Jason Zweig’s column in today’s Wall Street Journal is titled “Why the Fuss over Facebook Doesn’t Make It a Homerun” and it provides fodder for two posts on this blog today.
This first post shows that market buzz, such as the Goldman Sachs induced mania on Facebook, often creates inflated values and losses for investors’ portfolios. At the end of this post, I will provide a short list of businesses with inflated market values relative to objective measurements of business value. I will leave it for you to decide whether these valuations make sense.
In the second post (above), I will write about a method of analysis that helps asset managers stay grounded and ignore the mania. Charlie Munger, Warren Buffett’s partner, describes this method as: “Invert; always invert.” Jason’s column provides two good examples of this method with respect to Facebook’s valuation.
The market mania on Facebook this month was created by Goldman’s “underwriting” of Facebook’s private equity and the offering of that equity to Goldman’s “most favored” clients. Jason Zweig correctly explains that “the market for Facebook’s stock, reportedly around $50 billion, or some 25 times the company’s revenues, has been set in a closed feedback loop rather than in an open market.”
Good Companies versus Good Investments
Jason explains what too few investors are able to grasp: that companies may offer great products and services—products and services that you would buy from that company over and over—but make lousy investments.
“Even if Facebook continues to hit the mother lode of social-network profits, new investors could end up with little to show for it.”
Zweig gives an example from the 1870s of a silver mining company in Nevada that was bought by late investors for fifteen times revenues that ultimately destroyed investor wealth despite the firm’s profitability. But, there were hundreds of such businesses only ten years ago in the dot com bubble. For example, here is what Scott McNealy, CEO of Sun Microsystems said in Business Week of his company’s stock at the time. This quote can be found in James Montier’s Value Investing:
“(In 2000) we were selling at 10 times revenues. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold…That assumes zero expenses, which is really hard for a company with 39,000 employees. That assumes I pay no taxes…and that assumes zero R&D for the next 10 years…Do you realize how ridiculous those basic assumptions are? …What were you thinking?”
Cognition versus Behavior
I say too few are able to grasp it, but it seems to me that there is a lot more to it than a lack of understanding. After all, there are some high IQs running around on Wall Street and it only takes a minority to arbitrage away the insanity. No, it seems to me that the best investors are almost programmed to avoid these investments; to look for objective ways such as Munger’s to reject them. It also seems that the majority of investors are programmed to run with the herd and seek them out.
What are the odds?
Zweig writes that there are some businesses that traded at extremely inflated values that turned out okay for investors, such as Google and Apple, but that for every one that turned out well there were hundreds that destroyed wealth. In other words, taking an outsider’s perspective, the odds are overwhelmingly against investors who buy companies that trade at high prices relative to objective measures of value such as sales or tangible book value.
High Priced Firms Relative to Objective Values
Here is a simple list of some high price-to-sales firms. Of course, everyone should employ extensive fundamental analysis to find high priced firms that are most likely to fall in value and use several methods to measure price-to-value. It is also wise to have strict limits on how much capital you can dedicate to a short on a single company because as John Maynard Keynes once said:
“Markets can remain irrational longer than you can remain solvent.”
Keynes knew this well; he reportedly became insolvent several times because of his investments. So, one of the most respected economists of the twentieth century, and by some accounts one of the most intellegent people on earth, could not avoid making a series of bad investments. Some programming must be impossible to overcome.
Select List of High Price-to-Sales Firms with Over $1 Billion in Market Capitalization
Data as of January 7, 2011, from Thomson-Reuters
|Nova Gold Resources Inc.||NG||2,672.8|
|Ivanhoe Mines, Ltd (USA)||IVN||249.1|
|Vertex Pharmaceuticals Inc.||VRTX||65.0|
|Universal Display Corporation||PANL||53.1|
|Baidu.com, Inc. (ADR)||BIDU||36.9|
|Northern Oil & Gas, Inc.||NOG||34.7|
|Kodiak oil & Gas Corp||KOG||34.3|
|Silver Wheaton Corp. (USA)||SLW||31.7|
|Silver Standard Resources, Inc.||SSRI||26.4|
|HeartWare International Inc.||HTWR||25.4|
|Human Genome Sciences||HGSI||25.3|
|NuStar GP Holdings, LLC||NSH||23.9|
|Bingham Exploration Co||BEXP||22.9|
|Apco Oil & Gas Intl.||APAGF||21.6|
|The St. Joe Company||JOE||21.3|
|Open Table Inc.||OPEN||21.0|
I believe I caught all companies with a P/S ratio of 20 or higher. Notice the preponderance of natural resource and biotechnology firms on the list. Companies in these industries are most difficult to value for the lay investor and most susceptible to cocktail party chatter. I am somewhat surprised that only one Chinese firm made the list.
Also notice that The St. Joe Company made the list. JOE was the subject of market attention when David Einhorn, outstanding value investor at Greenlight Capital, gave a presentation at the Value Investing Congress last year explaining why he was short the company. Also, Open Table makes the list. Whitney Tilson has written extensively on why he is short OPEN. OPEN is another example of a great service, but probably a lousy investment.