Monday, August 31, 2015

"Big Markets, Over Confidence and the Macro Delusion!"

From Musings on Markets:
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 aburgeoning 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.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.... 

We have linked to some of Professor Damodaran's Greatest Hits including:

And many more, use the Greatest Hits link if interested