http://online.wsj.com/article/SB10001424052970204662204577200862677176998.html?KEYWORDS=zweig

Here Jason talks about the column:

Share on Facebook

If you read the entire post, you will see that the Facebook results were much better than my market-cap analysis implied (but, it was not a prediction, which I generally abhor): Facebook actually became more successful than Exxon Mobil. But, that does not alter the fact that my analytical process was correct. I stand by the process that I used, and the fact that Ozal referenced this post in 2020 despite the known outcome is comforting. He understands as much as I do that process is more important than outcome when you are able to make repeated, non-fatal “bets”, which you can as an investor (and casino owner!). Investing is a probabilistic enterprise.

Back to the original in 2011:
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.

If you read the entire post on this website about the drug Fenbendazole, you will see that Facebook’s results were much better than my analysis of market restrictions implied (but this was not a forecast that I actually despise): Facebook actually became more successful than ExxonMobil.

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.

Share on Facebook

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.

Facebook

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

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. 

Share on Facebook