During the last week, some very smart investors have been writing about Facebook’s acquisition for AUD21 billion of an app that, up until the announcement, I hadn't heard of. One successful fund manager wrote, “Clever people are doing things I don't understand and I am just feeling old and tired.”
The comment reminded me of those made by Warren Buffett in 1969 who, after the heady go-go days of the bull market, shut his private partnerships and handed all the funds (and Berkshire stock) back to investors, saying:
“The investing environment … has generally become more negative and frustrating as time has passed. Maybe I am merely suffering from a lack of mental flexibility … Quite frankly, I just don’t see anything available that gives any reasonable hope of delivering such a good year and I have no desire to grope around, hoping to “get lucky” with other people’s money. I am not attuned to this market environment, and I don’t want to spoil a decent record by trying to play a game I don’t understand just so I can go out a hero.”
One observer commenting on security analysts over 40 stated, “They know too many things that are no longer true”.
What's happening?
Something is up. Money is cheap and there’s oodles of it that has to find a home. Arguably, there’s even more looking for a shrinking universe of safe harbours as it flees the emerging markets.
Coincidently, local commentators are excited that Joe Hockey has, apparently single-handedly, aligned the G20’s leaders to ‘go for growth’, and then suggested it will translate into further gains for the stock market.
Ashley Owen's articles in Cuffelinks (linked here) support Warren Buffett’s research that there is no relationship between economic growth rates and stock market performance. It is interest rates and corporate profits as a percentage of GDP that drive longer-term returns.
In this environment, it comes as no surprise that you have Facebook buying WhatsApp for more than the international debt of Sri Lanka, Tunisia, Cuba, Ecuador and a litany of other countries.
And you have Xero, the New Zealand cloud-based accounting software provider trading on a market capitalisation of $4.6 billion, even though it is yet to turn a dollar of profit from it 250,000 customers.
You might remember the tech boom of the late 1990s which peaked just as earnings multiples and book values had finally succumbed to new valuation metrics that relied on clicks and users, with little thought paid to how this traffic would be monetised.
Facebook has paid AUD46.70 for every one of the 450 million monthly WhatsApp users who send each other text messages, photos and videos via the internet, bypassing the costly mobile phone networks. You have to wonder how you are going to extract money from those who can’t afford to pay or don’t want to pay to send a text message on a mobile phone network.
Xero is trading on an eye-watering market-cap of $18,400 per user. According to Xero’s website, the most popular package is $720 per year. The annual revenue run rate might be $180 million if everyone was subscribing to the most popular package. The company is trading at 26 times revenue and there’s no profit as of yet.
Bricks versus clicks
You don’t need to be old and tired to realise that unlike the gold rush of the 1800s, online real estate is not in short supply. It is abundant and probably infinite and even if you secure the competitive advantages associated with the network effect by being a first-comer, online customers can still prove to be disloyal and fickle. And switching costs are low, as my team demonstrated recently by changing back to MYOB from Xero without a hitch.
Despite this, Xero’s market capitalisation is about the same as Flight Centre or Bendigo and Adelaide Bank, whose 2013 profits were $269 million and $359 million respectively. Xero’s market cap is higher than TPG, Platinum Asset Management, Boral and Tatts Group.
There have been some spectacular failures over the years in the internet space and I am not suggesting that Xero or WhatsApp will join the list. However, you do need to think about investing to the slow and gentle chime of an old grandfather clock, not to the rapid and almost hyperactive beeps of a Formula 1 team’s stopwatch.
It seems the pendulum is still swinging towards the cheap and easy money, and the delight of big deal-making will spur investment bankers to encourage others to do deals. These, in turn, will draw a crowd and prices will move ahead.
As I have said here previously, we haven’t seen the bubble yet but the seeds are germinating nicely.
When the investment pendulum swings back however, just as surely as it does on the grandfather clock, heady takeover premiums will give way to big write-downs and investors who savoured the best of the party will carry the worst of the hangovers. Then the previously old and tired might gain a bit of a spring in their step.
Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able‘