A bad meme -- a contagious idea -- began spreading through the United States in the 1980s: America is in decline, the world is going to hell, and our children's lives will be worse than our own. The particulars are now familiar: Good jobs are disappearing, working people are falling into poverty, the underclass is swelling, crime is out of control. The post-Cold War world is fragmenting, and conflicts are erupting all over the planet. The environment is imploding - with global warming and ozone depletion, we'll all either die of cancer or live in Waterworld. As for our kids, the collapsing educational system is producing either gun-toting gangsters or burger-flipping dopes who can't read.
By the late 1990s, another meme began to gain ground. Borne of the surging stock market and an economy that won't die down, this one is more positive: America is finally getting its economic act together, the world is not such a dangerous place after all, and our kids just might lead tolerable lives. Yet the good times will come only to a privileged few, no more than a fortunate fifth of our society. The vast majority in the United States and the world face a dire future of increasingly desperate poverty. And the environment? It's a lost cause.
But there's a new, very different meme, a radically optimistic meme: We are watching the beginnings of a global economic boom on a scale never experienced before. We have entered a period of sustained growth that could eventually double the world's economy every dozen years and bring increasing prosperity for - quite literally - billions of people on the planet. We are riding the early waves of a 25-year run of a greatly expanding economy that will do much to solve seemingly intractable problems like poverty and to ease tensions throughout the world. And we'll do it without blowing the lid off the environment.
-- Peter Schwartz and Peter Leyden, "The Long Boom: A History of the Future, 1980-2020," Wired Magazine (July 1997)
History teaches us to beware and to be skeptical of new paradigms, especially when high valuations are incorporated in response to the optimism associated with the next big wave/boom.
Social media is a clear case in point.
When you give away something for free, the prospects for the number of things that you give away look damn good.I have always marveled at the power of free. For example, it is amazing to behold the draw of free food -- even in the canyons of Wall Street's top banks managing directors and assistants swarm like seagulls to get a plate of wings and cold fries or greasy pizza. It is hard to deny that the free-ness isn't the driver. Personally, my lunch standards definitely fall at a price of zero compared to full price. I always come back to the following thought when considering all these great new social media platforms: When was the last time you were deterred from trying something that was free? How is this basic issue not discussed more often? I sure as hell hope people like your thing or service enough if all they have to do is type in their 20 character email address to use it. If you are selling something at a loss or at cost I would hope you are beating the established players that the market expects to make a profit, right? Ultimately, then, it all comes down to advertising. Advertising is driven by corporate and consumer spending. There will be some redirecting in advertising spending, but where are the new advertising dollars in a mature and stumbling-along economy going to come from? Real profits will have to come to support all these hundreds of billions of dollars in equity prices that early investors will look to cash out a realized return on in coming years. A lot of things need to go well for the power of free to pay out all that it is promising. Trade them if you like, but, with few exceptions, I would avoid investing in most social media stocks at current valuations.I intend to be on the other side of the power of free via, at the appropriate time, putting on outright shorts and long-dated puts in social media and new tech. Just like when you are stuck at your desk and you get to the free lunch buffet late and there is nothing left but a few soggy waffle fries, long-term investors will likely be disappointed (and maybe even shocked) with returns from current levels. More Directly I have been distracted by other research projects this week, so I haven't looked too deeply into Facebook's (FB) or Twitter's (TWTR) earnings reports. Having said that, anyone who is buying Facebook or Twitter on the fundamentals of three months of reported performance should immediately reassess their thesis. For me, at these valuations and within the context of the broader market's levels, there is a bit of you either are a believer or you aren't. Obviously, anything can happen in the short term, and more power to profitable trading. As an investment, however, the markets (and their valuations) seem to be saying that Facebook, Twitter, Zillow (Z), OpenTable (OPEN), Priceline (PCLN), TripAdvisor (TRIP), Yelp (YELP), GrubHub (GRUB), LinkedIn (LNKD), Salesforce (CRM) and that ilk are indeed not just changing the world for consumers and corporations but are going to be profit machines for decades. That is not hyperbole. Being here-to-stay, which is even uncertain for some of the aforementioned names, is not even close to good enough, in my humble opinion. I am not a believer in social media, new tech, sustainable profit margins of the cloud, the endless power of big data, the optimistic prospects for smart advertising and the like being profit machines for decades. I am not even a believer that a majority of these companies will be profit machines, ever. Rather, the new social media paradigm is reminiscent of another new paradigm infamously featured in a column in Wired Magazine back in 1997, "The Long Boom: A History of the Future 1980-2020." Written by Peter Schwartz and Peter Leyden, the article started with the following summary of view that proved to turn out poorly, as two recessions (one was shallow; the other represented the deepest contraction in nearly 80 years) followed soon after during the next decade.
"We're facing 25 years of prosperity, freedom, and a better environment for the whole world. You got a problem with that?"
-- Peter Schwartz and Peter Leyden, "The Long Boom: A History of the Future, 1980-2020," Wired Magazine (July 1997)A much more valued and important opinion than mine is that of David Einhorn and the following excerpts are worth re-reading from Greenlight's third-quarter 2013 letter to its limited partners dated Oct. 15, 2013, and first-quarter 2014 letter to its limited partners dated April 22, 2014. Greenlight's third-quarter 2013 letter:
There is evidence of much more (and increasingly creative) speculative behavior. Some companies have convinced the market to embrace earnings reports that ignore what they must pay employees to show up to work every day, provided the employees accept equity rather than cash. We don't understand how some investors view this as economically different from the company selling shares into the market and using the proceeds to pay workers. Then there's the sizable group of companies (including a number of recent IPOs) that are apparently not subject to conventional valuation methods. Many have no profits and no real plan to make future profits. The market doesn't seem to mind – in fact, it is hard to fall short of such modest expectations and the prices of these stocks have performed particularly well of late. Finally, there are the market participants whose investment process appears to be "bet on whatever has made money most recently." They've noticed that stocks with large short-interest ratios have materially outperformed over the last year and they continue to invest accordingly. When "high short interest" becomes a viable stock-picking strategy and conventional valuation methods no longer apply for many stocks, we can't help but feel a sense of deja vu. We never expected to find ourselves in an environment like this again, given the savings that were lost when the internet bubble popped.Greenlight's first-quarter 2014 letter:
And once again, certain "cool kid" companies and the cheerleading analysts are pretending that compensation paid in equity isn't an expense because it is "non-cash." Would these companies be able to retain their highly talented workforces if they stopped doling out large amounts of equity? If you are trying to determine the creditworthiness of these ventures, it might make sense to back out non-cash expenses. But if you are an equity holder trying to value the businesses as a multiple of profits, how can you ignore the real cost of future dilution that comes from paying the employees in stock?
Given the enormous stock price volatility, we decided to short a basket of bubble stocks. A basket approach makes sense because it allows each position to be very small, thereby reducing the risk of any particular high-flier becoming too costly. The corollary to "twice a silly price is not twice as silly" is that when the prices reconnect to traditional valuation methods, the de- rating can be substantial. There is a huge gap between the bubble price and the point where disciplined growth investors (let alone value investors) become interested buyers. When the last internet bubble popped, Cisco (the best of the best bubble stocks) fell 89%, Amazon fell 93%, and the lower quality stocks fell even more.
In the post-bubble period, people stopped talking about valuing companies based on eyeballs (average monthly users), total addressable market (TAM), or price-to-sales. When the re-rating occurred, the profitable former high-fliers again traded based on P/E ratios, and the unprofitable ones traded as a multiple of cash on the balance sheet. Our criteria for selecting stocks for the bubble basket is that we estimate there to be at least 90% downside for each stock if and when the market reapplies traditional valuations to these stocks. While we aren't predicting a complete repeat of the collapse, history illustrates that there is enough potential downside in these names to justify the risk of shorting them.In other words, caveat emptor, cool kids and investors in social media stocks. It is very hard to counter his point on equity-based compensation, and to paraphrase David, there is a clear difference between a great product that consumers can use or purchase for free or at cost or even a discount to real cost, and a sustainable, long-term profitable business. Amazon (AMZN) is the ultimate example of this, and it looks like Coca-Cola (KO) compared to the profitless (reported or when you actually factor in equity-based compensation) and revenue-light social media companies today. A lot of smart skeptics are usually early (and I have the scars on my back to prove the statement), and David's first-quarter 2014 letter is distant history in today's short attention span investing landscape, let alone way back to third quarter 2013, but I'd give his points a thorough read in between friending someone on Facebook, having to add someone to your LinkedIn network because of those annoying emails, favorite-ing a Jimmy Fallon tweet, checking out real estate on Zillow, booking a dinner reservation on OpenTable and ordering lunch on Seamless. The new world is exhausting for sure, on whether it is actually lucrative in the long term, the jury is still out of town at an amazing bed and breakfast in Maine they found on TripAdvisor (with a $14.3 billion market cap, around 12x projected 2014 revenue, 68x P/E). Not to mention that David Einhorn's basket of shorts has probably performed reasonably well, even as we are at record index highs. I have no idea what names he shorted, but LinkedIn and Twitter are down 15% and 26%, respectively, year-to-date, for example. Obviously, there are highfliers that have kept soaring, but I am guessing Greenlight has some solid winners in his basket.
This column originally appeared on Real Money Pro at 9:04 a.m. EDT on July 31.
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