“It is better to be roughly right than precisely wrong.”
– John Maynard Keynes
Welcome to this week’s edition of Market Caviar. In our weekly publications we attempt to break down complex investment concepts to help our readers get a glimpse into our thought process. Last week, Lewis Johnson, our Co-CIO, described “Reflexivity” and how understanding its powerful effects could impact investment returns. Recently, Zev Abraham, our Director of Research, described how important “Trust” is when it comes to investing. This week I will show you how we seek to quantify the “Expectations” that investors price into and out of stock prices.
We believe that simple logic makes for a deeper understanding, especially in finance with its confusing jargon. In my opinion, far too much of the investment writing is illegible. We drown in data. Today’s strategy piece has a simple goal of cutting through that clutter to discuss the role of expectations in investing.
Think about your daily life. Expectations are built into almost everything we do. When things go as expected, we hardly notice. It is life’s surprises that grab our attention. If Muhammad Ali lost to the heavily favored George Forman in 1974, would we still remember the “Rumble in the Jungle” as one of the world’s most famous fights? Or would it have slid into obscurity?
I believe investor expectations are probably the single biggest driver of security prices, in the short run. This is because expectations can change in a heartbeat. When widely shared expectations become outdated, big moves can happen fast. As investors, we face the challenge of making decisions in real time, quite often with incomplete information.
What are the tools we use to help manage through the uncertainty?
The recent volatility of Facebook (FB) is an illustrative example. While the earnings estimates that FB reported were off by a single penny, the stock was very volatile. We believe it was not the penny that mattered, you see, rather it was a meaningful change in expectations. But how can we try to understand if the change was too much – or not enough?
To step back for a moment, it’s clear that FB is one of the most amazing businesses in the history of the world. From a dorm room project, FB has grown into one of the largest companies in the world – and has done so in only 15 years. Incredible! Is there a way to think about and value such a unique company? We think there is, and it begins with a deeper dive into the simple unit level drivers of the business.
FB has around 2 billion users worldwide. At its highest valuation, the market was valuing the company at approximately $300 per subscriber. Facebook generates annual profits per user of about $10. Viewed at this level, the company makes less than a dollar per month in profit per user! An extra $0.50 per user per month would grow income more than 50%. Half a dollar per month may be all it takes to move the needle. Do we think it’s possible that one of the fastest growing, most unique companies in the history of business has tapped out its profit potential only 15 years into its existence? I would not want to make that bet.
What would have to happen for earnings to double at FB?
If the company never grows its user base again but generates an extra $1 per month in profit per user, company-wide profits would double. A dollar a month does not sound unreachable to me. This quick exercise shows how with a few numbers, we can get to the heart of even the most complex investing question. In investing as in life, simpler is often better!
We will never lose sight of the fact that the securities we own are much more than blinking lights on a computer screen but rather claims on real businesses. The price of these claims goes up or down every day in the publicly traded markets. The expectations on which these securities are priced may change rapidly – often far more rapidly than the fundamentals of the underlying businesses.
Often it demands great effort, especially in real time when news is scant, to develop a thoughtful view on whether market volatility is a hysterical over-reaction, or a logical recalibration to new information. Investor expectations can have a profound impact on security prices. Our belief is that focusing on unit-level economics can help us find the signal amidst the daily market noise. We know of no better sanity check when markets are moving fast.
Investors should seek to avoid the talking-heads of the financial press and focus their inquiry where it should be, on the fundamentals of the business and what expectations are priced into securities. Our nearly two decades in the investment research business have taught us a few important lessons along the way. John Maynard Keynes was onto something when he said “It’s better to be roughly right than precisely wrong.” We think he would approve of our focus on unit level economics, and the importance of understanding the expectations priced into investments.