Great Expectations

Not a good day for FANG. Facebook in particular:

180726_FB
Source: Google

Let’s cut to an investor reaction shot, courtesy of the FT. This made me laugh so hard I had to screencap it for posterity:

180726_FT_FB_Quote
Source: Financial Times

Uh oh. Looks like someone was just plugging management guidance into her model. Or forgot to fade revenue growth and returns on capital. Or both.

Look. Schadenfreude aside, FB is a good business with a good product. As far as I’m concerned, the jury’s out on the valuation (of the so-called FANG stocks I have very strong opinions on NFLX and AMZN, but not so much on GOOG and FB). I have no real opinion on the long-run prospects for the business. Today’s price action is simply a helpful reminder that good businesses selling good products can still be bad investments if you overpay.

In my experience, that last bit is the hardest thing about investing for laypeople to understand. Most people understand what makes a good product. Somewhat fewer understand what makes a good business. But almost no one outside finance understands why overpaying can overwhelm everything else.

Let’s explore this further. Here is the most important chart in all of fundamental investing:

justified_pe_fade
Source: Demonetized Calculations

What are you looking at?

You’re looking at the valuation life cycle of a business (an exceptional one, btw) with the following characteristics:

 

justified_pe_fade_inputs

I generated the graph with a simple model called a fundamental H model. In an H model, a company’s life is divided into two parts: an “advantage period” featuring excess growth and returns on capital, and a “steady state” period where the company simply earns its cost of capital.

The intuition here is really, really simple. It’s so simple I’m not going to bother going into the details of what an H model actually looks like.

Ready?

Companies with exceptional growth and profitability attract competitors. Competition decreases profitability and slows growth (more companies are fighting over the same pool of customers). As competition drives down future growth and profitability, every company in the space becomes less valuable. Or, in another variation, a market simply becomes saturated, and there is very little growth left available. Or, new technology is developed that makes a company obsolete. You can go on and on. The variations are endless.

Some businesses are better at defending their profitability and growth (they have “moats”). If you are good at identifying strong moats, you can make a lot of money. This has worked out well for Warren Buffett. Especially since he was able to lever his bets with insurance float. All else equal, you should be willing to pay more for a business with a “wide moat.” How much? Believe it or not, figuring that out is the fun of it. It’s the game all of us long-term, fundamental investors are playing.

Likewise, in some industries with only a few large players, the players are smart enough to realize they should protect their profit pools, not undercut their competitors on price just to gain market share (this is uncommon).

Also, it’s technically possible to grow your way out of a contracting valuation. If the E in P/E grows large enough, fast enough, you can still make money even if the ratio shrinks. You could have paid several hundred times earnings for WMT stock back in the day, and still made money. But only a select group of businesses have this ability, and personally I think they are far more difficult to spot ex ante than people like to admit.

Anyway, all that’s beside the point.

The point is that growth and profitability inevitably fade to some degree. And when they do, valuations de-rate. When people overpay for businesses, what they are doing (whether they realize it or not) is being overly optimistic about the magnitude and the rate of the fade.

Basically, they are forgetting how capitalism works.

Disclosure: Small positions in FB and GOOG, via a mutual fund manager. But less than 1 bp on a lookthrough basis. So, practically speaking, no positions in anything referenced in this post.

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