CEO Philosophy On Stock Price: Amazon and salesforce.com

The Jeff Bezos Approach to Stock Price

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

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

The salesforce.com Contrast

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

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

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

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

They understand you, and you yearn to be understood. 

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

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

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

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

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

***

For some more posts related to this topic, refer to these...

To Be Misunderstood...The Witch's Dilemma

Whom Does Management Serve

My Contribution To the Facebook Noise 

Update on the Shleifer Effect (WMT,INTU)

Earnings season is hunting time for the Shleifer Effect and provides the most concrete "new news" updates to track the progress of targets already on the Watchlist.

Shleifer Effect Concept Summed Up

The Shleifer Effect is rooted in the social psychology concepts of representativeness, conservativeness, and overreaction as highlighted in Andrei Shleifer's book Inefficient Markets: An Introduction to Behavioral Finance. (I introduced the construct here in the context of evaluating Aeropostale (ARO) as an investment opportunity.)

In a nutshell, Professor Shleifer describes how investors have a tendency to interpret a series of events as a pattern that will continue in the future (representativeness); once they believe a pattern is in effect, they stick to their view until multiple instances of "new news" suggest a new pattern has taken hold (conservativeness); at which time they tend to pull an about face, believing the new pattern will persist into the future, and make their investment bets in dramatic fashion according to the new news (overreaction).

Together, these behaviors create the Shleifer Effect whereby investors overreact to news sending the price of some stocks soaring above and some stocks plummeting below any reasonable assessment of their intrinsic long-term value.  These tendencies create opportunities for investors who pay attention and are ready to take advantage of the thinking "glitch." We're most interested in overreaction on the down side creating buying opportunities in high quality businesses.

Tweaking the Concept - Introducing Salience

Walmart and Intuit both reversed previous announcements of bad news with an instance of good news. This creates an interesting question for how we manage the Shleifer Effect Watchlist. If the company manages to sidestep multiple instances of bad news (multiple being the theoretical requirement needed to produce investor belief in a new trend and thereby force an overreaction), does that mean they fall off the list altogether?

My gut reaction is "no." I'll suggest that existing owners are taking a wait and see approach. For Walmart in particular, the older bad news came from the NY Times story about bribery scandal allegations in its Mexico operations (featured here). The stock took a five percent hit the day after the story broke. The repercussions of that story are still unfolding and will likely take years before the full affect is known. I think it's fair to consider it to be on its own overreaction track. A separate track, I suspect, from a larger earnings representativeness bias that was in process and taking a higher priority in the minds of investors...namely, the challenge with same store sales in the US and its depressing impact on overall corporate earnings.

The latest earnings news (the press release is here) arrested the down trend by showing growing earnings, beating analyst expectations, and (most importantly, I think) the growth coming on the back of 2.6 percent growth in US stores.

In terms of tweaking the concept, I'll hypothesize that there's an element of salience to be considered here. In other words, the Mexico bribery scandal grabbed a lot of headlines. Some investors reacted by selling their shares. But its salience to the base of most existing investors was not very high. They didn't consider as an event significant enough to affect the earnings power of the business. And that - the earnings power of Walmart - is the most important issue to investors. The story with the most influence on earnings (therefore most salient) is the sales performance of US stores.

So, when the latest report shows an improvement in US store performance, the Mexico story loses its punch as it applies to the Shleifer Effect. The Walmart Shleifer Effect is temporarily suspended. Since putting Walmart on the list, it's up over six percent. If the report had been negative, I believe there would have been a compounding result. The belief in a trend of US stores being in overall decline would become stronger. The conservativeness bias as Walmart being a "has-been" retailer would strengthen. And this would have built on the Mexico scandal, sending investors into a selling overreaction.

I'll keep Walmart on the Watchlist for now with zero occurences of bad news. The next potential for Shleifer Effect news seems to be the annual meeting, scheduled for Friday, June 1, 2012 (information here).

That's my current thinking anyway. The whole Shleifer Effect is a construct-in-progress, so give me the freedom to shoot a bit from the hip while I figure out how it works in this live fire Watchlist environment.

On to Intuit (the initial post was located here). On April 20, 2012 Intuit made an announcement suggesting that third quarter earnings might fall below Wall Street expectations because of the digital tax prep category under-performing slightly. That's caused the stock to fall about six percent.

Last week it changed the course, reporting that - despite the impact of digital tax prep - Q3 was quite good and management is optimistic enough to increase its guidance for earnings performance for the full fiscal year 2012. (That release is here.) The stock has recovered somewhat, but still sits just below its price at the initial write-up. 

With that, I'm suspending Intuit from the Shleifer Effect Watchlist. The two stories off-set each other, and I don't see any momentum right now toward investors believing a new negative trend is developing. It falls back into its previous mode, in which investors expect it to continue growing at a nice clip and are content with it sporting a 20+ P/E ratio. 

I'll keep tracking it on the list, but we're putting it back to square one with ZERO occurrences of bad news. 

Confirmation Marketplaces and Ideological Amplification

Here's a thought in the early stages of baking in my mind...

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

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

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

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

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

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

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

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

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

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

What Would You Buy If Price Didn't Matter?

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

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

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

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

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


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


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

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

While putting the following control in place:

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



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

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

Sincerely,

Paul

You can email me at pauldryden (at) gmail.

***

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

- Charlie Munger

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

Greenblatt vs. Burry: Even Value Investors Disagree

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

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

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

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

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

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

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

From the book:

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

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

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

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

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

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

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

*****

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

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

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

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

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

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

To Be Misunderstood...The Witch's Dilemma

The Witch's Dilemma

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Back To the Witch's Dilemma 


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

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

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

Being misunderstood is very hard on a person.

Allow me this aside about the concept of learned helplessness...

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

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

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

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

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

***

Anyone For Investing In a Car Periscope?


I'll conclude with a light-hearted parallel...

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

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

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

My Contribution to the Facebook Noise

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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