Facebook’s Great Reset

Nestlé was founded in the 1860s by Henri Nestlé to solve a consumer pain point: mothers who couldn’t breastfeed didn’t have a good alternative to breastmilk. After much experimentation, Nestlé perfected the world’s first infant formula. This formed the basis for a business that grew over time—through new product innovation and acquisitions—into one of the world’s most successful consumer companies. At the base of it all: trust. Consumers came to view Nestlé’s products as worthy of their family’s trust.

Facebook, created over 140 years later, sought to solve a different problem: digitizing our most intimate human connections. Every day, nearly 1.5 billion users around the world trust Facebook with their most cherished conversations and interactions.

In its second quarter call on July 25, Facebook reported stellar results. Revenues were up 42 percent, and profits up 32 percent. The number of users—a massive 1.7 billion daily and 2.2 billion monthly—grew by 11 percent. Prices per ad were up 17 percent and ad impressions up 21 percent.

In his forward guidance, however, CFO David Wehner announced a decline in the revenue growth rate going forward (implying growth of over 20 percent by the end of the year), and a glide path towards a lower operating margin of mid 30s (from the current mid 40s) over the next two years.

These metrics are astonishingly good, but they surprised the market, and Facebook’s stock sank 20 percent the following day.

Financially, I believe the market was rational in its rapid reappraisal of Facebook. Certainly, lower revenue growth and lower profit margins—while still very high—imply a lower present value.

But let’s dig into the why.

Since the dawn of social media—when there were competitors like My Space, Orkut and Friendster—Facebook won by providing a superior user experience. The social network that sprang from a Harvard dorm room in 2004 never stopped growing for precisely that reason. Over time, through acquisitions and new product development, Facebook became a social media conglomerate spanning 2.5 billion users of core Facebook, Instagram, Messenger and WhatsApp. It’s developing an exciting slate of upcoming products such as Direct (Instagram chat in a separate app), Portal (a rumored voice assistant), and innovations from its virtual reality company, Oculus, to mention a few.

First, let’s look at the expense side of Wehner’s guidance.

As you’ve probably heard, Facebook has been used by folks who want to influence elections or spread fake news. To ensure election integrity, remove fake content and bad actors, the company is investing a lot of money into its content filtering, using both humans and machine learning to go through the billions of pieces of content uploaded every day. In fact, Facebook has been warning for several quarters that investments in security would “significantly impact our profitability.” Adding more features for protecting privacy might also impact marketers’ ability to target ads, potentially resulting in lower ad prices. All of these investments are very likely to result in a better user experience, at the expense of lower profitability.

But that’s not all. As Mark Zuckerberg explained in the Q2 call, “In light of increased investment in security, we could choose to decrease our investment in new product areas, but we’re not going to—because that wouldn’t be the right way to serve our community and because we run this company for the long term, not for the next quarter.” These new product areas include building out eight new data centers (there are currently six) to deal with what Zuckerberg called “hyper-growth” in machine learning across the products, as well as in WhatsApp and Instagram. These investments also include augmented and virtual reality, marketing, and content acquisition (Facebook has been investing aggressively in original video content and sports broadcast rights).

These investments are exactly what the long-term owner of a business would want to see. Now, let’s look at the revenue side.

Here, Wehner said that Facebook is building and promoting engaging new experiences like Stories that “currently have lower levels of monetization.” This is a bizarre excuse, given that Stories is one of the fastest-growing media formats ever. But the reason is that many advertisers aren’t yet aware of Stories, and those that are, haven’t yet figured out how to create ad content for it. This is typical of new ad formats, and because Facebook’s ad system is set up as an auction (much like Google’s), fewer bids translates into lower ad prices.

Stories—ably copied by Instagram CEO Kevin Systrom from rival Snapchat—has since eclipsed its creator:

Source: https://www.recode.net/2018/8/8/17641256/instagram-stories-kevin-systrom-facebook-snapchat

Facebook is leaning into this opportunity, emphasizing this experience for users, and this emphasis will decrease revenue growth; better user experience at the expense of short-term profitability, which exactly the right approach. Going back to the origins of Facebook and throughout its history, management’s playbook has been to first grow the audience for a particular product or feature (grow users), increase engagement (grow minutes or hours of use per user), make it sticky (create the habit, make sure users keep coming back), and only then, monetize.

Strategically, then, it seems that the reasons for Facebook’s lower revenues and margins will only serve to widen its long-term moat. Better user experience with new media (Stories), less fake news, more election integrity, and additional privacy options. It seems to me that these investments, while painful in the short term, might in fact allow Facebook to make more money in the future, because a better user experience will result in more engaged users and more advertisers.

Reset of trust

Many of Facebook’s investments are designed to reset user trust. Not widely publicized, for example, is the fact that Facebook now allows anyone to search political ads for up to seven years. Each ad is clearly labeled so anyone can see who’s paying for them. This type of transparency is unprecedented in any medium in history. If well executed, the investments Facebook is making have the potential to make the company a leader in trust and transparency.

The near-term future of Facebook

Facebook’s stated mission is to “give people the power to build community and bring the world closer together.” And that includes bringing businesses closer to consumers. One achievement of Facebook’s has been the removal of friction for small businesses; with Facebook, they have access to the same advertising tools as multinational advertisers.

I believe the near future will see more of this. One new format the company highlighted in its Q2 call is Click to Messenger ads. These allow businesses to interact directly with consumers inside Messenger, from an ad placed in News Feed, for example.

In India, Facebook’s WhatsApp has 200 million users, and the app is frequently used for commerce. Using the country’s direct payments protocol, WhatsApp is working to obtain approval to create an in-app payments system. Globally, WhatsApp Business was launched and is being tested by three million businesses, who will pay to interact directly with consumers.

Longer term, it’s interesting to think of Facebook as a toll booth on the world’s economy. Below is a chart showing revenues per user by geography. In more advanced geographies—like North America—advertising markets are more developed, consumer incomes are higher, and therefore ad prices are much higher. Notice the gap between North America and Europe, and then between North America and Asia and the rest of the world.

As broadband and smartphone penetration continues to increase; as ad markets develop; and as income levels grow, we should see a continued rise in revenue per user around the world.

Source: Company filings, Heller House estimates.

On Avoiding “Technology”

Many investors, particularly those brought up in the traditional “value investing” school, pride themselves on avoiding “technology.” The term “technology” is used derisively to refer to anything new, anything one does not understand.

That’s a very counterproductive attitude. If we were setting up shop in 1860, there would be very little to invest in—by modern standards, anyway. Yet that period was the start of a series of technological revolutions: railroads, electricity, telephone, and the internal combustion engine, to name a few. Entirely new business models, and enterprises, were created.

An investor insistent on avoiding technology would’ve been left behind, like a buggy whip manufacturer unwilling to understand the automobile.

The author Douglas Adams once wrote that “I’ve come up with a set of rules that describe our reactions to technologies: Anything that is in the world when you’re born is normal and ordinary and is just a natural part of the way the world works. Anything that’s invented between when you’re fifteen and thirty-five is new and exciting and revolutionary and you can probably get a career in it. Anything invented after you’re thirty-five is against the natural order of things.”

As investors, we must lean against this innate tendency to dismiss the new.

A more useful definition of technology is that espoused by Clayton Christensen in The Innovator’s Dilemma: “Technology […] means the processes by which an organization transforms labor, capital, materials, and information into products and services of greater value.”

That’s tremendously refreshing. Everything around us is technology, and at one point, it too was considered high tech: the wheel, indoor plumbing, and everything else you take for granted (because it was invented before you were born).

Judging by the steepness of technology adoption curves, the world is indeed changing faster than ever, at least in domains touched by information technology (which are many; after all, software is eating the world, in the words of Marc Andreessen).

Investors unwilling to be learning machines and to stay on top of new technologies do so at their—and their investors—own peril.

Buffett’s World War II Debut

At this year’s Berkshire Hathaway annual meeting, Buffett did something I wish he did more often: he put up some very educational slides. The first showed the front page of the New York Times on Sunday, March 8, 1942, three months after Japan attacked Pearl Harbor. If you think today’s headlines are scary, you’re in for quite a shock:



The following day, Monday, March 9th:



Tuesday, March 10th:



Buffett had his sights on Cities Service preferred stock, which was trading at $84 the previous year and had declined to $55 in January. And now, on March 10th, it was selling at $40.

That night, 11-year-old Buffett decided it was a good time to invest. As Buffett recounted, “Despite these headlines, I said to my dad, ‘I think I’d like to pull the trigger, and I’d like you to buy me three shares of Cities Service preferred’ the next day. And that was all I had. I mean, that was my capital accumulated over the previous five years or thereabouts. And so my dad, the next morning, bought three shares.”

The following day was not a good one for the markets. The Dow broke 100 to the downside, sliding 2.28 points (bottom right of this image):



And here’s what happened to Cities Service preferred:




Buffett successfully top-ticked the market at $38 ¼, with the shares closing at $37 (down 3.3 percent). This, he joked, “was really kind of characteristic of my timing in stocks that was going to appear in future years.”

The world’s greatest-investor-in-training would eventually see the shares called by the Cities Service Company for over $200 per share more than four years later (these images are from the slides shown at the annual meeting):




But the story doesn’t have a happy ending. Here’s what actually happened:





From the 38 ¼ Buffett paid, the stock went on to decline to $27 (down nearly 30 percent from his cost!).

What Buffett didn’t say at the annual meeting is that he had enlisted his sister Doris as a partner in the idea of buying the shares. Every day on the way to school, Doris “reminded” him that her stock was down. (This story is recounted in the excellent book Snowball).

After enduring so much pain, he was happy to sell at a profit only a few months later, in July, for $40. “As they always say, ‘It seemed like a good idea at the time,’” Buffett joked.

Despite the ugly headlines, Buffett said everyone at the time knew that America was going to win the war. The incredible economic machine that had started in 1776 would see to it. So imagine, in the middle of this crisis, you had invested $10,000 in the S&P 500. There were no index funds at the time, but you could have bought the equivalent basket of the top 500 American companies.

Once you did that, imagine you never read another newspaper headline, never traded again, never looked at your investments.

How much would you have today? Buffett again: “You’d have $51 million. And you wouldn’t have had to do anything. You wouldn’t have to understand accounting. You wouldn’t have to look at your quotations every day like I did that first day when I’d already lost $3.75 by the time I came home from school.”

The massive number — most people I polled guessed far less than $51 million — is the result of compounding over long periods of time. In this case, 76 years at a compounded rate of 11.9 percent per year.

Of course, Buffett’s advice to buy the S&P 500 is the best advice for most people. (Buffett notes that it’s an advice that’s easy to give in hindsight. He didn’t mention that for extended periods of time, like the ten years from 2000 to 2010, the S&P 500 returned exactly zero percent including dividends.) Enterprising investors — like Buffett himself — can do better by picking superior businesses and running a more concentrated portfolio.

But at least three very important lessons come from this short presentation.

First, scary headlines are just noise. What really matters is the long-term performance of the underlying businesses you invest in. Don’t act — or fail to act — because of short-term price action or scary headlines. Easier said than done, of course. But that’s why it’s such a valuable lesson.

Second, pick your partners wisely. Having partners with the same long-term approach as you can make a huge difference to actually achieving the long-term in the first place.

Finally, always remember the power of long-term compounding. Patience and compounding is how one turns $10,000 into $51 million in a lifetime.




From Franchise to Ordinary Business

Our focus is on finding investments where the odds are in our favor: a high probability of winning big, and a low probability of losing a small amount (or ideally, of not losing at all). These investments come in many flavors: a bond issued by a corporation trading at a wide discount to par, where our analysis of the business indicates an ample margin of safety; a trust selling assets and returning cash to shareholders, bought below net asset value (sometimes, we can hedge the assets, creating a risk-free arbitrage); or an exceptional business acquired at a discount to our conservative estimate of its intrinsic value.

These examples are only a few of the tools in our arsenal, but the most financially rewarding is the exceptional business: it’s the goose that lays golden eggs year after year, generating ample free cash flows and reinvesting them for growth. If the price remains below the company’s growing intrinsic value, we can compound our investment for years without having to sell. This delays capital gains – and taxes – and achieves what Charlie Munger aptly calls “sit on your ass investing.”

So, what exactly constitutes an “exceptional business”? Let’s use an extreme example to make the point: the world’s most exceptional business would be one that (1) has no employees; (2) has no competitors; (3) generates ample excess cash not required in the business and (4) can reinvest those free cash flows at high rates of return. Obviously, there aren’t many of these types of business lying around, but this list is useful as a guide for what to look for.

One way to conceptualize these attributes is to look for what Warren Buffett calls franchises instead of businesses. “An economic franchise,” Buffett explains, “arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation.”

In addition, a franchise can tolerate mismanagement: “Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.” In conversation with his friend Bill Gates, Buffett termed these businesses “ham sandwiches,” because even a ham sandwich could run them. Buffett joked that in the 1960s and 1970s, if you owned a network TV station, it was such an easy business, even your dumb nephew could manage it.

In contrast, a business “earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight.” Even a smart nephew might have difficulty doing well.

Around the time Buffett wrote these words – the year was 1991 – the ground under the media industry began shifting. As Buffett explained, “the number of both print and electronic advertising channels has substantially increased.” His large holdings in media – Capital Cities/ABC, The Washington Post and Buffalo News – were losing pricing power in advertising because of this fragmentation.

With the benefit of hindsight, this trend looks obvious. However, 1991 was years before the internet became a household name (official statistics began in 1990, and by 1991 less than two percent of the U.S. population was online). The internet was growing exponentially, but from a small base. Had Buffett understood the trend, he could have perhaps imagined the advent of the platform businesses that would finally push a stake through the hearts of the traditional media companies: Google and Facebook.

Later in his 1991 letter, Buffett notes that these developments began transforming former franchises – the newspaper and media companies he loved – into mere businesses. Today, this metamorphosis from franchise to business is manifest in many other industries, such that the franchises of yesterday are unlikely to remain franchises in the future. Because the value of a business is determined by its future cash flows, we must therefore attempt to peer into the future and focus our efforts on the franchises of tomorrow.

As an aside, I should note that with changes in industry structure, it’s possible for lousy businesses to turn into strong franchises. One example is the railroad industry. Railroads began operation in the U.S. in the early 19th century and didn’t enjoy sustained profitability until over a century later, following the Staggers Rail Act of 1980. The industry consolidated, and today each of the four Class I rails in the U.S. is extremely profitable and has strong a competitive moat. In this case, Buffett did understand exactly what was happening (and in fact acquired BNSF, one of the Class I railroads). That’s because he followed the railroad industry closely. We keep an eye on consolidating industries for this reason.

My journey towards uncovering the franchises of tomorrow has led to the study of the history of technology since the dawn of the Industrial Revolution. The world until then had been relatively static in terms of productivity and wealth creation:

The chart above shows the results: exponential growth in wealth. If you were a forecaster in 1500, there’s little chance you could have imagined the riches and abundance that lay ahead. Indeed, Thomas Malthus, who famously wrote a book in 1798 proposing that any improvement in wealth would cause population growth, thus cancelling out the improvement, turned out to be dead wrong, even though by then the Industrial Revolution was well on its way. If today’s pace of change seems quick, imagine how our ancestors felt at the start of the exponential curve.Over a period of only fifty to sixty years, the U.S. and the U.K. witnessed the transition from canal transportation to railroads, from whale oil lamps to electric lamps, from human muscle power to the steam (and later internal combustion) engine, from telegraph to wireless telegraph (later radio) and telephone, from horse-drawn carriage to car, and then the airplane.

One of the fundamental innovations of our time is the internet, which has enabled the creation of new computing paradigms (from the personal computer to mobile) and has spawned the creation of entirely new business models and platforms. At this year’s Berkshire Hathaway meeting in Omaha, Warren Buffett mused at how he completely screwed up by not investing in Google. At the time of the Google IPO, the founders of Google visited with Buffett and discussed the business model. GEICO (owned by Buffett’s Berkshire Hathaway) was advertising on Google, and each click cost GEICO around $11. Buffett noted what a marvelous business it was to collect $11 per click for an item that cost Google absolutely nothing. Charlie Munger (Buffett’s long-time partner) joined and noted how they also screwed up by not investing in Walmart, even though they had nearly figured it out, and how they completely missed Amazon, calling founder Jeff Bezos “another species”.

I’ve spent many years learning what to do by studying Buffett’s and Munger’s successes, and I also learn what not to do by studying people’s failures. Buffett’s mistake is even greater than he cares to admit, because not only did he miss Google and Amazon, he also fundamentally misunderstood the role of the internet in transforming a scarce resource (distribution in media and shelf space in retail) into an abundant resource (free distribution online and infinite shelf space on Amazon and other e-commerce sites) with zero marginal costs. This shift has upended the media and retail industries, and more recently began eroding the brand equity of the consumer product companies Buffett has invested in for many decades. It’s tempting to believe – indeed I do believe this – that if Buffett had paid attention to and studied the rise of the internet when its penetration was still very low in the early 90s (perhaps with the same attention he paid to railroads), he could have made better investment decisions over the subsequent 25+ years.

The traditional formula for building brand equity in the 20th century relied upon the power of broadcast media and the scarcity of distribution. In order to reach customers, brands would advertise on prime-time TV or newspapers. There were few broadcast TV channels and one, maybe two, newspapers of interest per household. The brand owners would further exercise their power by controlling scarce shelf space and endcaps at local grocery stores. It was, in a way, a closed system: turn on the TV, watch a commercial for Tide, buy Tide at the local supermarket. Rinse and repeat, and profit flowed to the brand owner (in this case, Procter & Gamble).

The advent of the internet broke this closed loop. A cornucopia of entertainment options drew attention away from traditional broadcast TV (slowly) and completely unbundled newspapers (swiftly). Buffett likes to reminisce about his teenage years delivering newspapers for Washington Post and still challenges, at the age of 87, visitors to the annual meeting to a newspaper tossing contest (you must roll the newspaper yourself, no rubber bands allowed). Distribution was also the scarce resource for newspapers: the difficult part was taking the integrated editorial and advertising product and put it in the hands of paying customers.

The internet made the marginal cost of distribution zero. No more boys on bicycles tossing newspapers. News quickly unbundled, and power shifted to new aggregators such as Facebook, which controls demand (users) as opposed to supply (editorial). The rise of cheap computing infrastructure (Amazon Web Services) enabled anyone with an idea to have access to world class computing power, storage, and web hosting, without having to hire teams of engineers or buy expensive servers. Well-oiled attention-catching platforms such as Facebook, Instagram and Twitter with self-serve advertising platforms meant small brands could all of a sudden target customers with precision. Upstart brands could also garner followers by posting videos on social media, building brand equity without having to resort to the expensive TV or newspaper advertising of the old days (the poster child for this was Dollar Shave Club).

This trend has created enormous challenges for traditional brand owners like Procter & Gamble. The problem of distribution, which P&G and other CPG (consumer packaged goods) companies had solved, is now being replaced by the problem of “search.” When a consumer walks into a supermarket, she sees a product on the shelf and recognizes the brand she’s been previously exposed to through advertising. In order to actively search for that brand online however, the consumer must recall the brand, which is a much tougher ask.

Of course, brands still matter. The purpose of a brand is to lower search costs, enabling consumers to use a mental short-cut to arrive at a product decision: “I’ve heard about this brand, and I trust it,” or feel an emotional connection to it. But it’s unclear how brands for most CPG companies will adapt to the twin loss of dominance in advertising on TV, and the move to ecommerce with its infinite shelf space.

One critical insight from studying the history of technology is that at one point, all of the prosaic technologies of today were considered cutting edge technology at the point of creation. One is reminded of the advice proffered in the movie The Graduate (1967): “Plastics.” Over a century earlier, at the dawn of the railroad age, railroads were considered high tech enough to be thoroughly mocked:

What could be more palpably absurd than the prospect held of locomotives travelling twice as fast as stagecoaches?

The Quarterly Review, March 1825

That any general system of conveying passengers would […] go at a velocity exceeding ten miles per hour, or thereabouts, is extremely improbable.

– Thomas Tredgold (British railroad engineer), Practical Treatise on Railroads and Carriages, 1835

Rail travel at high speed is not possible because the passengers, unable to breathe, would die of asphyxia.

– Dr. Dionysus Lardner, professor of Natural Philosophy and Astronomy at University College, London

Yet many of the high-tech wonders of yesterday have become the franchises of today. Buffett, the railroad investor, is a high-tech investor: he’s just nearly two centuries behind.

To be sure, there were many more high-tech wonders than those that survived: we forget about all the promising highflyers that never made it. Yet we can certainly see in some of the established high-tech leaders of today all of the elements of an enduring franchise.

One argument frequently espoused by traditional investors like Warren Buffett against investing in technology is that it’s a fast-moving field with great risks of disruption. Commentators who agree with this position will point to episodes such as the demise of Nokia – once the leading handset maker – as an example of what can happen to an incumbent that is challenged by an upstart (in this case, Apple’s iPhone).

The irony of today is that all the seemingly “boring” and “stable” businesses (and indeed many franchises) are either under assault, or soon will be, by current or emerging technologies. Here is a short list of what’s happening or likely to happen in the coming years:

  • The rise of the Internet destroyed the very profitable and stable business of newspapers – an industry Buffett and Munger spent years studying and investing in;
  • The rise of Google and Facebook and the resulting shifts in the attention economy has completely upended the advertising industry, hurting traditional ad agencies and their customers (TV networks and CPG companies, among others);
  • The rise of Amazon is dramatically impacting the retail industry, has already bankrupted many traditional bookstores, and is affecting adjacent industries in groceries, logistics (UPS and Fedex, through Amazon’s own vertical integration efforts), media (music and video), and most recently, pharmaceuticals;
  • New developments such as electric and autonomous vehicles could in turn make railroads less profitable (through truck platooning), completely upend the economics of car dealerships (which earn most profits through repair and maintenance), and destroy the economics of car insurers such as Berkshire’s GEICO (autonomous cars won’t crash nearly as often);
  • Blockchain technology could disrupt traditional financial services providers, most obviously title insurers (putting the entire chain of title for a property on a secure and decentralized database obviates the need for insurance).

What is most susceptible to disruption after all, traditional or new technologies? I think the answer is that this is the wrong question to ask. The right question instead is, “Which businesses and industries will have growing earnings and widening moats over the next ten to twenty years, and on the other hand, which ones will be facing increasing headwinds in the years ahead?” Today it is clear, for instance, that the future will have more ecommerce, not less, so as an investor, on which side of that trend would you rather be?

This is the fundamental problem with the argument against investing in technology. By ignoring technology, one risks being blindsided by it. From Buffett’s 1993 letter to investors:

“For example, a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. Did we foresee thirty years ago what would transpire in the television-manufacturing or computer industries? Of course not. (Nor did most of the investors and corporate managers who enthusiastically entered those industries.) Why, then, should Charlie and I now think we can predict the future of other rapidly-evolving businesses? We’ll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?”

It’s time to apply Munger’s advice, borrowed from the algebraist Jacobi: invert, always invert. It’s quite possible that the needles in plain sight – the easy cases – are the tech franchises of today, and that the businesses that don’t lend themselves to reliable evaluations of their long-term economics are the stable businesses of yesterday.

Needless to say, I have been putting an enormous amount of time and effort into figuring out who are likely to be the winners and losers of this ongoing shift, where we can invest with a margin of safety, and which franchises will turn into mere businesses and vice-versa.