climbing upward. (p197)

There is a disconnect here. It’s creating some serious cognitive dissonance for me. On the one hand, these CEO’s are smart and savvy. They don’t need a lesson in Stocks 101 from me…they understand that the stock price is not a direct reflection on the performance and/or promise of the business. I can’t imagine many CEO’s actually subscribe to the theory of efficient markets in which the stock price is somehow magically aligned with the true value of the business. No, they understand that the stock price is subject to whims, fancies, and misunderstandings of investors.

And yet, there’s this other hand. They keep playing to it. That makes sense in the Home Depot case from 1984 as they desperately needed capital to grow the business, and they saw the best source of capital as issuing new stock or new debt, both of which would be affected by the current stock price. If it plunged, their access to capital would be cut off.

I get that. I understand that when you need their capital, you’re hostage to the Wall Street game. You have to go to fund managers and analysts from time-to-time with hat in hand.

What I don’t get is that they often seem to be struck by the bug themselves. They tend to get caught up in the price, as if it were somehow the only scorecard by which they can measure their success as people in business. And worst yet, they allow (and perhaps encourage) their employees to do the same thing…to get excited by a rising stock price and to believe they are somehow doing something wrong when the price goes the other way.

That may be true some of the time. Sometimes (oftentimes even) the stock price does react to legitimate bad decisions by people in the company. But sometimes it just moves up and down, completely disconnected from the reality of the business.

I have no immediate way of understanding why many CEO’s do what they do. I’ll punt this discourse on the complexity of human psychology and just revisit the quote from Jeff Bezos that got it started (here). It seems wiser the more I think of it:

We have three all-hands meetings a year, and I’ll tell people that if the stock is up 30% this month, please don’t feel you are 30% smarter. Because when the stock is down 30% a month from now, it’s not going to feel that good to feel 30% dumber.

The Jeff Bezos Approach to Stock Price

In April 2008, Peter Burrows of Businessweek sat down for an extensive interview with Amazon CEO Jeff Bezos. The article, Bezos On Innovation, featured this piece of quotable wisdom on how to teach your employees to think about the value of the stock they own in your business:

We have three all-hands meetings a year, and I’ll tell people that if the stock is up 30% this month, please don’t feel you are 30% smarter. Because when the stock is down 30% a month from now, it’s not going to feel that good to feel 30% dumber.

The salesforce.com Contrast

I thought of the quote early this morning while drinking coffee and reading Behind the Cloud by Marc Benioff. The salesforce.com CEO has this to say about the morning the company listed on the NYSE:

 

The elation I felt on the morning we went public lasted long beyond the opening bell. It was incredibly gratifying to watch the stock climb; you can’t help but take it very personally. We ended our first day of public trading at $17.20, a 56 percent gain – making salesforce.com the best-performing tech IPO 2004 had seen thus far.

I don’t fault him for being excited. He just realized a long-held professional ambition for himself, doing so at the helm of a business that was ushering in a paradigm change (and that is not hyperbole, I can’t overstate what salesforce.com has done to software) in the way an entire industry operated. Elation is a natural and justifiable emotional response.

He does represent, however, the starkest EMOTIONAL contrast to Bezos’ highly RATIONAL approach to what the stock price of your business actually means. It’s tempting for CEO’s to interpret it as a sort of validation of their ideas and performance; that a high multiple of price to earnings means you’ve done something intelligent and virtuous to earn the trust of Wall Street.

They understand you, and you yearn to be understood.

But what have you committed yourself to? What happens when you have to make a decision that you know is in the best long-term interest of your business but that hurts short-term profitability, up-ending your string of quarter-over-quarter earnings growth?

Now you’re misunderstood. Wall Street punishes you. That stock price, trading at such a high multiple to profits, suddenly seems way too high to the analysts and existing investors. It plummets.

How do you feel now? More importantly, how do you explain that to your employees who shared your excitement but don’t really understand that stock price and business performance are often disconnected?

Jeff Bezos earned his perspective the hard way. Later, in the same article as above, Bezos has this to say:

When the Internet bubble burst, our stock went from over 100 a share to a low right after September 11 of 6. Throughout that entire period, the fundamentals of the business continuously improved. You can see the stock price going in the opposite direction of the fundamentals. So it wasn’t that worrisome to us.

 

Here’s a thought in the early stages of baking in my mind…

In his 2009 book, The Big Switch, Nicholas Carr describes a experiment in which researchers brought together one group of politically liberal-minded folks and an off-setting group of conservatives. They surveyed each participant beforehand to understand his pre-existing views on topics such as same-sex marriage, affirmative action, and global warming. This was the baseline. Then they put the liberals together in one room and the conservatives in another and basically said talk amongst yourselves.

When discussion time expired, the researchers surveyed the individuals again, asking the same questions as before. How did the discussion with like-minded participants influence the initial views as expressed in the baseline questionnaires?

In short, people’s views became more extreme and more entrenched on all three issues. The liberals came out more liberal, and the conservatives came out more conservative.

Deliberation thus increased extremism…every group showed increased consensus, and decreased diverstiy, in the attitudes of its members.

The researchers came to call the effect ideological amplification. It’s one of those funny wiring glitches of the human brain, and its effects go far beyond matters of politics.

Throughout the weekend I found myself thinking about this tendency and its potential to create trouble. If you’re in a profession that requires complex and nuanced logical thought – think scientific discovery, philosophical truth-seeking, medical diagnosing, investing – it’s imperative that you find ways to root out the bias that inevitably creeps into your process of thinking. You must design thinking mechanisms for identifying them and then formulate the discipline to root them out.

Yet this is hard to do. Very, very hard. It’s so difficult to challenge your own ideas. Our natural tendency is to find ways to support what we’re thinking, not to disconfirm it. And this becomes more true the more we develop the idea, especially if we begin promoting it to the world.

And since we’re social creatures, too, we often take our ideas to the world in search of support. It’s a rare person that takes his ideas to groups of people that are likely to shoot them down. More often we take our ideas to Confirmation Marketplaces…supporting family members and like-minded colleagues. Or industry conferences, email listservs and online forums whose tendencies we already recognize to be aligned with the bent of our existing thoughts.

What happens here, and I don’t think we sufficiently account for this in our thinking process, is ideological amplification. These groups and forums become places for us to feel better about what we’re thinking. To confirm our existing thoughts – and often to promote them – rather than challenge them.

Such confirmation is probably fine if you’re idea is already well-threshed out and true. But more often than not, the ideas require a healthy dose of intellectual pummeling to verify and/or deny the reasoning behind them. Disconfirming challenges to off-set our natural confirmation biases. If we seek out the echo chamber of confirmation marketplaces, we’re not likely to get that.

I didn’t intend this to be a series, but it has quickly turned into one. The original idea, from this post, is that holding up company managers as “shareholder friendly” (in that they do a fine job representing shareholder interests) can be like a backhanded compliment. Which shareholders, exactly, are they representing? Because it’s a certainty that few of the company owners share the exact same interests or desires for the business.

The most stark contrast might be between investors with an interest in the business showing short-term gains to impress the market, increase the stock price, and provide an opportunity to exit with a profit. They will want managers to work over their accruals as best as possible to show higher earnings. Or to just stop making investments in the business and let the lowered expenses generate a bigger bottom line.

Their objectives are not going to mesh with the investors hoping to stick around for the long haul. This group will not be excited by elaborate accounting to increase GAAP earnings. Nor will they want executives to neglect important expenses (like marketing, talent acquisition, research and development, etc.) in order to show a fatter profit next quarter. These expenses are investments in spurring growth and/or maintaining strong barriers to entry, both important in maintaining long-term profitability.

And even reasonable, level-headed investors can disagree with each other and therefore have diverging interests.

 

Case in point: Joel Greenblatt versus Michael Burry, a disagreement Michael Lewis brought to light in his book, The Big Short.

Joel Greenblatt, of value investing fame for his various books and tremendous track record with Gotham Capital, seeded Michael Burry’s hedge fund and benefited from multi-year period of impressive returns. Then Burry made his big bet against sub-prime lending, a complex and hard to understand investment, but one with a high likelihood of success (in Burry’s estimation at least).

Burry’s fund was down 18 percent in 2006. It was making his investors very edgy, and most of them – while being perfectly happy with his extraordinary returns in the years leading up to this – pushed him hard to ditch the strategy. As they threatened to pull their capital from him, he locked it up.

From the book:

In January 2006 Gotham’s creator, Joel Greenblatt, had gone on television to promote a book and, when asked to name is favorite “value investors,” had extolled the virtues of a rare talent named Mike Burry. Ten months later he traveled three thousand miles with his partner, John Petry, to tell Mike Burry he was a liar and to pressure him into abandoning the bet Burry viewed as the single shrewdest of his career.

Listen…there is a certain fog of war to these things. This stuff is not black and white. What seemed such a low-risk, high-return investment to Burry appeared quite different to Greenblatt. Perhaps Burry did a poor job communicating his ideas to the Gotham Partners. Perhaps the partners did a poor job listening. Regardless of the reasons, here we have two very intelligent investors and reasonable people disagreeing over how the money should be invested.

What is the shareholder friendly move in this dilemma? Should Burry try to liquidate his bets to give Greenblatt his money back? Not only would that go against a thesis Burry held with deep conviction, but it would ensure a loss as the strategy had not yet matured.

Or was the the shareholder friendly move the very action that Burry took? In other words, protecting Greenblatt against himself by locking up the money (no redemptions) and handcuffing him to the trade.

History tells us Burry was right. Greenblatt made off like a bandit by getting stuck with his former mentee. But this is just one example. I have no doubt there is no shortage of counterpoint examples in which hedge fund money is locked up, promptly lost (Philip Falcone anyone?), and investors are left holding the pittance that remains.

If reasonable, intelligent people (even value investors) can have diverging opinions and interests in a hedge fund example like this, surely the conflict only broadens when you have a wide base of investors in a public company.

So, what exactly does it mean to be shareholder friendly? Does it mean paying out a fat dividend to keep pension funds happy even when you have an expansion opportunity to plow that cash into growth? Does it mean cutting your marketing staff during a down turn because you know your margins will be pressured and you don’t want to disappoint Wall Street with a down earnings period? Does it mean cutting off a research initiative after two years of losses when you have high conviction that it will pay off in a big way if you just suffer another two years of losses to get it going?

*****

I’m a big fan of Joel Greenblatt. His books have helped my thinking tremendously, and he is serving an important role as he spends time educating people about his investing methods. And while I use the story of Michael Burry to illustrate my point, I want to make sure Greenblatt has the chance to make his case.

He did so in an October 2011 presentation to the Value Investing Congress (courtesy of Market Folly here).

In a Q&A Greenblatt was asked about Lewis’ account of events. His response was witty (and I suspect true), but more importantly he provided some balance to the whole affair…

Michael Lewis has never let the facts get in a way of a good story. What they got wrong in the book is Burry wanted to side pocket both mortgage and corporate CDS… we did not want him to side pocket the liquid corporate CDSs … only reason we took money from him was we were getting redemptions.

Greenblatt was not the unreasonable ogre Lewis made him out to be. He had his own pressures. This doesn’t contradict my point. In fact, I think it strengthens it. Sometimes a manager must be able to ignore the panic of his investors. He just might be protecting them in the long-run by sticking to his strategy despite their immediate needs. We know this happens in publicly traded companies, too. Large investors (hedge funds, pension funds, mutual funds) get calls for redemptions that force them to sell their holdings to generate cash to pay out departing investors. They must sell irrespective of the investment prospects.

The CEO of a publicly traded company can’t, of course, stop investors from selling. But in understanding that investors will often have interests that diverge from those of the business itself, one can see that it does make sense – sometimes – to vest enough authority in managers to let them ignore their shareholders and keep plugging away for the long-term benefit of the franchise.

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I’m offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company’s earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you’ll get five percent; 15 percent gets you 15 percent; 30 percent…whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It’s all legit in this little magical mystery market of mine.

So, let your mind wander. If you’re freed from the constraints of price…if you get to pick any company you want that trades in the public markets…let your brain get excited and greedy over the exercise, and decide…what five companies would you pick?

The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely…

1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it’s not losing business to the competition) and/or margins (competitors aren’t finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can’t buy companies that grow in unprofitable ways…though I doubt many of these could last ten years.)

What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I’ll keep a running update on the blog.

Sincerely,

Paul

You can email me at pauldryden (at) gmail.

***

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

– Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

 

All eyes are on Facebook and CEO Mark Zuckerberg as the stock is scheduled to debut on the NYSE this Friday. They have lips flapping as pundits and gurus are shouting over each other to get their opinions noted on whether this business is worth your investment dollars. Allow me to add to the din by expanding on my previous post, Whom Does Management Serve?

Zuckerberg has garnered plenty of criticism for pocketing the majority of voting rights, ensuring that he will have total and complete control over every aspect of the business, not the least of which is strategic direction. And he’s not shy about saying has his own plans for the company which is likely to be at odds frequently with investors looking for financial results.

Facebook’s Registration Statement (filed in February with the SEC) contains a letter from Zuckerberg outlining his priorities. Some excerpts…

 

Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works…

Simply put: we don’t build services to make money; we make money to build better services. And we think this is a good way to build something…

These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.

By focusing on our mission and building great services, we believe we will create the most value for our shareholders and partners over the long term — and this in turn will enable us to keep attracting the best people and building more great services.

We don’t wake up in the morning with the primary goal of making money, but we understand that the best way to achieve our mission is to build a strong and valuable company. This is how we think about our IPO as well.

Here we have a CEO telling the world, in no uncertain terms, that maximizing profits is not his priority. He has a bigger and different vision for the world. As investors we should be aghast, right?

Before addressing that, let me admit that I have no idea what Facebook is worth as a business. It’s probably a fair amount, but my prevailing model used to understand social media companies is MySpace.  It was the pre-Facebook darling, beneficiary of young eyeballs and the power of the network effect. As such, it was scooped up by News Corp for a fat price. And shortly thereafter all the eyeballs left. Quickly and unceremoniously. That fickle bunch decided Facebook was the place to do all the stuff they had previously done on MySpace. And now MySpace is a shadow of its former self.

We’re assured that Facebook is superior, having solved all the problems that plagued MySpace and left subscribers willing to entertain an alternative. That would never happen to Facebook, we’re assured. Maybe. But I’m not comfortable with the possibility, and so it’s a clear pass for me.

That being said, I’ll confess the utmost admiration for the move Zuckerberg pulled to consolidate control. And if Facebook is going to live up to its potential, it will come at the hands of the founder. He has a vision for it that extends beyond share price. I think that’s essential for a business. They lose their soul when they get too eager to please shareholders.

If I could get pass the MySpace hang up, I would assess the following in determining if Facebook was a good investment…

First, is it participating in a large and/or growing market for the services it offers? I believe it probably is. It has a lot of room to add new users and expand the ways members utilize it today.

Second, does it have a profitable economic model? (i.e., Do its revenues exceeds its costs and expenses and can it produce earnings in excess of its costs of reinvested capital?) Most likely, yes. It’s profitable now, though throwing tons of cash back into growth. That user base must have some economic value, and the management minds at Facebook will likely discover the right method for tapping into it.

Third, does it have competitive advantages in place that protect its market share and margins from encroachment? That’s the part that I just don’t know, and I don’t think I could wrap my head around that issue even if I decided to spend a lot of time researching it.

If the answers to these questions were yes, and I believed Mark Zuckerberg had the ability to drive its success by focusing on the long-term value of Facebook as it serves as social connector for the world…but that in continuing to build it in that model, he was likely to face the ire of investors that would prefer profits now rather than wait…

Then I would celebrate Zuckerberg cornering control the way that he did. As a long-term investor, I would celebrate a CEO that openly denigrates profit decisions in favor of investing in the long-term competitive advantages of the business. And I would relish the fact that profit-takers would have no voice in the decisions guiding the business.

I would appreciate that the characteristics that make Facebook a franchise will be stronger five or ten years hence, and that I would therefore own a piece of a much more valuable pie.

But there are a lot of “ifs” to be satisfied first.

The Witch’s Dilemma

The witch gave the man two options. One, he could have a woman that, to him, would appear stunning. But the world would see her as ghastly. Or two, he could have a woman that, to him, appeared hideous. But to the world she would look beautiful.

So goes the dilemma from some fairy tale I recall from childhood, the source of which eludes my most diligent Wikipedia searches.  (If anyone remembers the title, please pass it along.)

Imagine yourself in a revealing moment of brutal honesty. Which option would you choose if the witch forced this decision on you? Switch the genders around if needs be, but be truthful.

I suspect most people would claim option one, confident in their ability to filter out the judgment of people around them. But I think they would be overestimating their capacity to be misunderstood. Disapproval and criticism from our family, friends, and colleagues has a withering affect on our psyches. Even if we put on confident airs, we shiver at the thought of others ridiculing our choices behind our backs. We want to be understood. We want our people to confirm our choices with their support. We want inclusion in the most desperate way.

And so I believe, despite our protests, the vast majority of us would select option two.

Yet there are those with the steely resolve to pull off option one. They are outliers. They have a tremendous capacity to be misunderstood.

Corporate CEO’s, the Capacity To Be Misunderstood, and Decision Making

I’d like to hire a social psychologist to visit the CEO’s of all publicly traded companies, administers the Witch’s Dilemma test in conjunction with a heavy dose of truth serum. I would ask her to use the responses to rate the individual executives’ capacity to be misunderstood. (Perhaps there are alternative questions we could devise that get to the heart of the matter. These CEO’s are emotionally intelligent folks. They didn’t get where they are without developing the ability to read into people’s intentions…the questions behind their questions.)  And I would compare that rating to the CEO’s track record of making bold (albeit sensible) long-term investments in the well-being of their businesses versus managing earnings to keep various constituencies content.

My suspicion is that those CEO’s that could be lumped in with option one (ugly wife) would correlate more closely with making better long-term decisions on behalf of their businesses. The other group would have a more difficult time departing from the expectations of their shareholders, employees, customers, family members, etc. Understandably so. It’s tough to do.

Getting to my point, when I see a business that combines some set of competitive advantages with the potential to grow and compound earnings, I want the leaders of that business to invest in that growth. This should go without saying, but very often it’s a difficult thing to do. Not so much because the operational expansion is daunting (though there is that part, too), but because the company must often take a winding path to secure that growth. It’s confusing. It changes things. It’s easy to misunderstand.

Let’s think a little about how a company grows. First, it must identify an opportunity to a.) expand its current offerings; b.) add new offerings; and/or c.) move offerings into new markets. In most cases, each option requires teams to make a judgment call. On the most fundamental level it is, can we execute that growth in a profitable way? In other words, will the added costs of increasing headcount, ramping up production, expanding infrastructure, investing in R&D, buying equipment, or marketing more aggressively…are these costs likely to succeed AND produce revenue in excess of costs and invested capital?

While executives can learn to mitigate risk (just as we do with investing), there is no crystal ball providing play-by-play of how the future will look. They must use their judgment. And investors hope they bring a certain amount of analytical rigor, management skill, experience-based intuition, and wisdom to the ways they spend the company money. In an ideal scenario, they possess a deep understanding of the strengths of their business – its advantages over the competition, barriers to entry, and moats – and know how to invest behind these strengths. (The better the strength, the easier the planning process!)

But there are no guarantees. Expansion is and always will be an exercise in predicting the future. It is about, after all, believing that additional supply you produce will be consumed by increased demand. A management team will try and fail. They MUST try and fail (at least occasionally) to test the limits of the business potential.

The most bold attempts to grow and compound earnings on behalf of investors – those investments with the greatest possibility for outsized rewards – do not happen in short time frames. They require big investments over long horizons with the real possibility of depressed earnings over the ramp-up period.

This enervates holders of the company’s stock – investors, employees, the CEO, his/her family. While all of them will say they want the earning to grow, each group tends to be averse to the risk and time required to make that happen. If you were to provide them with a slight bump in their dividend payout versus putting the same amount of cash into investments that have a high likelihood of paying out a nice return in, say, five years (but impair earnings growth in the meantime), far too many will forego a better payday for the feel-good immediate gratification.

Worst yet, if the investments are made in growth, they depress earnings for multiple periods, and the market has trouble understanding how and/or when the investments will pay off, the stock price will feel that misunderstanding.

And this is where the CEO’s decision making becomes hard. He must choose between investing in the long-term prospects of the business, a move that will impact earnings next quarter and bring the ire of Wall Street.   Or he can punt. Making timid investment choices; managing the earnings by looking first at whether the next statement will satisfy analyst expectations for the company’s performance. And then deciding how much more to allocate to investment in the company’s future.

If he invests for the future and is misunderstood, the move will generate a share price drop. And a lot of people are affected by the stock dropping. People that are important to the CEO. People he must see everyday. People who influence his life; that invested in no small part because they believed in him.

Back To the Witch’s Dilemma 

So here the CEO is playing out the Witch’s Dilemma. If he goes with option one – investing in the future of the business that impacts short-term results…the woman that looks pretty to him, but ugly to the world – the share price will be hammered. He will be misunderstood. People who have invested with him will be disappointed. They will feel less wealthy as a consequence of his decisions.

And all CEO’s know that if they get labeled with the dreaded letter “U” (Underperformance), many of the constituents they disappointed, along with a new slate of activist investors, will turn up the heat. They will make noise and start demanding change. The pressure will be enormous.

The CEO asks himself…will I even be around long enough to see these bold investments come to fruition? Or will my board bend to the discontented swarm and show me the door?

Being misunderstood is very hard on a person.

Allow me this aside about the concept of learned helplessness…

The psychic punishment of being misunderstood conjures memories of “learned helplessness” a concept belonging to psychology and the term being coined by Dr. Martin Seligman in the late-1960s.

Seligman ran a research lab at Cornell University and spent much of his time experimenting with lab rats. In one particular and somewhat cruel study, he placed a lab rat in a specially constructed box, repeatedly rang a bell, and followed the sound with a mild electric shock. The rat quickly learned to anticipate the shock when he heard the bell. As you can imagine, the rat would become frantic at the sound, running around his box in a futile attempt to avoid the discomfort.

It took very few rounds of this “bell-plus-shock” routine before the rat’s behavior changed. The bell still evoked agitation, but once he resigned himself that he had no control to stop the shock, the rat basically gave up and took it.

This observation led Dr. Seligman to his theory of learned helplessness, a phenomenon as easily applied to humans as rats. When faced with stressors most humans – including powerful CEO’s – that perceive they lack the control to resolve or avoid it end up sucking it up and going with the flow.

And so most CEO’s elect to avoid the discomfort of being misunderstood (if not fired) and choose the Witch’s option two. Even though they know the investments will pay off for long-term shareholders, that they will enhance the firm’s competitive advantages, that they will compound its earnings…the vast majority of CEO’s swallow hard and go with the woman that looks beautiful to the world but that they recognize as unattractive and unsavory.

***

Anyone For Investing In a Car Periscope?

I’ll conclude with a light-hearted parallel…

Season eight of HBO’s Curb Your Enthusiasm highlights this dilemma in an episode called Car Periscope. By way of quick summary,  Larry David and his agent Jeff are weighing an investment with an inventor of a device you snake above your sunroof in traffic jams to see the source of the slowdown and review your options for getting out quickly.

It’s a terrible concept, clearly, and the two are ready to decline the investment opportunity. But they meet the inventor’s wife and are struck by the disconnect. She is somewhat homely while the inventor is a decent looking guy. Larry is unabashedly shallow. He always wants the younger more attractive woman. It’s foreign to him  that a man would ever choose anything less; that someone would subject himself to the ridicule of the guys. This inventor is an outlier. He sees something in his wife that others don’t, and he possesses the capacity to be misunderstood.  Surely this belies some deep-seeded virtue in this inventor. In Larry’s logic, if he has the qualities that permit him to be comfortable and confident with the less attractive girl, perhaps he possesses the tenacity required of an inventor and businessman.

Hijinks ensue. The investment falls through, but Larry believes he has found a new model for gauging the character of men. He meets with his investment manager and, upon seeing a photo of his gorgeous wife, fires him. He selects another adviser on the sole basis of his plain-looking spouse.

This week I’ve been a bit obsessed with the idea that the manager’s job is to represent the interests of shareholders. It brings to mind the Yogi Berra epithet:

In theory there is no difference between theory and practice. In practice there is.

In theory it makes sense. Companies are vehicles for invested capital to find returns. We entomb that concept in law and in corporate structure where the board of directors is explicitly charged with representing shareholders. Managers run the day-to-day and should have investors’ interests on their minds, remaining on constant look out for ways to increase shareholder value.

But we put the idea in play, how does a manager best represent investor interest? Indeed, which investor?

Investors are far from a like-minded group bound together by common interests in the business’ success and united in their opinions on how that success is best achieved. Oh no. To highlight just a few investor archetypes:

There are the hedge fund traders, moving in and out with positions measured in millions of shares and closed out within minutes or hours when the stock moves up or down by a penny or two.

There are the pension funds for (as an example) retired nuns. They hold shares for years but issue measure after measure for shareholder consideration on such social issues as whether you should offer health benefits to your lowest paid employees.

There are the corporate raiders that accumulate massive positions, gain board representation, and then force management to monetize assets and distribute the cash. This pushes the share price up for a time, during which the raiders sell out and move on to their next target.

All are investors in your public company. Each has very specific objectives. And those objectives are divergent and irreconcilable.

So, how does management effectively represent investors when their interests don’t align?

As a frequent visitor of Charleston, South Carolina, I’ve been required to read the works of native son Pat Conroy. My favorite book is his memoir My Losing Season in which he details his time playing basketball for the Citadel.

The Citadel, a military prep college in Charleston, is hard on its first year students (called “Knobs”), believing it must break each of them down and build them back up again in its own disciplined model. Conroy was not spared the hazing rituals. In a particularly poignant scene from the book he recalls being surrounded by several upperclassmen who begin demanding he do a variety of conflicting activities. As I recall, one would get in his face and scream that he do push-ups. Another would degrade him for doing push-ups, telling him he’s supposed to jump up and down. And yet another would scream at him for jumping; he should be reciting the school’s creed.

The demands came rapid fire. After several minutes of this Conroy was a wreck. He instinctively fell into fetal position on the floor, his mind unable to process another command. The older cadets walked away, satisfied that they had broken this cocky Knob.

The human mind cannot process conflicting orders without freezing up. It’s simply not how our wiring works. And so, while the idea that management works for investors sounds good in theory, in practice it’s unworkable. Many an executive has driven himself to exhaustion trying to appease these feckless masters.

What’s a manager to do?

Focus on the business itself.  Use the overall health of the business as a proxy for the long-term investor…that investor whose interests are aligned with the company investing in its advantages, foregoing immediate gratification en lieu of higher earnings further down the line.

These are the businesses I want to invest in. The opposite are those that pledge allegiance to blind total shareholder return, returning cash to investors that could be reinvested in the business to fortify its barriers to entry, improve its offerings, or make itself invaluable to its customers.

The first form of pricing power is the ability to raise prices or continually charge a premium (featured in this post). The second is the ability – and willingness – to lower them. We discussed the general benefits (here). Now we will look at how it applies to Amazon.com specifically.

*****

In November 2011, Wired Magazine featured a Jeff Levy interview of Amazon CEO Jeff Bezos. Here is an excerpt:

Levy: Speaking of pricing, I wanted to ask about your decision to include streaming video as part of Amazon Prime. Why not charge separately for that? It’s a completely different service, isn’t it?

Bezos: There are two ways to build a successful company. One is to work very, very hard to convince customers to pay high margins. The other is to work very, very hard to be able to afford to offer customers low margins. They both work. We’re firmly in the second camp. It’s difficult—you have to eliminate defects and be very efficient. But it’s also a point of view. We’d rather have a very large customer base and low margins than a smaller customer base and higher margins.