Thoughts on Investing

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Investment Philosophy: Thinking Outside the Style Box

Investors simply love to group stocks and companies together. By industry, by sector, by market cap (large, small, mega, mid, or even micro), and most insidiously, by style. Anyone who's ever tried to look into a mutual fund manager or even watched a few hours of CNBC will be familiar with the distinction between "value" investors, and "growth" investors. And conceptually, we understand that the value guys will buy anything that presents itself as a bargain, even if it's a security of objectively lower quality, while the growth guys are true believers who worship at the altar of "quality" and don't mind paying a premium for a share in a better company and a better management team. But the thing I've learned in over a decade of institutional equity investing is that the value guys and the growth guys (the good ones anyway) are both doing the exact same thing. They are looking for underappreciated assets. They just approach the opportunity set from different directions.

The "Growth" guys believe that the market has a hard time fully valuing a high growth business with a great management team, because the multiples on current earnings seem high, and it's hard to predict what the next big thing might be. They back the best horses, and they let them run. The value guys, by way of contrast, start with companies trading at low multiples and revel in low expectations that can be easily exceeded by even mediocre managers and businesses, having started with the belief that it's easier to determine what's irrationally out of favor than it is to divine the future of a business, or industry, or the economy as a whole. And when you have two different approaches, you get two different investment processes and two different investment portfolios, but ideally they're both full of underappreciated assets.

I'm a value investor. That's just how my brain works. It made sense to me when I was reading books about investing in college, and it made sense to me when I went to work for a value 7manager after I graduated. But I don't go in for all the nonsense that I hear value managers saying on TV and in the opinion columns. What I hear a lot of is managers saying that for most of the last decade, "growth" has outperformed "value" and that their portfolios stood no chance at success in the short run (the last 7 years or so). They seem to be saying, "all of these low multiple stocks must go up eventually," but they are not saying, "I've done the work to determine that this company doesn't deserve its low multiple, and this is an underappreciated asset." Companies in industries like Oil & Gas exploration, for example, look cheap. Maybe they are, but they face real, visible headwinds on the demand side from the advent and improvement of alternative energy sources. It's not enough to note that the multiple is cheap without doing more work. And it's irresponsible to blame portfolio under performance entirely on the "FANGs," (Facebook, Amazon, Netflix, and Google), which few value investors own.

Indeed, I am about to make the case that one of the most obvious values in the market today is one of those very stocks, and that value investors who aren't willing to look at a high P/E stock to determine whether or not it's cheap aren't really doing their jobs. The subject of today's blog post on thinking outside of the style box is: Facebook (Facebook, Inc. 190.78 -8.08 -4.06%).

In the interest of full disclosure - I am long facebook in Antrim's portfolio, and it's my largest position. In what can only be classified as a near term illustration of my good luck, I have an average cost basis in FB shares of $140.79, having fortuitously taken advantage of what I believed to be a severe mis-pricing during intra-day market volatility in mid-March. But I hope to be a FB shareholder for a long time, and I'll explain why as concisely as I can.

Facebook is unquestionably a "growth" company in the sense that, over the past three years, they've grown operating income at a compound annual growth rate of 25%, on the back of 37% revenue growth, and they trade at a nominally high multiple - around 25x trailing earnings, and generate a fully levered, trailing free cash flow yield on enterprise value of just over 5%. But my contention is that at today's price, Facebook is trading at a bargain valuation. And the simple reason is that it is a near certainty (nothing is truly certain) that FB will continue to grow at near these rates over the next 5 to 7 years, well above the overall market, and regardless of the depth or length of recession that we are likely already in the midst of as a result of the Covid-19 pandemic. If you believe that, you should be running to the front of the line to buy FB shares yielding 5% on enterprise value and trading at a mere 1x PEG ratio vs last year's net income. Maybe I'll be able to convince you it's true with one datapoint from their Q4 earnings presentation:

In Q4 of last year, Facebook had 1.6B daily active users, 190M of which were located in the U.S. and Canada (roughly 11.4% of their user base). But Facebook generated, on average, $41 of revenue per user in the U.S. and Canada, which amounted to almost 49% of their revenue. In the rest of the world, FB hasn't yet monetized its user base to the same degree. Europe is closest at $13 in average revenue per user, but there's a long way to go before Facebook is generating $41 per year off of each of their 294M daily active European users.

That's it. That's all you need to understand. By the time that Facebook has monetized its user base, globally, to the same extent it has in the U.S., it's revenue base will be over 4x the size of where it is today. That's 5 years of ongoing 35% annual revenue growth that FB has in their pocket, so to speak. All they need to do is successfully execute in the Rest of the World the playbook that they have put in place in the U.S., and I understand there are differences in those markets from a regulatory perspective, and there are investments in cyber-security and privacy that need to be made. I know that ad revenue growth slows during a recession. But I also know that Facebook engages their users, and there is absolutely no reason to believe that engagement is almost 75% less attractive to European advertisers than it is to U.S. based marketers.

We haven't even talked about Instagram, which could grow into an excellent source of e-Commerce revenue for the company as merchandisers harness the power of Instagram as a visually enticing platform for shoppers. I haven't mentioned messenger or WhatsApp, which are home to Facebook payments and chatbots that can sell you anything from insurance to tennis shoes. At today's prices, you don't need to value those nascent business lines (which are too small to be broken out separately in FB financial reporting), in order to value FB.

That's how I define a bargain valuation, and I would challenge you to do the same. If the market has come up with some reason (ESG, user privacy, GDPR, recession) to undervalue a "growth" company trading at a reasonable, or even "high" multiple, that may be a better value than a "value" stock trading at a nominally low multiple of book or earnings.

Disclosure: I am long FB in Antrim's proprietary portfolio as well as my own personal retirement accounts. Neither Antrim nor myself has any business relationship with FB or any other company mentioned in this blog post.

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