Carl Gustav Jacob Jacobi was a German mathematician who lived in the 1800s. Jacobi once said “man muss immer umkehren” which translates to “Invert, always invert.” Jacobi believed that the solution for many difficult problems in mathematics could be found if the problems were expressed in the inverse.
Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, is fond of quoting Jacobi’s maxim and using that logic to find solutions to difficult problems in investing. This is the second post inspired by Jason Zweig’s January 8 column in the Wall Street Journal pertaining to Facebook’s valuation. The first post appears below this one.
In investing, inversion means that investors will examine a problem backwards as well as forwards. While many sell-side Wall Street analysts are content to pin a growth expectation on a business and then calculate valuation based on the present value of free cash flows implied by that growth, investors who invert start with the price observed in the market and analyze if the implied growth that determines that price makes sense. Investors who invert when faced with difficult valuation problems will surely avoid many mistakes.
There were two good examples of inversion in Zweig’s column. I shall simply quote them. Ralph Wanger, retired head of the Acorn Fund:
“Starting from such a high valuation, Facebook would have to grow at least as successfully as any company in history has ever done to deliver even a market return.”
Jay Ritter, University of Florida finance professor offered this analysis and quote:
“Let’s say the company grows so fast over the next decade that it will match the size of the world’s largest stock, Exxon Mobil, whose shares this week had a total value of around $380 billion. So, if the company grew in total value from its current $50 billion to $380 billion over the next 10 years, Facebook’s stock would generate an average annual return of 22.5%. ‘As a maximum upside,…that’s not as rosy as I think some investors might hope.’”
A 22.5% annual return that only materializes if Facebook becomes the most successful company in history? Needless to say, the odds of that happening are ridiculously low. By inverting, we can avoid a lot of disasters.
A final note: It is often believed that value investors shun companies like Facebook because they have a bias against growing companies or because of a bias for old world businesses. That belief is a wrong. Value investors love businesses that can grow free cash flows–the faster the better–it is just that value investors will assign reasonable valuations to reasonable growth projections. Glamour investors often seem to assume that high growth will continue forever and will pay anything to be in the new, hot thing. Facebook seems to be the latest example of the latter.