I’m sure everyone is wondering about the mini “crash” (crash-ette? perhaps?) we saw Friday and Monday. I think it’s important to keep a few things in mind. Given that an increasing amount of trading is done by computers and done using ETFs and versus humans trading individual stocks I think big drops (and big gains) in one day in the market should not be viewed as unusual. It might be uncomfortable to see or experience but it shouldn’t view as very abnormal at this point. What we saw was likely due to issues surrounding a few funds that made very risky bets about stock market volatility. It was also probably quite healthy to see the market down quite a bit. We’ve experienced about two years of steadily rising stock prices without a major drawdown. It’s reasonable to expect the market to have periodic periods of worry and turmoil.
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However, long term the economic fundamentals look good. For the first time since the great recession every major world economy is growing. There is really not much more that needs to be said beyond that.
Now, back to our regularly scheduled newsletter.
Some of the most popular stocks over the past few years have been the so-called “FANG” stocks or Facebook, Amazon, Netflix, and Google. There are really a few more to include, so perhaps the best acronym that I’ve seen would be “FMAANGT” or Facebook (FB), Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), Google (GOOGL), and Tesla (TSLA). Of the sextuple, we own only the MAG part or Microsoft, Amazon, and Google.
The reasons we don’t own the others are varied. Let me explain.
Tesla’s CEO Elon Musk originally promised investors that Tesla would produce 100,000 to 200,000 new “mass market” Model 3 sedans in the second half of 2017. What did they actually produce? 1,550. Was Musk furiously working to correct the manufacturing issues Tesla was having? Maybe. He had time, however, to use Twitter to market a flamethrower his infrastructure company (The Boring Company) developed.
While the above is a good anecdote that sums up the company, there are also more intellectually rigorous reasons why we don’t own Tesla. Having a CEO on Twitter selling flamethrowers while his car company misses production estimates by 99% isn’t the only reason we don’t own Tesla. Even if the company transforms itself into a profitable automaker, its valuation is far too high. Even if Tesla became a major auto industry player alongside companies like Ford or Nissan, it’s already valued about $10B above them. The market is already pricing Tesla like it is going to be wildly successful. At this point, there is not much upside left. A huge amount of downside remains if the company can’t produce a profitable mass market car and stem its negative cash flow.
Facebook is one of the tougher companies to evaluate. Advertising dollars are no doubt moving online, and Google and Facebook are two of the biggest beneficiaries. Facebook has been wildly successful, but we are unsure about its prospects going forward. We have three key questions without answers:
1. People are on Facebook to interact with friends and family. Ads on the platform are more disruptive to users versus ads on Google. For instance, if you want to research whether or not the 2014 Honda Accord you’re looking to buy is reliable, then you aren’t going to mind ads for Honda Accords appearing in your search results. Can Facebook successfully balance user engagement and enjoyment with ad loads high enough to generate enough profit?
2. Is Facebook being completely truthful with the ad metrics it discloses to advertisers? Over the past few years, Facebook has had to revise about a dozen ad metrics. All of the metrics were skewed in favor of showing advertisers that their content was performing better than it actually was. None of the ad metrics that had to be revised were anything major, but the fact that all were skewed in the same direction is worrisome and raises questions. You would expect the results of random errors to be evenly distributed (some favor advertisers, some favor Facebook).
3. Does the Facebook platform have staying power? We all know that teens don’t like hanging out with their parents. Teens tend to eschew Facebook in favor of Instagram (owned by Facebook), Snapchat, and other social apps. Are those teen users gone for good, or will they return to Facebook as they become adults? This past quarter marked the first time Facebook’s daily active users in the US decreased. Has user growth begun to plateau?
Since Apple is huge and only a few people do not have cell phones, we see little room for growth. In fact, there is even a risk that phone sales will slow if consumers stretch out the phone upgrade cycle similar to what happened with PC sales. Yes, Apple has a growing services business and is working on a variety of different projects from possibly producing its own media content to developing self driving cars. But here’s the problem. None of those opportunities really offer much growth.
Take, for example, self-driving cars as a new market for the company. Suppose (as we think it will) that advanced driver assistance systems (ADAS) become more widespread in vehicles over time and eventually become standard equipment in all but the cheapest vehicles and becomes a $40B market in a few years. There are probably about a dozen different players in the market, so let’s round it down to ten to make the math easy. Each company gets $4B worth of sales. Last year, Apple sold $141B in just iPhones! If it rakes in a good chunk of the ADAS market, that gives them only a 3% increase in sales compared to their iPhone business.
Now look at Texas Instruments (which we own), another ADAS player. Texas Instruments did $13.3B in sales last year. Another $4B in ADAS sales for them is a 30% increase! If you are bullish on cars becoming increasingly technologically complex, then there is more upside in smaller players in the self-driving market than Apple.
Netflix is a fantastic consumer service. Everyone who has it loves it, and it continues to grow. It’s even growing faster internationally than I (and others) thought it would. The consumer facing side of Netflix is a wild success. The business side is where things get uncertain. The company burned through almost $2B in cash last year and is spending around $10B on content costs. The idea is that eventually the company will recoup its content costs. It spends money upfront now to develop original series and movies that it then will have in its library essentially forever. Netflix is basically trying to become HBO in a quarter of the time it took HBO to become HBO.
The good part of that is that HBO is a successful, profitable business and currently viewed as Time Warner’s crown jewel. Contrast this to Tesla, which is attempting to become a successful auto manufacturer in an industry that, on a good day, means single-digit profit margins and perhaps 1% return on assets over a business cycle. Netflix is aiming to become a great business.
The question is whether or not Netflix will reach “escape velocity.” Will it get enough members paying high enough prices while it stabilizes its content spending to start earning a profit eventually? I have no idea. It’s an intriguing company but a very risky stock.
What I do know is this. The media landscape is changing. New companies with bigger pockets, like Google, Facebook, and Amazon, are accelerating their content efforts. There is a war going on for viewers’ attentions. While anyone with enough money can produce a new show or a movie, live sports content is one thing that is in limited supply. The NFL, despite falling ratings, recently saw a 40% increase in the value of its Thursday Night Football package. What about the value of NBA games with rising ratings and more favorable demographics? Or how about the MLB with stable demographic trends? We’d rather invest in sports teams like the NY Knicks and NHL Rangers (NYSE:MSG) and the Atlanta Braves (NASDAQ:BATRK) than to take a wild shot in the dark with Netflix.
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Article by Ben Strubel, Strubel Investment Management