It’s Not Time to Break Up Facebook

I finally read the Chris Hughes piece on breaking up Facebook. While he makes some excellent points, he also repeats mistakes that others have made in proposing a solution to Facebook’s power.

Hughes asserts that WhatsApp and Instagram would be profitable if spun off. This is far from certain; Instagram relies on Facebook’s infrastructure to a very large degree. It makes money selling ads, but a standalone Instagram would need to make heavy investments in building its own independent backend systems.

WhatsApp, on the other hand, has no business model to speak of. Instead, WhatsApp is a communications utility that users get for free. You don’t have to view ads and the communication is encrypted end-to-end. It generates massive consumer surplus.

The second mistake Hughes makes is believing that if Facebook were broken up, a social network in which users paid a fee not to view ads would flourish.

A social network is most valuable when all your friends are actually on it. Logically, this leads to a horizontal service that can reach as many people, at the lowest cost possible (free!).

Lastly, calls for antitrust action in software markets tend to reach a crescendo just as there is an underlying paradigm shift that makes such action pointless.

As an example, the call for antitrust action against Microsoft happened around the same time the internet took off, followed by mobile. Microsoft’s organization was not suited to deal with either, and the world saw innovation with Google, and then Apple and Android. Microsoft has continued to flourish by focusing instead on the enterprise market.

I suspect the same will be true of Facebook. What’s the paradigm shift this time? Crypto. In time, we’re likely to see an explosion of innovation—including social networks—in which users get paid through tokens.

The best way to deal with Facebook’s power is to give that power up to an independent body. Mark Zuckerberg has talked about this for over a year. An institution that can independently judge what content is allowed or not on Facebook would resolve the majority of the pain point for Facebook’s critics, including Hughes.

Facebook’s New General

Over the past week, we’ve seen a cascade of negative news stories on Facebook. To close observers, none of them reported anything new. Lost amongst all this noise was the fact that Facebook is fighting a war—against both bad actors on its platform and poor public perception—and has a new general. His name is Mark Zuckerberg.

In a remarkable 4,500-word post last Thursday—which, notably, received zero press coverage—Zuckerberg has finally come to grips with the steps he needs to take to solve the problem of content moderation across Facebook’s various services. Together with a conference call held on the same day, Zuckerberg came across as assertive and determined.

Here are some of the most interesting points from Zuckerberg’s post:

One of the most painful lessons I’ve learned is that when you connect two billion people, you will see all the beauty and ugliness of humanity.

After many years of dealing with content moderation issues, Facebook is finally ditching its Pollyannish assumption that the internet is only good. If there was ever a forcing function needed to spur Zuckerberg into action, this new understanding was it.

The problem, though, is that content moderation is a very tough problem. Where does one draw the line? Is showing a nipple good, or bad? The answer is… it depends. A recent Radiolab podcast explored this in depth. After iterating several times on what type of content was allowed for lactating women, Facebook’s content moderators had to decide what to do about an image of a teenage African girl breastfeeding a goat:

And we googled breastfeeding goats and found that this was a thing. It turns out it’s a survival practice. According to what they found, this is a tradition in Kenya that goes back centuries. In a drought, a known way to help your herd get through the drought is, if you have a woman who’s lactating, to have her nurse the baby goat along with her human kid and so there’s nothing sexual about it.

The episode ends inconclusively, but makes clear that content moderation is an endless game of whack-a-mole. People are always trying to push the boundaries of what’s acceptable, and the boundaries of what’s acceptable are always changing. As Zuckerberg noted in his post,

As with many of the biggest challenges we face, there isn’t broad agreement on the right approach, and thoughtful people come to very different conclusions on what are acceptable tradeoffs. To make this even harder, cultural norms vary widely in different countries, and are shifting rapidly.

It’s a positive development, then, that the French government will be allowed to peek behind the curtain and see Facebook’s content moderation in action. Regulators—judging by their questions at Facebook’s various public hearings—don’t really understand the scale and difficulty of the challenges Facebook faces.

The big shift over the past couple of years, though, has been from one of reactive moderation—where Facebook waited for user reports of problematic content before taking it down—to instead being proactive, understanding that the internet amplifies both good and bad, and actively detecting and either demoting or deleting problematic content.

Being proactive has resulted in important early successes. For context, it’s instructive to go back to pre-internet days. In 1974, a lady suffering from depression committed suicide on live TV, the first person ever to do so. Facebook gave anyone a broadcast license, and a few months after introducing its livestreaming feature in 2015, several people did the same.

This is the update Zuckerberg had to provide on this front:

Another category we prioritized was self harm. After someone tragically live-streamed their suicide, we trained our systems to flag content that suggested a risk — in this case so we could get the person help. We built a team of thousands of people around the world so we could respond to these flags usually within minutes. In the last year, we’ve helped first responders quickly reach around 3,500 people globally who needed help.

Another sign of progress has been Facebook’s attitude towards countries, like Myanmar, where Facebook effectively is the internet:

In the past year, we have prioritized identifying people and content related to spreading hate in countries with crises like Myanmar. We were too slow to get started here, but in the third quarter of 2018, we proactively identified about 63% of the hate speech we removed in Myanmar, up from just 13% in the last quarter of 2017. This is the result of investments we’ve made in both technology and people. By the end of this year, we will have at least 100 Burmese language experts reviewing content.

Importantly, Zuckerberg notes that there are now “around 30,000 people” responsible for enforcing Facebook’s content policies. But Facebook can’t be the arbiter of free expression; to this end, it’s creating an “independent body” to review content decisions. The goal is to have this body—like an external Supreme Court—established by the end of 2019.

This work will now be reported alongside Facebook’s quarterly earnings. For instance, here is the most recent report for Community Standards Enforcement, along with minutes of the standards forum meeting.

Incentives Matter

In early September, Jack Dorsey, CEO of Twitter, testified before both the Senate and the House. He mentioned the problem of incentives—that the purpose of Twitter is to act as the town square and encourage conversation—but that increasing “likes” and “followers” might not be the proper way to do so.

In his post, Zuckerberg wrote about a related incentive problem:

One of the biggest issues social networks face is that, when left unchecked, people will engage disproportionately with more sensationalist and provocative content. This is not a new phenomenon. It is widespread on cable news today and has been a staple of tabloids for more than a century. At scale it can undermine the quality of public discourse and lead to polarization. In our case, it can also degrade the quality of our services.

There’s a saying in journalism, “if it bleeds, it leads.” Some researchers have documented how, since the 1970s, “the mainstream commercial media in the United States changed their editorial policies […] to focus more on the police blotter.” Other work corroborates this finding.

In a new approach, Facebook will take content that people don’t like—but can’t help engaging with—and demote it. Here’s what the natural engagement pattern looks like:

Our research suggests that no matter where we draw the lines for what is allowed, as a piece of content gets close to that line, people will engage with it more on average  — even when they tell us afterwards they don’t like the content.

This is a basic incentive problem that we can address by penalizing borderline content so it gets less distribution and engagement. By making the distribution curve look like the graph below where distribution declines as content gets more sensational, people are disincentivized from creating provocative content that is as close to the line as possible.


There is much more in Zuckerberg’s post, and it is very much worth reading in its entirety. The comment section under the post is also filled with positive reactions and appreciation from Facebook users.

Thinking from First Principles

Communications networks created before the advent of the “information superhighway”—the newspaper, telegraph, telephone, radio and TV—did not allow global participation and interaction by anyone with an internet connection. Facebook, by creating a digital representation of our real-world, physical connections, enables a type of network humans have never dealt with before. It is, in effect, a new type of technology.

And every new type of technology going back to the discovery of fire has always been a double-edged sword, useful for both good and evil. Humans have created fixes, which frequently have unintended consequences (“revenge effects” or “bite back” as Edward Tenner calls it). In particular, technological capabilities can become quite complex and outstrip our ability to understand them:


Kevin Systrom, the co-founder of Instagram, noted recently that “Social media is in a pre-Newtonian moment, where we all understand that it works, but not how it works.”

Now that we are beginning to understand the incentive problems in social media, it’s time to put the pedal to the metal and fix them.

Fixing Facebook

Benedict Evans, a partner at venture capital firm a16z, made the astute obervation that “Facebook is really just an extended case study of Goodhart’s Law.”

Goodhart’s Law states that “when a measure becomes a target, it ceases to be a good measure.” In Facebook’s case, since the company went public in 2012, investors have obsessed with reported metrics such as daily and monthly active users. But what if that’s the wrong metric?

Zuckerberg’s early mantra was “move fast and break things,” later amended to the “much less sexy version of move fast with stable infrastructure.”

Today, Facebook’s new marching orders should be “move fast and rebuild trust.” Trust should be the new measure. Zuckerberg gets this. In last Thursday’s call with journalists, he said,

One [of] the most basic thing that people trust us with is that people come to our services and about 100 billion times a day choose to share some text or a photo or videos with a person or a group of people or publicly and they need to know that our services are going to deliver that content to the people that they want. And that’s the most fundamental thing and I think we continue focusing on delivering that and I think people have good confidence in general that when they use their services, that’s what’s going to happen.

At the corporate level more broadly, I think people want to be able to trust our intention and that we’re going to learn and get stuff right. I don’t think anyone expects every company to get everything right the first time, but I think people expect companies to learn and to not continue making the same mistake and to improve and learn quickly once you are aware of issues.

The Media Makes Some Noise

While Facebook is making its best effort yet at addressing these issues—David Kirkpatrick, who wrote a book on Facebook, praised Zuckerberg’s tone in last week’s call as the best tone he’s ever heard as far as taking seriously these sets of problems—journalists continue to bash Facebook as if instead it were doing nothing.

A cynic would point out that the media has many reasons for picking on Facebook:

  • Facebook has turned the traditional gatekeeper media companies into commodity providers, and helped accelerate the unraveling of their business models
  • Journalists, who are overwhelmingly left-leaning, are angry that Facebook helped elect Trump
  • Facebook is a company a lot of people care about, and writing lots of scary-sounding stories about it generates pageviews and advertising revenues

Perhaps the media’s inability to appreciate the progress Facebook has made has to do with information asymmetry. Throughout Facebook’s history, there have been several episodes of folks complaining about changes the company has made, which ultimately were vindicated; the crowd, without the benefit of seeing Facebook’s internal data, was wrong.

The best-known example is, of course, the creation of the newsfeed in 2006. Antonio García Martínez, who once worked at Facebook and wrote a book about his experience, wrote: “Journalists who cover Facebook and bristle at their haughty disdain and/or patronizing condescension, consider this illustrative example from Daniel Ellsberg, discussing a conversation he had with Kissinger.”

The Ellsberg story is an interesting example of the Dunning-Kruger Effect, in which one is clueless about a topic, but is clueless about one’s cluelessness. Ellsberg explains to Henry Kissinger that once Kissinger joins the government and has access to incredible amounts of information he previously never had access to, he would be incapable of learning anything from anyone without the same security clearances.

That’s how journalists perceive Facebook: while they think Facebook isn’t doing enough, the reality is that Facebook insiders have a huge informational advantage and can see things the outside world can’t.

The media’s noise has taken a toll on Facebook’s stock price and employee morale; and while many stocks have been highly correlated to Facebook’s stock price decline, it’s interesting to ponder whether folks are trading on all this noise.

This reminds me of an excerpt from one of my favorite books on behavioral finance, Misbehaving:

Larry Summers had just written the first of a series of papers with three of his former students about what they called ‘noise traders.’ The term ‘noise traders’ comes from Fischer Black, who had made ‘noise’ into a technical term in finance during his presidential address to the American Finance Association, using it as a contrast to the word ‘news.’ The only thing that makes an Econ [rational person] change his mind about an investment is genuine news, but Humans [normal people] might react to something that does not qualify as news, such as seeing an ad for the company behind the investment that makes them laugh. In other words, supposedly irrelevant factors (SIFs) are noise, and a noise trader, as Black and Summers use the term, make decisions based on SIFs rather than actual news.

Summers had earlier used more colorful language to capture the idea that noise might influence asset prices. He has an infamous but unpublished solo-authored paper on this theme that starts this way: ‘THERE ARE IDIOTS. Look around.’

For Zuckerberg and his troops, the message is clear: ignore the noise, and march onwards.

Forcing Functions Win the War

I’m reading (listening to) this interesting book, Freedom’s Forge, about how U.S. industrialists were the driving force behind our victory in World War II.


During the decade following the Great Depression, government had defunded our military and defense contractors. Low consumer demand had left our industrial base depleted. However, in the late 1930s, with the threat of a German invasion of England—which would give Hitler the arsenal to mount a credible attack on the U.S.—Roosevelt began commandeering industrialists to help produce ever increasing amounts of materiel for our troops.

One key player in making all this happen was William Knudsen, who began his career under Henry Ford and helped Ford establish the company’s famous assembly line and mass production efforts. Knudsen then led the same efforts at General Motors, resulting in a dramatic turnaround in that company’s fortunes and productive capacity.

Under Knudsen’s guidance, the production of machine tools—tools used to build the parts needed to mass manufacture airplanes, tanks, ships and guns—tripled. The production of military aircraft went up 100x. The outcome defied warnings from experts who believed achieving even a fraction of this level of production to be impossible.

It’s evident that this type of effort, and result, would have never happened without a forcing function—in this case, an existential threat to the U.S. The book makes clear that we had no chance at winning the war without the might of our industrial leaders behind us. This is why Jeff Bezos, at an interview last month, said that “If big tech companies are going to turn their back on US Department of Defense, this country is going to be in trouble.”...

Forcing functions are all around us: deadlines, competitions and races are all examples. The threat of the German nuclear program was a forcing function that led to the Einstein-Szilard letter to President Roosevelt and the creation of the Manhattan Project.

The series of DARPA Grand Challenges—the first of which was held in 2004—spurred autonomous car research and led to the creation of Waymo. Tesla has served as a forcing function to get other automakers serious about electric vehicles.

One of my favorite movies, Whiplash, has a great scene in which the conductor tells the story of how Jo Jones once threw a cymbal at Charlie Parker during a trial, humiliating him off stage. Parker practiced harder, and delivered a spectacular performance the following year; the rest is history....



In life, business and sport, we all need forcing functions. They help us rise to the challenge, galvanize a team, and get ever closer to achievement. They help us win the war.



October’s Upside-Down Market

In October, it felt as if stocks fell off a cliff. Worries about rising interest rates, tariffs and trade wars dominated headlines. While the S&P 500 fell about 7 percent, many individual stocks—both within and outside the index—fell much more.

Of course, there were stocks that were positive for the month. For instance, here are some members that propped up the S&P 500 index in October:

Some stocks that went up

Organic sales growth

2016 2017
Campbell Soup -1% -1%
General Mills -4% 1%
Coca-Cola 3% 3%
Hershey 1% 1%
Walmart 3% 3%
Procter & Gamble 2% 1%
Philip Morris 0% 8%

Note: I checked the sales growth figures above to present them in the most flattering light possible, thus the “organic” label. In some cases, GAAP sales were significantly worse than presented above because of divestitures and/or currency headwinds.


What these companies have in common is that they’re considered “consumer staples,” i.e., they sell products consumers will buy in good times and bad. At least, that’s the narrative.

What else do all these companies have in common? They have little (in some cases no) sales growth. They’re mature, selling into saturated markets, and competing with consumption (most folks eating breakfast cereal already are consumers of breakfast cereal, and have many options to choose from). Most are challenged in a digital world that levels the playing field for small brands.

I’m not kidding. This is a thing.


On the other hand, innovative companies growing sales 20, 30 percent or higher, fell hard in October. A list of over 140 fast-growing disruptors I track, for instance, fell on average 14 percent. Only four stocks on the list were positive for the month; a quarter of them fell 20 percent or more.

Some of the biggest decliners were fast-growing businesses that will remain dominant for a very long time. One example is a consumer staple business of the 21st century, Alphabet (the parent company of Google). It has grown sales north of 20 percent in each of the past two years, but its stock was down 10 percent. Amazon, which has grown sales around 30 percent in each of the past two years, fell 20 percent.

What I find interesting about these price moves is that they appear short-term rational. If a recession is coming, it makes sense to sell stocks priced for growth and move money into low- or no-growth bond-like names. 

(I can’t help but point out, however, that the old-school staples are not “cheap.” For instance, if we simply take expected earnings for the upcoming fiscal year, it turns out Walmart and Coca-Cola are priced at 22x earnings, similar to Alphabet, despite significantly lower growth and inferior competitive position.)

It’s also interesting to note how long-term irrational this is. If tasked with making half a dozen investments they couldn’t touch for the next ten years, few people would choose any of the low-growth companies in the table above.

“I’m waiting for a pullback”

A common refrain I frequently hear from current and potential investors who are thinking of adding or initiating an investment is that they are “waiting for a pullback” in the markets before doing so.

This is understandable. After all, nobody wants to be the sucker who makes an investment, only to see the stock market decline the next day. Better to wait for a pullback first!

“I’ll know the bottom when I see it”

Timing the bottom is of course devilishly difficult, if not impossible. The financier Bernard Baruch famously warned, “Don’t try to buy at the bottom and sell at the top. This can’t be done—except by liars.”

When markets do have a pullback, as they invariably do, pundits and journalists race to find stories to justify falling stock prices. This is the result of a well-known phenomenon, the narrative fallacy, which tricks our brain into believing a cause-and-effect story that sounds just right.

For instance, at the time of writing, the S&P 500 is down 6 percent this month (although still slightly positive for the year), and many stocks are down much more. For example—to pick some well-known names—American Airlines is down 23 percent, Caterpillar 21 percent, Harley-Davidson 16 percent, and Hilton 14 percent. Just this month.

Around the world, stock markets are down quite a bit more year-to-date. European indices are down anywhere from 9 to 15 percent in local currency. Chinese stock indices are down between 10 and 20 percent in local currency. 

There is a saying in journalism: if it bleeds, it leads. Put another way: bad news sells. The headline, “The world today is a bit better off than it was a year ago” is really boring. Nobody’s going to click on that. But a headline like “Caterpillar drops the most since 2015 after industrial giant says costs are rising from tariffs” sounds scary and gets clicks. Clicks generate pageviews and advertising revenues. Cha-ching.

And so, as you would imagine, journalists are having a ball. Now, if you actually go and read Caterpillar’s earnings release, you’ll learn that sales were up 18 percent in the quarter. Costs are expected to rise because of tariffs, but price hikes and efficiencies are “expected to more than offset” those cost increases. The company maintained its outlook and stressed that “nothing material has changed since we updated the outlook in July.” (These details are from the company’s conference call.)

This is a classic case of biased assimilation: stocks are down, and we selectively absorb stories that justify our fears. The process is accelerated by availability cascades, or stories that get repeated because they sound like plausible explanations.

Searching the news right now, “tariffs”, “rising interest rates” and “China slowdown” seem to be easily available stories to justify just about anyone’s pessimism.

This is summarized in one of my favorite cartoons:


“I’ll wait until there’s more certainty”

So here we are, in the middle of a pullback. Most investors will say, “I’ll wait until there’s more certainty.” This is understandable. Nobody wants to be the sucker who invests, only to see stock prices go down further. There might be a recession just around the corner; isn’t it obvious investors should wait?

Again, this is a narrative fallacy. Stock market pullbacks have not been good at predicting recessions. By now, you can see where this is going. Investors will trick themselves into thinking there is more certainty when prices are going up, and pundits will choose stories to justify those price movements. Biased assimilation will kick in, and instead of focusing on the negatives (tariffs, interest rates going up), those stories will focus on the positives (consumer confidence, historically low unemployment).

Dollar-cost averaging is the way to go

Because the future is unknowable, the humble way to approach this problem of whether to invest now or wait is to split the difference, and invest over time. This is also known as dollar-cost averaging. Since we don’t know the direction of markets, adding a bit every month, or every quarter, is the sensible play.

Just tell me what’s on your crystal ball

Everyone wants to know what’s going to happen over the next few months, but the economy is a complex-adaptive system: nobody knows. The economist John Kenneth Galbraith smartly observed that, “The only function of economic forecasting is to make astrology look respectable.”

That’s true in the short term. Over long periods of time, it’s important to think in terms of base rate probabilities. In simple terms, this can be stated as, “what’s the most likely outcome”? And the most likely outcome is that the economy will continue to grow, as it has done since the dawn of the industrial revolution. Why must it grow? Because capitalism, entrepreneurship, technological progress and innovation are incredible wealth-creating engines.

But don’t take my word for it. Here’s a handy chart of world-wide wealth over the past couple thousand years. The explosion you see around 1870-1900 was the result of the technological innovations of that era:


In the short term, nothing about the economy seems off. Yes, interest rates are rising from historical lows, but the 10-year Treasury bill is still under 3.2 percent, and the 30-year is under 3.4 percent. In comparison, in October 1999 (to pick a date at the end of a bull market), both the 10- and 30-year Treasury bills were quoted over 6 percent. Valuations today are also very reasonable; they were stretched in 1999. This matters because very high interest rates can bring down stock prices, but we’re nowhere near that vicinity. China is still growing its GDP over 6 percent, if that number is to be believed, and consumer confidence in the U.S. hit an 18-year high just last month.

There is little short-term predictive value in all of this, because stock markets can go bananas at times; for all we know, the market could go down 20 percent or more for little reason, as has happened before.

We are entering earnings season, and it’s possible that more companies will become cautious—some certainly will simply because of the headlines swirling around—and that this pessimism drags consumer confidence and brings about a recession. 

But over the long run—and this is where base rates come in handy—the market goes up, because corporations innovate, invest, grow profits, and stock prices follow.

And here’s the kicker: with the current pullback, investors are buying all that future growth and innovation at a discount. As Buffett explained earlier this year, even a “dumb” index-buying strategy can generate astonishing results over long periods of time. A well-executed, more focused portfolio should do even better.

Waiting for pullbacks is expensive

I’ll leave you with one last story. Peter Lynch was an extremely successful investor, having generated double the S&P 500 returns between 1977 and 1990 at the helm of the Fidelity Magellan Fund.

This is what Lynch had to say about waiting for pullbacks:

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.

In a 1994 talk, Peter Lynch cited some market statistics at the time:

There have been 93 years this century. The market’s had 50 declines of 10 percent or more. Of those 50 declines, 15 have been 25 percent or more. If you’re not ready for that, you shouldn’t own stocks. And it’s good when that happens. You take advantage of these declines.

Now you might think this is all bluster, but it’s not. Lynch lived through the 1987 market crash. At the time, he was on a golf vacation in Ireland:

On Monday the market went down… and my fund went from $12 billion to $8 billion… that gets your attention… there was nothing I could do about it.

About other garden-variety pullbacks, he noted,

I was very consistent. In the 13 years I ran Magellan, the market went down 9 times, and every one of those 9 times, Magellan went down.

Finally, in terms of staying the course, Lynch wrote in one of his books:

Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head but the stomach that determines the fate of the stockpicker. The skittish investor, no matter how intelligent, is always susceptible to getting flushed out of the market by the brush beaters of doom.


Putting it all together

Markets are unpredictable over the short term, but will do well over the long term because they’ll follow the underlying wealth creation of the economy. We humans are always creating stories to justify the short-term wobbles of the market. When markets go down, it’s usually a good time to invest.

We’re in a pullback. Investors should take advantage.

Is VR the Future of Computing?

Last week I attended the Oculus Connect 5 event. As the name implies, this was the fifth year the event was held, and yet in terms of adoption of virtual reality, we are very much still on day one. In his opening keynote, Mark Zuckerberg joked that Facebook’s goal is to have 1 billion people in VR one day, but that we’re not even 1% of the way there right now:

Still, the vision outlined in Zuckerberg’s post announcing the Oculus acquisition in 2014 remains incredibly prescient. The reasoning was simple yet powerful: desktop computing was overtaken by mobile, and now mobile had become the old thing. In search of what’s next, Facebook was making a bet on the immersive qualities of virtual reality. In due time, this would be the future:

But this is just the start. After games, we’re going to make Oculus a platform for many other experiences. Imagine enjoying a court side seat at a game, studying in a classroom of students and teachers all over the world or consulting with a doctor face-to-face — just by putting on goggles in your home.

This is really a new communication platform. By feeling truly present, you can share unbounded spaces and experiences with the people in your life. Imagine sharing not just moments with your friends online, but entire experiences and adventures.

These are just some of the potential uses. By working with developers and partners across the industry, together we can build many more. One day, we believe this kind of immersive, augmented reality will become a part of daily life for billions of people.

As someone who has tried all of Oculus’s current headsets (the high-end Rift, the intro-level Go, and the newly announced Quest), I can say that the immersive experience is truly exceptional, and unlike anything else currently available in computing.

And yet, why hasn’t VR gone mainstream? Consumer products are adopted when they are (a) affordable, (b) convenient, and most importantly, (c) when they solve a real pain point or provide clear benefits.

So far, VR is none of these. While the Oculus Go device introduced earlier this year is affordable at $199, it’s not affordable relative to how much you can do with it. Want to watch a movie? The Go provides a compelling immersive experience, but much cheaper mobile devices offer better resolution and are good enough. So is your TV, and everyone has one of those. In terms of convenience, VR devices are still too bulky and the resolution still too low. And finally, what pain point do they solve, or what benefit do they provide? Right now, the main application of VR systems is gaming, and while that is a compelling use case in itself, it’s not what will drive mass consumer adoption.

But technology never emerges fully baked. Early desktop computers were slow and clunky, and it took years for the killer app—spreadsheets—to begin to drive real consumer adoption. The same was true of smartphones. The first iPhone was slow, had lousy battery life, and no app store. Eleven years later, it packs many times more computing power than the render farm used for the first installment of Toy Story, has adequate battery life, and enough apps to obsolete a plethora of gadgets like the still camera, camcorder, fax and scanner, among others.

The demand for viable AR and VR systems clearly exists. At the Oculus event, I met a Tesla engineer who would like a good VR system so he can walk through a car factory before building it, to iron out design flaws. He said that merely looking at CAD renderings, even in 3D, isn’t enough. This could potentially save Tesla hundreds of millions of dollars in factory design mistakes.

One session I attended, with Walmart executives, showed the power of VR for employee training. Before ever setting foot in a store, Walmart associates can go through a store in VR. One module, on “difficult conversations,” focuses on terminations. The employee does this in VR, and then watches a replay flipped on her—she’s firing herself. This helps train associates on how to better handle sensitive communications and is a use case that’s hard to do outside of VR. Walmart has already trained 360,000 employees this way.

The most compelling part of the opening keynote at Oculus Connect was Michael Abrash’s forecast for the next few years. He made an analogy to computing in its early days, as told by Steve Jobs after a visit to Xerox Parc in 1979 and witnessing the first graphical user interface:

And within 10 minutes it was obvious to me that all computers would work like this someday. It was obvious. You could argue about how many years it would take. You could argue about who the winners and losers might be. You couldn’t argue about the inevitability. It was so obvious.

In Abrash’s retelling, AR and VR—which he believes will converge into one device—are also inevitable:

Now let’s apply Steve’s words to the second great wave: VR and AR. You couldn’t argue about the inevitability. It was so obvious. Imagine a VR headset that’s a sleek, stylish, lightweight visor with a 200 degree field of view, retinal resolution, high dynamic range, and proper depth of focus; with audio that’s so real, you can’t believe it’s computer-generated; that lets you mix real and virtual freely; that lets you meet, share and collaborate with people regardless of distance; and that lets you use your hands to interact with the virtual world.

If that existed, we’d be working, playing and connecting in it every day.

Imagine AR glasses that are socially acceptable and all-day wearable; that give you useful virtual objects like your phone, your TV and virtual workspaces; that give you perceptual superpowers; a context-aware personal assistant and above all the ability to connect, share and collaborate with others anywhere, anytime.

If those glasses existed today we’d all be wearing them right now. That’s all obvious. And while it may be hard to believe, it’s all doable. We really will be wearing those AR glasses and working, playing and connecting in VR before too long.

There’s just one minor obstacle: the technology that would allow most of that to happen doesn’t yet exist.

But it will.

Abrash notes the various technological hurdles to get there—and there are many—but also the known solutions to each problem. It seems clear from his analysis that in 4-5 years, we’ll have most of the required technology to deliver on a compelling consumer experience that fulfills much of this vision.

The same way the iPhone, and smartphones in general, replaced a lot of gadgets before them, Abrash says smartphones, the TV, the PC, and likely much more, will be mere virtual objects inside a future headset.

Where do Facebook and Oculus fit into this vision? Currently, headset sales are led by Sony, with 43 percent market share, followed by Oculus at 20 percent, HTC with 13 percent, Microsoft with 3 percent, and various others with the balance of around 21 percent. The main use case is gaming, and indeed most developers at the Oculus event, and certainly all the demos, were focused on gaming.

It’s quite likely that the hardware will commoditize, and the market might somewhat resemble smartphones: lots of suppliers producing low-margin devices running Android, with most of the rewards accruing to companies that monetize indirectly (Google, through the Play store and search advertising), and one or more integrated suppliers of hardware differentiated by software, like Apple and (less likely) Magic Leap.

In this world, Facebook might remain just another app inside this next computing platform. It might be akin to Google, collecting tolls on the Oculus Store and ad revenues inside games and the AR/VR equivalent of Facebook, Instagram and messaging.

On the other hand, Oculus seems to be vertically integrating to create differentiated hardware. It has made acquisitions to improve its technological capabilities in mixed reality and eye tracking. In this alternate world, Oculus resembles Apple, although it starts with a disadvantage in terms of developer ecosystem.

Will the companies with the largest developer communities in enterprise and consumer—Microsoft, Google and Apple—split the pie somehow? Or will Oculus be able to grow its first mover advantage into a large enough developer community and ecosystem to win longer term? Is that even the right question? Will it matter?

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:


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.