Stig Brodersen  1:20 

Let’s just jump right into it here, John. I’m sure everyone in the audience is familiar with Facebook, but could you please kick off this conversation by explaining Facebook’s business model?

John Huber  1:30 

Sure, and I’m sure everyone’s familiar with Facebook, at least from a user’s perspective, and probably many from a business model perspective as well. It’s really a simple business model. Facebook, at the core is a media company. It’s called social media, obviously, but it operates very much like any traditional media company, it shows content to viewers and then it makes money by selling ads to businesses that want to sell stuff to those viewers right.

It’s a really simple model, like I said, similar to a TV station, radio station or even a newspaper. In that regard, so are most other traditional advertising-based media companies that produce content and then collect advertising revenue. But there’s one very critical difference between Facebook’s model and the traditional ad model. Facebook doesn’t pay anything for the content that it owns. Facebook’s users produce their own content, right? I post a picture on Instagram for you to see, Stig and you post a picture that your friends see, etc. We’re collectively the content producers for Facebook, and it’s not paying anything for that content, which makes it a very profitable business.

It’s interesting. I was reading about Netflix recently, they’re going to spend $15 billion on content this year, which is by far their biggest expense. There’s no $15 billion content acquisition cost at Facebook. There’s no $300 million Ryan Murphy contract to deal with. We are collectively the Ryan Murphy’s at Facebook, right? We’re not we’re not producing content that’s nearly as good but we’re still producing content that people want to see. So, it’s a great business model and the result is that the company has a 3% gross margins.

That big gross margin leaves the company with a lot of room to spend on its growing roster of employees. R&D spent $10 billion on R&D last year. Security, other investments that it’s making in an effort to protect its platforms and maintain its current position. I think the company’s moat comes from the network of fact that it’s developed over the years, and so that’s the other piece of the pie. It’s a great business model. The question is how durable it and I think the network effect is extremely powerful.

It’s worth noting that Facebook is much more than just the namesake platform that obviously gets the most press. Though the namesake platform gets a lot of the publicity, but it also owns Instagram. It also owns WhatsApp and messenger, and all of those platforms have over a billion users and they all have different models in terms of making money. Some of them aren’t monetized yet, but the common denominator with all of the Facebook properties is that they have a really strong network effect.

Facebook has begun reporting this combined to have 2.7 billion users that use at least one of the Facebook properties on an active basis, which is just a remarkable number to think about. Most people are familiar with what a network effect is, each user increases the value incrementally for all the other users. Facebook is valuable because you know the whole world is on it. Instagram is valuable because it’s where all your friends are. WhatsApp is valuable because that’s how you communicate with family and friends.

The great thing about the network effect is that its moat is actually widening as it grows. It gains strength, the larger it gets. The sheer size of Facebook’s network at this point is what I think makes it durable. I think people underestimate how durable it is. In fact, it’s not invincible, for sure, but I think it’s more durable than the market currently believes. So just like Facebook itself, forget about Instagram and WhatsApp, I think, eventually, those platforms could be more valuable than Facebook itself.

What’s interesting is just on Facebook, the namesake platform, it has 2.4 billion monthly active users. What’s remarkable is that it added 55 million new users in just the last three months alone. In the last year, it’s added 179 million users. To put that in perspective, Twitter has 300 million total users, Snap has 200 million users, and Facebook added 179 million in just the last year which is almost Snap’s entire user base.

The point here is that when you have 2.4 billion people using your network, I think it’s more durable than people realize. Another way to put it in perspective is MySpace had 75 million users at the peak in 2008, which is about 3% of Facebook’s current user base. So, to me when I think about Facebook, it’s a great business model that’s highly profitable. The network is very strong, and despite the constant negative headlines, the evidence is at least to this point, it continues to grow users. It’s growing revenue, it grew at 26% last year, and it doesn’t suggest that the platform is in terminal decline, but you might think if you focused on the headlines.

Preston Pysh  5:48 

So John, the story about Facebook is a story about accelerated growth. Currently, the top line of the company is bringing in almost $60 billion a year and the annual growth rate over the past five years is 48% annually. For a company this size, the growth rates are somewhat absurd. As we look to the next five years, five to 10 years, what kind of growth rate can we realistically expect out of a company of this size?

John Huber  6:14 

I do think there’s a long runway ahead. So, Facebook, as you mentioned, I think 55 billion in revenue last year, it grew its revenue at 26%. In the most recent quarter, it’s not just an incredibly profitable business, but it’s still growing very fast, not growing as fast as it was obviously, but it’s still growing at a fast clip when I analyze companies and when I think about investments, Stig, I don’t really build spreadsheets to try to get overly precise with estimates because I think that leads to a false sense of precision. I’m a big believer in the the idea that it’s better to be approximately right than precisely wrong. So, when I think about Facebook and its runway, the company the way I think about it is the company did 55 billion in ad revenue.

That’s just a single digit percentage of the $600 billion global advertising market and that $600 billion ad market does not include certain expenses that companies spend. They get classified as marketing. So certain things like direct mail, billboards, even product placement fees that food brands pay grocery stores, for example, if we include those marketing expenses, which are dollars that could easily transition to companies like Facebook and Google eventually, then we have an addressable market that’s over 1 trillion and it’s growing at 5% annually.

So, a trillion dollar market that Facebook only has about 5% share of, and a trillion dollar market that’s adding $50 billion a year, which is about the size of Facebook’s current business right now. In short, it’s a big pie. The pie is growing, and Facebook only has a small slice of that pie, still.

Stig Brodersen  7:40 

As you mentioned, the vast majority of Facebook’s revenue is really generated through digital advertising. Could you outline the competitive situation between the main players in the space – that would be Facebook, Google, and now Amazon has also started to come into the space.

John Huber  7:55 

You have the main competitors. Google did $115 billion in ad revenue last year, Facebook did $55 billion in ad revenue, and Amazon did about $10 billion in revenue. So those are the three main players. Facebook’s still five times the size of Amazon. Obviously, Amazon is growing much faster, but they’re coming off a small base. The way it breaks down is Google’s growing the slowest, but it’s the biggest. Amazon’s growing the fastest, but it’s the smallest. All three of them are still growing fast.

A big reason for that, I think is that the overall digital ad market is still growing fast. In the US, the digital ad market is about $130 billion and it’s growing at about 20%, still. So, the digital ad market continues taking a share of the overall ad market, and I think all three of these companies are going to benefit from that tailwind going forward. They are competing with each other. Amazon is right about at the current moment, I think beginning to maybe take a little bit of share from Facebook, but the pie is still growing at such a clip that all three of those companies are still growing fast.

Preston Pysh  8:51 

So John, talk to us about the future of digital advertising with the rise of AI and deep machine learning. Experts in the industry talk about a new competitive situation where the best digital marketing platforms will have close to 100% of the market share. How do you see the competitive situation in a world where big tech companies will know even more about us and can target us much better than they are already today?

John Huber  9:15 

I don’t think anyone will get 100% market share. The big ad agencies are basically the capital allocators for the big advertisers, so those guys are the incumbents. They’re the middlemen in the industry, and they basically help the advertisers decide how to spend their advertising budget to oversimplify it. This is changing the ad agencies are losing their foothold. And in large part because Facebook and Google are becoming so big, and so the balance of power has shifted. Some advertisers can just go directly to Google, for example, and just cut out the middleman but generally, the ad agencies still have a strong position. I don’t think this changes overnight.

There is a lot of inertia in that business just like it’s similar to the mutual fund business. The mutual fund in terms of the inertia, when you think about mutual funds, are they providing their investors with value balance? Most of them are not, but it remains a trillion-dollar industry because of inertia. That’s the case right now in the ad world. Another similarity, actually, between the ad agencies and the mutual fund industry, is they both preach diversification. It’s not the best way to allocate capital, maybe, whether it’s advertising or investments, inertia means that’s likely to be slow to change.

I don’t think any company will get all of the market because advertisers, whether they’re using ad agencies or not, advertisers don’t want all of their advertising eggs in one basket, so to speak. The shift will continue, and you bring up a good point, I think more and more dollars are going to flow towards higher return platforms but I don’t think it’ll flow all to one company. I do think there will be competition.

You’re seeing it right now, as we just talked about with Amazon. Amazon is is a $10 billion ad business right now, which is a big business. Much smaller than Google and Facebook, but they are competing with Google and Facebook effectively right now. You’re actually seeing more of a balance of power. At least when you think about the oligopoly that it used to be; you’re seeing a third competitor emerge as a viable competitor in that space. I think that will continue but in general, ad dollars are going to shift from low return platforms to higher return platforms. I think that will continue.

Stig Brodersen  11:13 

If you consider what Facebook is doing in digital marketing and what Google is doing in digital marketing, it seems like today, you need so much computer power to compete with someone like Facebook, where you can go in and say, “Okay, I spent $1.2 million in marketing and I got $1.8 out of it. Then you can simply go in and say, “Okay, I want to spend up until I have a marginal cost that is exactly the same as my marketing revenue of doing this.” Like this has never been possible before. That really goes more to the thesis of why wouldn’t advertisers just go to where they get the best return, because it’s so transparent today compared to what it used to be?

John Huber  11:48 

It’s a great question, and I think the answer is that it is happening. That shift is occurring right now. When you think about it from an everyday example, like when I drive down the road, and I’m listening to some sports radio, talk radio or something. I hear the same advertisement. I’ve heard the same advertisement from this local plumbing company for probably 10 years. If you think about how that business works, the sales executives at the radio station have developed a relationship with this plumber, and he’s the owner of a small business, maybe his plumbing company does a couple million dollars a year revenue. It’s a fairly good-sized plumbing contractor here in the local area.

Maybe 10 or 15 years ago, he decided his business was growing, he’s going to take out an advertisement. At that point, you could advertise in print, on television, on radio. Radio might have been the most cost-effective thing to do, and over the years, he has developed a relationship with his sales guy and that process continues. There’s a lot of inertia. So, I think part of the answer to your question on why wouldn’t that shift automatically happen right away, I think human relationships get involved and things are slow to change, but I do think things are changing.

I had lunch yesterday with a friend of mine, and he runs a painting business here. He’s got about 40 employees, his painting company does about $3 million a year in revenue. So, he’s got a decent advertising budget for a small business, and he was telling me he’s ramping up his spend this year because his returns have been so good on advertising. He advertises on Google. He does Google AdWords, he does advertising on Facebook, and I think he does some Instagram advertising as well.

You know, 20 years ago, this type of business would have been called on by people in those same sales departments of the local radio station, but for my friend, he’s never going to take out a radio ad, he’s never going to buy a print ad in the paper, he’s only going to use these high returns. So, as that change occurs, it doesn’t happen overnight. It might take years for the shift to occur, but eventually, the superior economics of digital advertising overcome the inertia that currently keeps people from making that shift. So I really believe that’s the reason why more dollars haven’t shifted already, but that process will continue over time.

Stig Brodersen  13:57 

John, we’ve had the privilege of talking about a dominant or even 100% market share without talking about antitrust and digital privacy issues. Of course, we have to address that too. The other discussion was much more a philosophic discussion of where we see this going, but we also know that the government can go in and intervene. How do you, as an investor, look at the concerns that surrounds all the big tech companies at the moment, and especially Facebook?

John Huber  14:22 

It’s something that’s obviously top of mind right now, and I’ve spent some time thinking about it. One thing that’s interesting is barriers to entry are lower today than I think they’ve probably ever been before. It’s because of these big four tech companies. When you think about antitrust, in the U.S., it’s very consumer centric. So is it harmful to the consumers? That’s really one of the key tests when you think about antitrust law here in the U.S.

In Europe, it’s different. It’s more focused on competition but when you think about it from the users’ perspective, we’re using these products for free and there’s an argument out there that we’re paying for these products, not in money, but the exchange of data. That’s true but there’s nothing that says we have to use social media. So, if you don’t like that exchange, if you don’t think you’re getting fair value for that payment, that data payment, if you call it that, then you don’t have to use the product. Nothing forces us to use Google or Facebook or any of these platforms.

From a consumer perspective, it’s a hard argument to make, but from a competition perspective, I think that’s where antitrust law is kind of heading. At least it seems that way. That’s interesting to think about. If you’re a small business today, from my vantage point, you have the chance to compete against these large incumbents for the first time really, in history.

Think about Dollar Shave Club. It got off the ground with a YouTube ad. If not for YouTube, Gillette would still be dominating the razor blade industry, for example, and people would be paying way too much for razors. Kraft Heinz would still be dominating the grocery store shelves or Campbell’s Soup, these big incumbent brands had huge advertising budgets, huge margins, and it was very difficult for small upstart competitors to compete.

I enjoy running and so when I scroll through Instagram, I see all kinds of relevant ads for clothing, energy bars, health food, workout equipment, running shoes, and by the way, I find the ads extremely relevant and useful. But the point is that I see ads all the time of small companies, clothing that’s manufactured or produced not by some VC funded startup but a legitimate owner funded small business that can compete using a tiny advertising budget and in some cases compete very effectively with much larger competitors.

You look at the thousands of small businesses that have been created using the tools of Amazon’s ecosystem, merchants can now buy their goods, store their inventory, locate buyers, ship to those buyers using nothing but Amazon’s platform. Oftentimes, the seller is able to make a sale and collect cash on that sale before even paying for the inventory. So, in other words, they get the cash up front, that negative working capital gives them the ability to compete with their better resourced and much larger competitors.

Amazon stores the inventory, handles the fulfillment, accepts payment, deals with the returns, handle shipping; all of that has enabled small businesses that 10 years ago, 15 years ago, would have had absolutely no chance to even consider getting into that business. So, I actually think it has spawned probably thousands of small businesses that wouldn’t have been in business, if not for these big tech platforms. It seems to me that they’ve created an enormous amount of competition on balance, and that might be sort of a contrarian viewpoint; but there are certain aspects of their behavior that could certainly be argued as anti-competitive.

Google got in trouble with the EU, for example. Amazon might prioritize some of its own private label products over competitors’ products, and that could be a problem. I don’t think there’s a lot different than what Kroger does, for example, putting their private label stuff strategically positioned on the shelf. But certainly, you could argue that Amazon’s algorithms make it unfair for competitors, but on balance, I wholeheartedly believe that the existence of these platforms have significantly enhanced competition and consumer benefits. I think a lot of people are looking at the negative aspects of these companies while simultaneously ignoring the incredible achievements that they’ve had.

It’s like looking at the liability side of the balance sheet without describing any value to the asset side. There might be regulation. There should be some regulation involved, but on balance from the user’s perspective, it’s free and I think on balance it has created competition. In terms of antitrust, another interesting thing I’ve been thinking about, I recently read a book by Ida Tarbell called The History of the Standard Oil Company, and it’s basically a collection of the original pieces that Tarbell wrote for McClure magazine.

She was the famous, probably the most famous muckraker, as they called it. It’s an interesting book to read because it was written in 1905 before the Supreme Court famously broke up Standard Oil in 1911. Tarbell was instrumental and she was actually a catalyst in getting the American public, and by extension, elected officials to rethink regulation and legislation, and in fact, enforce. The Sherman law was actually in place since 1890 but she was really the catalyst or one of the catalysts that got Roosevelt and his administration to begin thinking about actually enforcing it.

The reason I bring up Standard Oil is because I constantly hear people refer to Standard Oil when they’re talking about antitrust. It’s obviously the most famous case, so that’s not unwarranted. The Standard Oil behavior was so blatant and so egregious, just a classic monopolistic behavior. They basically consolidated the oil industry to gain market power. They colluded with railroads to fix prices on competitors. The deals they struck with the railroads are especially egregious.

What they did is they would not only negotiate kickbacks from the railroad for their own shipments, but they also demanded royalties from the railroads on competitors’ shipments. So competing refiners not only had to pay higher prices to ship each barrel of their oil, but part of that higher price was going directly into the pockets of Standard Oil, which is just free profit. They had a monopoly in a certain region would put these independent refiners out of business. Then of course, Standard Oil was able to gouge consumers and raise prices.

That’s the most famous case in history. Obviously, the monopolistic behavior was harmful to both competition and consumers there. It was literally restrictive on trade and forced refiners out of business. So, it’s interesting to compare, I think comparing that behavior with the behavior that you see today at the big tech companies is really night and day. The big four tech companies on balance, they’ve created greater selection of products and services. They’ve lowered prices. Like I said before, I think there’s more competition now, not less on balance, and there’s more transparency, too.

Standard Oil was the exact opposite. They lowered selection, they increase prices, and they hurt competition. So when viewed through the traditional lens of antitrust law, does this business restrict trade? Is it harmful to the consumer? I think it’s a hard point to argue on balance.

Preston Pysh  20:44 

So my next question is about Facebook’s management team. They’ve been widely criticized recently. Talk to us about whether you think Mark Zuckerberg and Sheryl Sandberg are the right people for the future of Facebook.

John Huber  20:59 

You know I actually think the management team is outstanding. I think they genuinely want what’s best for the ecosystem, and I think that’s evidenced by the enormous amount of money they’re spending to try to correct those problems and stabilize their ecosystem. They are long term oriented, which is a good thing. I think they could easily make more profits right now, if they were concerned about quarterly earnings, which they’re not. Obviously, that would be detrimental to the long-term health of the platform. So I think their motivation is in the right place.

One of the things I think about when I’m investing in companies now is whether or not the company is adaptable to change. I just talked about this in a recent discussion with someone but when you think about the technology sector, nowadays, you used to have 10 or 11 sectors in the S&P 500. You used to have the technology sector, the manufacturing sector, consumer staples, and real estate, retail and so forth. Technology used to be siloed in its own sector, nowadays, technology to touches all aspects of business.

Like I said before, these big incumbents like Kraft, Campbell’s, Coca Cola, they had a business model that didn’t really need to change much for 100 years, they didn’t really need to be adaptable to change because of that. Nowadays, I think because of technology, you have to be thinking about change if you’re in business, because change is much more of a constant now than it used to be. I think it’s really important to think about, and when you think about Facebook, I think they’re very adaptable to change.

The desktop shift to mobile was a very difficult change that needed to be made, and it was difficult because it was at a time when Facebook was just becoming a public company. Zuckerberg took the long view on that and effectively made the switch from desktop to mobile. Another example is text to photos. He bought Instagram, constantly looking where the puck’s going and being able to change your company and adapt to these changes as they come up is a very important thing to think about when you’re analyzing management teams these days. I think Zuckerberg and Sandberg have done a great job of that.

Have they made mistakes recently, in terms of Cambridge Analytica and the data privacy issues? Certainly their response to these issues at times could have been better. I definitely want them in charge of the company because in 10 years, you don’t know what that platform is going to look like. I think it’s very important to have a management team that is going to take that network of 2 billion people and shift it and steer it where it needs to go.

Stig Brodersen  23:26 

John, we had you on the show, Episode 154, and we’ll definitely make sure to link to that in the show notes. You pitched a very interesting stock at the time, it was Tencent. Tencent, Alibaba, and Baidu are the three main players in digital advertising in China. You might even say today that it’s not the big three, but the big two with Tencent and Alibaba. It’s very difficult to measure how much data these companies have. For obvious reasons, it’s not public, and we don’t necessarily know how much data a company like Facebook has.

We talked to Kai-Fu Lee, and he’s the former head of Google China and whenever he’s talking about the collection of data, he thinks that China is just lightyears ahead. Like they have access to so much more data and will have access to so much more data for various reasons that don’t have the same issues with privacy policy over there. If you look at this from Facebook’s perspective, currently, the two or three Chinese giants generate very little revenue on Facebook’s core market. Are they a long term threat to Facebook?

John Huber  24:25 

When you think about China, there’s this popular saying if they want to build a road, they just go build the road, right? You got two weeks to leave your apartment. That’s how they’re able in many ways to get so much accomplished so quickly, whereas it would take us six years and all kinds of fights and courts to build that type of infrastructure. I think it’s the same with data as you’re mentioning it. They can get the data. These companies like Tencent, Alibaba, and Baidu are essentially partners with the government when it comes to data collection practices.

So yes, I think in China, you understand that your data is not private. In terms of competition, I think there are two very different markets that have evolved. I think you have sort of the walled garden market of China, and that has spawned these homegrown national champions, the three that you mentioned, and specifically, Tencent and Alibaba.

The U.S. companies like Facebook and Google are excluded from that market, so they’re not really able to compete. They’re not allowed to really do business for the most part in China. You have the Chinese domestic companies that have already won China, and they will continue to win China. I don’t think anybody’s going to displace those companies for the foreseeable future, certainly not an outside company.

Conversely, the U.S. based companies, I think, have a much better chance of continuing to dominate their market. I think the two can coexist. You look at WeChat, it has had a hard time expanding outside of China. WeChat is about as strong of a moat, as sticky as a product, as you can imagine. I think you’ve been to China, Stig. I’ve been to China. When you go to China, you can’t really get around without WeChat, right? But here in the U.S., nobody knows it. I mean, people know what WeChat is, if you study businesses, but your average consumer doesn’t use and has no idea what WeChat is.

They’ve tried to expand; I think they’ve had a hard time doing it. I think it’s a testament to the power of the network effect. In China, no one needs Facebook because they have WeChat and outside of China, no one really needs WeChat because of all of the other platforms that they’re already on. Everyone else uses WhatsApp for chat, and they have their social networks that they use – Instagram, Facebook, others – and so I think it’s very difficult for those to compete. I think in general; you’re going to see that continue. I think Alibaba has tried to make inroads in the U.S. and they’ve struggled in terms of getting into the e-commerce market.

Again, conversely, Amazon tried to go to China and they couldn’t do it. I think they got up to 1% market share and they had to close up shop. The winners that already had the leg up are very very difficult to dethrone and that’s a good thing if you own stock in those companies. I don’t think that you’re going to see those companies go outside of their borders. Of course, Facebook’s worldwide, but I don’t think you’re going to see Facebook going to China, and I don’t think you can see WeChat go outside of China.

Preston Pysh  27:04 

So John, if the threat isn’t China, what is the threat in your eyes?

John Huber  27:08 

I think the biggest risk is a change in consumer behavior. I don’t think it’s antitrust, I don’t think it’s a competitor from China. I think it’s potentially a competitor that doesn’t exist today. Again, think about these platforms, and this is why it’s so important to think about the adaptability to change concept that I was describing earlier. You don’t know exactly what this platform is going to look like. My bet is that the management team is going to do an effective job at steering the 2.7 billion users toward wherever they need them to go.

That could be Instagram like they’ve already done, that could be to WhatsApp, that could be the more private messaging like Zuckerberg has outlined. I think his priorities are shifting more towards what he calls away from the town square, which is Facebook proper, and more towards private messaging, which might be more like WhatsApp, for example. Those shifts will continue, and I think they will have a very good chance at monetizing the massive user network that they have. That’s a very valuable asset that’s not going away anytime soon.

When I think about the threat of Facebook, the biggest risk is people leaving the platform. The key variable to think about when you analyze Facebook is what is the health of the network. I outlined it earlier, but the health of the network despite what you read about in the newspaper, to me, all the evidence points to the network remains healthy. When I say healthy, I’m not necessarily talking about the discourse, I know there are issues there, but I’m talking about the number of users that are actively engaged in the platform.

Facebook has 2.375 billion users that log in every month. They use the service and that has grown by nearly 200 million users in the last year. So users are up despite virtually the entire world outside of China being on Facebook, being on internet using world. They still continue to add users at a really remarkable rate in terms of the gross number of users. Then the revenue of the platform is obviously growing very fast as well. So that’s the key variable to watch. That could change, but there are other places where that could go.

One of the things we haven’t talked about yet is the announcement. They may just this week, which is their new cryptocurrency and to me, Facebook’s currency is much less of a cryptocurrency, at least the way I would think of it. A lot of the crypto world now, like Bitcoin is used for speculation more than it is any medium of exchange, I think Facebook currency is actually going to be a medium of exchange, and that could prove to be very valuable for Facebook. It could increase the number of transactions that take place on the platform, which will indirectly have a positive impact on advertising.

If businesses are doing more business on the platform, they’re going to be incentivized to advertise more on the platform. I also think the new payments could have an impact outside of platform. In other words, you might use Libra to pay for goods at a brick and mortar store, and it could be very disruptive potentially to the incumbents in the payments industry. It’s very expensive, I mean, Facebook outlined this in their white paper, but it’s expensive to send money across borders, especially if you’re in an area of the world where you don’t have a bank account. It costs as much as 7% to send money home to your family. So Facebook can do that for free with this new currency if it gets up and running.

There’s a lot of question marks surrounding it, but it could be a real boon for their business. That’s an example of something where I think the management team is again, looking forward through the windshield and trying to steer the ship where they think it needs to go. Those types of changes will continue but I think they have a very good chance with that user base that they have. Their user base is sticky and they have a very good chance to maintain their current position.

Stig Brodersen  30:51 

Payment processing. It’s very interesting that you would bring this up here in this discussion. We just talked about China and they have Alipay and WePay. It’s just the realization that if you have people’s wallet, you can really start making money off of them. A lot of people have realized that today, and they also realize how difficult it is. Just one example, Apple Pay, for instance, it’s been very, very tricky for Apple to roll that out. There are so many competitors in that space right now who are offering different products, you might say. There’s Square or PayPal, and then you have the grand old MasterCard and Visa who are doing their own thing. Why would Facebook be successful with their payment processing, call it cryptocurrency or not?

John Huber  31:27 

I don’t know. There’s a lot of uncertainty. I mean, this just came up this week so it’s not something that entered my mind in terms of a reason to buy the stock. I’ve own the stock for about a year now or somewhere around that mark. This was not real. It was always a potential that Facebook could get into payments, but this is just something that if it works, it could be a potential game changer. If it doesn’t work, it’s not really going to be that big of a problem. It really won’t be any problem because it doesn’t exist now.

I think Facebook’s business is going to be just fine without the payments. I do think there’s a potential advantage when you have so much natural interaction on the platform between two different people, and between businesses and individuals. If you have your own, you can call it whatever you want, but let’s call it ‘currency’. You have your own currency or just method of payment, it just reduces the friction in that transaction.

So if I see an energy bar on Facebook that with a click of a button I can buy without putting my credit card info in, and I might have saved that already. There are two advantages. One, I think it reduces friction for the users, and two, it’s less costly for the merchant. The Visas and the MasterCards, and some of the other incumbents are probably making profits that I don’t want to say they’re exploiting the system, but they’re certainly making hefty profit margins. I think there’s a case to be made that those profit margins could decline and someone else could come in and offer a better value for the merchant.

I think it has a potential when you have, again, 2 billion people engaged. You have this natural ecosystem where some sort of a medium of exchange could be a real benefit to that platform. It could reduce the friction, it could lower costs, it could increase transactions, and then it could benefit Facebook indirectly through higher advertising. Then of course, maybe directly as well, it could become a platform somewhat similar to WeChat payments, where it’s used not just online, but offline as well.

Preston Pysh  33:17 

So John, we’ve talked a lot about the qualitative factors, but I’m curious what your evaluation process is, and how you go about your methodology for figuring out a value for Facebook.

John Huber  33:28 

When you think about Facebook, and this goes for any investment I make, I’m always thinking about the key variables of the platform. If you get the variables right, I think your investment case either works out or doesn’t work out based on those key variables. So the key variable here, as we talked about, is the health of the platform going to remain strong? And if it does, I think Facebook is going to continue to grow.

So just like I said before, I don’t like to be precise with my valuation work, but when you think about Facebook, it did $55 billion in advertising revenue last year. It’s a $600 billion market that again, could be over a trillion dollars if you factor in other expenditures that could be classified as advertising. So in my mind, Facebook has about 5% of the global market. Some of that’s off limits, as we talked about in China, maybe 20% of that’s off limits, because they’re not going to go to China, but they have a single digit percentage of a very large and growing pie.

Facebook’s currently growing at 25% a year, I think that growth rate’s going to slow down. It’s very realistic to think that Facebook is going to grow at say 15%, which means their advertising revenue is going to double in the next five years, and Facebook had 40% profit margins last year. This is a business that has very little incremental costs associated with each new ad that they show.

There are some costs and certainly they’re growing their expenses right now in an effort to correct some of the issues they have and they’re making some investments. I do think it’s very likely that in five years, their profit margin will be just as high as it is now, if not higher, because I do think there’s a lot of incremental operating leverage inherent to that.business model. So with a business that does $110 billion, double what it is now, that’s about $45 billion and close to 50 billion in profits, potentially.

I think they’re going to start doing more buybacks with the cash that they have available. They’ve done some, they did about $10 billion in the last year or so, which is a lot in gross dollar term, but it’s not a lot, maybe 2% of their float. I think that’s going to ramp up as these expenses level off. The expenses are not going to level off. The expenses will continue to rise, but they’re not going to rise faster than revenue forever. They are right now and they might for the next year or two, but you’re going to see that operating leverage come back.

So if you have a business that does $45 or $50 billion in profits, and it can retire, say 3% of its flow every year, for the next five years or so, you’re looking at a company that’s going to produce close to $20 a share somewhere in that ballpark. You can discount that back at whatever you think is fair, but I think it’s likely that Facebook is a $350 or $400 stock at that point, and so you kind of discount that back and compare it to what it is now.

When I did this a year ago, the stock was at $150 and I thought Facebook’s going to produce $15 a share in four or five years, and that’s a stock that’s probably worth $300, double what it is here. So I do think there’s a good chance for Facebook even without any increase in the valuation that you’re paying. In other words, no increase in the multiple just to the growth, you’re going to get a satisfactory resolve. I think the downside is limited, because the business is so good, and it continues to grow. That’s kind of how I think about the valuation. I don’t think it’s a lot of downside and there’s a good chance you get a satisfactory return over the coming years.

Stig Brodersen  36:34 

Fantastic, John. We’ll definitely make sure to link to all your letters and notes that you have on your website. We’ll do that in the show notes. I just want to say that Preston and I learned a ton from you here today. I’m sure everyone in the audience feels the same way. So John, thank you so much for taking the time to speak with us here today on The Investor’s Podcast.

John Huber  36:51 

Thank you very much. I really enjoyed it.

Preston Pysh  36:53 

So at this point in time, we’re going to play a question from the audience. This question comes from Audrey.

Audrey  36:59 

My name is Audrey Salus. Thank you for the friendly fill that TIP provides its listeners. My dad and I are interested in becoming stock investors, but the question is if we can truly be successful at it since there are many variables to be considered, with some success, we have been investing for the past few years. Our question is, is calculating the intrinsic value of the stock enough to be able to make educated stock picks?

Stig Brodersen  37:23 

Thank you for question, Audrey. The short answer is no. You need to understand all the other variables before you can make an intrinsic value assessment of a specific stock and create a successful portfolio. Perhaps I can best illustrate this by the valuation process of a company like Facebook. If you want to estimate the intrinsic value, your starting point has to be the normalized cash flows, and basically that means it is what a company will make in a normal year.

Before you can make that assessment, you really need to understand the business in depth because the numbers that you read the financial statements are likely not the normalized free cash flows. Perhaps they are investing more or less than usual and perhaps they are at the top of the cycle. This is all something you need to include in your analysis. Then even when you have your normalized cash flow, you still have to protect to potential growth scenarios. So, one thing is to understand the business but also really to understand the industry that they’re operating in.

So for Facebook, you might say that their business in advertising is growing, say 15% per year, and you use that as your short term growth rate. Or you might have a qualified estimate on why you think that Facebook would take market share in that market. Plus, you also have to include if you have reasons to believe that Facebook can make money from other initiatives like the new crypto initiative, Libra, and your estimate of the value really depends on those growth projections too.

So while there’s no reason to make stock investing more complicated than it really is, if you look at this in the perspective of constructing a portfolio, you can have many stocks that you estimate are undervalued. You also have to consider correlation and which underlying factors could influence the health of the entire portfolio. Audrey, really to answer your question, and I know I said the short version was no, this was the longer version, then I would say that the intrinsic value assessment comes after you understand all the other variables, rather than your starting point for building a stock portfolio.

Preston Pysh  39:24 

Audrey, I like your question a lot because you seem to have a deep appreciation for how difficult stock picking is. It is not easy, and I’m going to answer your question a little bit differently than Stig did, since he addressed the question head on. So here’s what I want to tell you. If you decide that you want to pick individual stocks, I think it’s so important for you to understand the importance of having at least 10 to 15 different picks. If you can make those uncorrelated picks that’s even better because the fact of the matter is, you’re definitely going to make mistakes, and if you participate in the markets long enough, you’re going to put on a bad position and by having at least 10 to 15 positions in your portfolio, you’ll at least limit your downside risk and allow yourself the opportunity to learn and continue to optimize your approach as you’re moving forward.

The intrinsic value is a vital part of the process. If you don’t have an idea of what the intrinsic value is, you probably should not be investing in stocks. It’s no different than buying a business on Main Street. If you’re going to buy a small business and you don’t know what the return is going to be for your down payment or for your investment, you’re most likely going to have a very volatile experience owning that business.

Like owning a small business, it might work out and I would attribute that if you didn’t come up with a valuation and you just started a business on a whim and didn’t do any of that math and ended up being successful. I would argue that it was probably more attributed to the luck or just your sheer passion for what you were doing, and it’s probably a lot lower likelihood of being successful because most of that is going to math behind luck.

So, I would tell you that stock investing is not much different than that scenario. When you’re investing, you need to think of it in that light. Like Stig said, the other factors beyond the valuation are vital, especially if you’re trying to come up with an expectation for what you think those growth rates are and what the potential risks are moving into the coming five to 10 years. So try to understand what those are and then once you understand what those are, try to quantify that and conservatively build that into your valuation and your intrinsic value.

So, Audrey, we loved your question. We have an online course called our Intrinsic Value Course, that we’re going to give you completely for free. Additionally, we have a filtering and momentum tool, which we call TIP Finance. We’re going to give you a yearlong subscription to TIP Finance completely for free. Leave us a question at asktheinvestors.com, that’s asktheinvestors.com. If you’re interested in these tools, simply go to our website, theinvestorspodcast.com and you can see right there in our top-level navigation, there are links to TIP Finance and also the TIP Academy where you’d find the Intrinsic Value Course.

Stig Brodersen  42:09 

Alright guys, that was all that Preston and I have for this week’s episode of The Investor’s Podcast. We’ll see each other again next week.

Outro 42:17 

Thanks for listening to TIP. To access the show notes, courses, or forums, go to theinvestorspodcast.com. To get your questions played on the show, go to asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP Network. Written permission must be granted before syndication or rebroadcasting.