In early October of 2013, I was sitting in CNBC, waiting to talk about Twitter, which had just filed its prospectus (for its initial public offering). I was sharing the room with an analyst who was very bullish on the company, and he asked me what I thought Twitter was worth. When I replied that I had not had a chance to value the company yet, he suggested that I should save myself the trouble, and that the stock was worth at least $60 a share. Curious, I asked him why, and he said that Twitter would use its large user base to make money in the "huge" online advertising market. When I questioned him on how huge the market was, his answer was that he did not have a number, but he just knew that it was "really big". I am thankful to him, since he framed how I started my valuation of Twitter, which is with an assessment of the size of the online advertising market globally. Since I talked to that analyst, I have also become more more aware of the big market argument, and I have seen it used over and over in other markets, often as the primary and sometimes the only reason for assigning high values to companies in these markets. These analysts may very well be right about these markets being very big, but I think that suggesting that a company will be assured growth and profits, just because it targets these markets, not only misses several intermediate steps, but also exposes investors and business-owners to the macro delusion.
Big Markets! Really, Really Big Markets!
Would I rather that my company operate in a big market than a small one? Of course. Increasing market potential, holding all else constant, is good for value, but for that value to be generated, a whole host of other pieces have to fall into place. First, the company has to be able to capture a reasonable market share of that big market, a task that can be made difficult if the market is splintered, localized or intensely competitive. Second, the company has to be able to generate profits in that big market and create value from growth, also a function of the firm's competitive advantages and market pricing constraints. Third, once profitable, the company has to be able to keep new entrants out, easier in some sectors than in others.
It is therefore dangerous to base your argument for investing in a company and assigning it high value entirely on the size of the market that it serves, but that danger does not seem stop analysts and investors from doing so. Here are four examples:
China: A billion-plus people makes any market large, and if you add rapid economic growth and a burgeoning middle class to the mix, you have the makings of a marketing wet dream. Visions of millions of cell phones, refrigerators and cars being sold were enough to justify attaching large premiums to companies that had even a peripheral connection to China. The events of the last few weeks have made the China story a little shakier, but it will undoubtedly return, once things settle down.
[drizzle]Online Advertising: It is undeniable that more and more of business advertising is moving online, and this shift has not only pushed Google, Facebook and Alibaba to the front lines of large market cap companies but has been the impetus behind Twitter, Yelp, Linkedin and a host of other social media companies capturing market capitalizations that seem outsized, relative to their operating metrics.
The Sharing Economy: Even as private businesses, Uber and Airbnb have not only captured the attention of investors, with multi-billion dollar valuations, but have also disrupted conventional approaches to doing business. In the process, they have opened up the sharing paradigm, where private property (car, house) owners can put excess capacity in what they own to profitable use.
The Cloud: This is a recent entrant to the "big" market parade, as both technology titans such as Intel, Google and Amazon and new entrants such as Box vie to put our music, video, data and even our computing capabilities on large shared computers. Bessemer Venture Partners, which tracks companies that generate revenues from cloud computing, estimated a collective market capitalization of $170 billion for these companies in August 2015.
I am sure that you will find more examples add to the list. For example, just a couple of weeks ago, Morgan Stanley issued a strong buy recommendation on Tesla and based it entirely on its potential growth in the mobility services" market. It took me two readings of the report for me to figure out that the mobility service market was a hybrid of the car sharing and driverless car markets, a potentially huge market, that would have become even enormous, if you were able to slap ads on the cars and put them in China.
The Macro Delusion: Individual Rationality, Collective Irrationality
When you label a market as a bubble, you take the easy way out, since a market bubble suggests that the investors who push prices to unsustainably high levels are being irrational, crazy and perhaps even stupid. It is for that reason that I have used the word guardedly (and when I have, regretted it), and taken issue with "market bubblers" in earlier posts. Even if you believe that assets (real estate, stocks, bonds) are being over priced, you will almost always be better served assuming that investors setting these prices have their own reasons for doing so, and understanding those reasons (even if you disagree with them).
To see how (almost) rational and (mostly) smart individuals can be fooled by big market potential into being collectively irrational, assume that you are an entrepreneur who has come up with a product that you see as having a large potential market and that, based on that assessment, you are able to convince venture capitalists to fund your business.
Note that everyone in this picture is behaving sensibly. The entrepreneur has created a product that he sees as fulfilling a large market need and the venture capitalists backing the entrepreneur see the potential for profit from the product.
Now assume that six other entrepreneurs see the same big market potential at about the same time you do, and create their own products to fulfill that market need, and that each finds venture capitalists to back his or her product and vision.
To make the game interesting, let's make each of these entrepreneurs bright and knowledgeable about their products, and let's make the VCs also smart and business savvy. If this were a rational market place, each entrepreneur and his/her VC backers should be valuing his/her business, based on assessments of market potential and success, and the existence of current and future competitors.
Let's now add the twist