Tag: investing

Why I Own Disney Shares

Why I Own Disney Shares

“It’s not share of market. It’s share of mind that counts.”

Warren Buffett

The happiest place on earth. It is near impossible to replicate Disney’s share of mind even if you have all the money in the world.

The Disney name is well-known to billions of people. It has a meaning, an emotion perhaps, attached to it globally.

It is hard to find another brand that is unanimously known as the happiest place on earth.

With Disney+, it is now able to ship this happiness at an unprecedented scale.

Creating movies profitably

In Berkshire’s 1996 annual general meeting, Buffett explained why Disney makes money for shareholders. Unlike many other movie companies.

Most movie companies are able to make a lot of money. But they make a lot of money for everybody else (e.g. acting cast, directors, etc) except for the shareholders.

Buffett shares, “The nice thing about the mouse (Mickey) is that he doesn’t have an agent… He is not there renegotiating (his salary).. every week or every month and saying, “Just look at how much more famous I’ve become in China.””

From 2006 to 2019, Disney made 44 films. Each film brought in an average of…

$850 million!

Pricing power

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Warren Buffett

For Disney, let’s take a look at their pricing power pre-COVID19.

Like clockwork, Disney theme parks, hotels, and cruise has been able to raise prices at approximately 5% per year.

Taken from Disney’s 2019 Annual Report

Coming off a low base, Disney+ is set to raise its price from $6.99 to $7.99 after just 1 year since launch. In sales, it is always easier to sell an incremental dollar than the first dollar.

The oil field that keeps gushing

Disney’s intellectual property (IP) is like an oil field that doesn’t dry up. We have seen the remakes of Beauty and The Beast, The Lion King, Aladdin, and many more.

Furthermore, IP created generates value beyond the box office. Box office hits will be translated into merchandise which ranges from toothbrushes to quilts, figurines, watches, legos, and more.

A quick search for Elsa will show you an endless array of products that could bring a smile to your daughter’s face.

Buy her a counterfeit Elsa and you will see her smile melt faster than Olaf.

Getting swindled on eBay over COUNTERFEIT Frozen dolls!!

The oil field doesn’t end here. The benefits will trickle to its theme parks, resorts, vacation, and cruise packages.

Disney+

“Disney is an amazing example of autocatalysis… They had all those movies in the can. They owned the copyright. And just as Coke could prosper when refrigeration came, when the videocassette was invented, Disney didn’t have to invent anything or do anything except take the thing out of the can and stick it on the cassette.”

Charlie Munger

With Disney+, the value of all the past IPs can be unlocked at scale. As Netflix’s and Spotify’s subscription-based business model suggests, monthly subscription fees are very sticky. Providing upfront, recurring revenue for Disney.

This is different from the traditional way of spending hundreds of millions of dollars upfront (e.g. Frozen costs $150 million). Locking up tons of working capital before the movie is released, reducing the amount of free cash flow for shareholders, or to grow its IP by producing more movies.

Depending on whether the movie becomes a hit, Disney would have difficulty estimating how much cash flow will be coming in. Which leads to difficulty in budgeting for new projects.

This is all about to change with Disney+.

In its investors day on Dec 2020, Disney exceeded 137 million in paid subscriptions across its Direct-to-Consumer (DTC) services. Smashing all of its earlier estimates.

Disney+ alone produced 86.8 million subscribers, with the rest coming from Hulu, ESPN+, etc.

To put it in context, it took Disney approximately 1 year to achieve what Netflix did in 10 years in subscribers count.

Disney+ estimates have been revised from 60 million to 90 million to 230 million to 260 million subscribers by 2024.

Netflix currently generates approximately $10USD per subscriber monthly. Applying that to Disney+, this will bring in $2.3 billion to $2.6 billion in upfront recurring revenue monthly, or $27.6 billion to $31.2 billion annually.

Data is the new gold

With Disney+, imagine all the data the company will be able to collect. It will have deep insight into how Disney fans interact with its content. Increasing its revenue per Disney fan.

Oh, your son watched Iron Man for the third time in the past 2 months, here’s an ad on how he could look like Iron Man!

Ride of a Lifetime

With Robert Iger’s 15 years at the helm, he has done some massive transformation for Disney.

In his book Ride of a Lifetime, Iger started making several gutsy moves once he took over. Taking over Pixar for $6.3 billion, bringing the world of Toy Story, The Incredibles, and Monsters Inc into Disney.

The acquisition of Pixar brought in Steve Jobs to Disney’s board of directors. Prior to the acquisition, Disney’s animation business had been struggling.

Disney then went on to acquire Marvel for $4.2 billion in 2009 with Avengers: Endgame raking in $2.8 billion in global gross box office receipts.

What seemed like expensive acquisitions turned out to be great deals.

After owning the world’s most valuable superhero property, Disney followed up by acquiring Lucasfilm (Starwars, Indiana Jones, etc) for $4.1 billion in 2012.

And of course, the biggest acquisition of the Twenty-First Century Fox which closed in Mar 2019. Which ended up costing $71.3 billion by flooding their balance sheet with debt.

All these moves required Iger to do a lot of convincing to the board of directors. But Iger understood that Disney’s moat is with its IP and he has executed beautifully. Churning out blockbusters after blockbusters.

After his 15 years of service, Iger has set Disney up nicely for its big move into streaming—Disney+.

Disney’s legacy business

Disney media networks segment comprise of cable networks and broadcasting. It currently contributes approximately 25% of the operating income for Disney.

Operating margins for this segment has been declining over the years due to cord-cutting.

Streaming companies (Youtube, Netflix, and IGTV) are eating up traditional TV’s market share (eyeball time). Much like what blogs, Facebook, and Google did to traditional newspaper advertising revenue.

With this as the backdrop, Disney+ seems to make sense from a long-term perspective.

In the short term, Disney is likely to face some pressure from this segment as it keeps its best content for Disney+. But it will benefit from its streaming business tailwind in the longer term.

This is similar to Adobe’s playbook when they first transit into a subscription model. Revenue would be impacted in the short-term as they cannibalize their existing business. In the long-term, the predictable upfront recurring cash flow will greatly benefit the company.

Conclusion

It is hard to find another brand that invokes a positive emotion and create blockbuster hits after hits. With Disney+ coming up huge amongst consumers, Disney stands to benefit hugely from introducing streaming into its ecosystem—upfront predictable cash flow, monetizing past content, data, and increased revenue per Disney fan.

Disclaimer: This is not a recommendation to buy or to sell securities. Please conduct your own due diligence or consult your advisor. I merely write to improve my investment and thought process.

Thank you for taking the time to read my blog.

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Year 2020 In Perspective

Year 2020 In Perspective

Year 2020 definitely hasn’t just been another year. We actually seen the streets gone empty and the office migrated online due to COVID-19. Previously an ‘impossible’ task as many companies cited security, morale, and productivity concerns.

Whether these changes are temporary or permanent will largely be determined by how much convenience these changes bring.

Solutions that reduces friction such as contactless payment and e-commerce will be here to stay. Online classes at least for students below 16 will probably not be permanent. Work from home arrangements and online meetings will probably lie somewhere in-between.

There were many lessons I have picked up. As the old adage goes, “never let a good crisis go to waste.”

I will broadly classify my lessons to investing and writing online.

Investing

Do not interrupt the magic of compounding

Needless to say, the market caught most investors off guard with a V shape recovery.

This outlines the most important law of growing your wealth by Charlie Munger, “the first rule of compounding is to never interrupt it unnecessarily.

This comes in two parts.

Firstly, ensure that your emergency fund and insurances are adequate before investing. The worst thing that could happen during a crisis is to sell due to loss of income or medical costs. COVID-19 showed that all 3 could happen at the time—loss of income, market drawdown, and increased medical cost.

Secondly, never time the market. Most investors who cashed out during March to buy back at a lower price probably never got to participate in the upswing.

Doing the most obvious thing works

In an interview with Gavin Baker, founder and CIO of Atreides Management, his advice for navigating bear markets is to do the most obvious thing and play in the present.

Don’t let anchoring or past mistakes affect your thinking. Take advantage of the volatility and the dislocation in value.

At the beginning of the bear market, doing the most obvious thing works. For example, selling airlines and buying Costco or Amazon.

Don’t price anchor

While I have no problem averaging down. Averaging up is a tougher feat for me. A reminder to myself to always look forward, if the company has been delivering and its outlook is rosier, the company may be a better deal at a higher price.

Focus on valuation, not price.

Too hard pile

This is also the year where I revisited many companies is what Munger and Buffett calls the “too hard” pile.

“We have a method of coping: we just put it in the ‘too hard’ basket. If something is too hard, we move on to something that’s not too hard. What could be more simple?”

Charlie Munger

Apart from expanding my circle of competence, a sense of FOMO struck when I saw share prices zoomed (pun intended) skywards.

Constant reminder to self that things belong to the “too hard” pile when it is (1) companies I don’t fully understand and (2) it has uncertain prospects over the next 10 to 20 years.

Swing at big fat pitches.

Options

Previously, I wrote off options without giving a serious thought about it.

This changed after listening to a sharing by MoneyWiseSmart on how options could complement long-term investing.

Quick example, during March 2020 I wish to accumulate more of Facebook’s shares but it hasn’t reach my target price of $140. Any price below $180 was considered cheap to me.

The risk of waiting is that the market may rebound and I may never get to accumulate more shares.

I could sell put options at $130+, which would allow me to own Facebook if it hit my target price. Otherwise, I will collect the premium while waiting.

At the same time, I would use the premium to buy call options at $180. Which allows me to capture the upside if the market rebounded quickly.

Brilliant move.

Writing Online

Writing online has been great. Anyone out there who wants to write, but has been putting it off, revisit your priorities.

I’m able to learn better and think clearer. Though the biggest benefit is connecting with people smarter than me from all around the world.

Keep it simple

I have become a better learner by sharing what I know by implementing the Feynman Learning Technique:

Taken from fs.blog

I can keep it simple only when I fully understand the concept.

Other lessons I picked up as a writer this year:

Keep on publishing

There will be many days when I don’t feel like writing or don’t feel like publishing.

This is especially true after publishing articles that went viral. The voice from within that says ‘perhaps this isn’t good enough’ tend to be louder when there’s more to lose.

If we need to be 100% ready before executing, we will probably not execute at all.

Not ready? Do it anyway.

Good content is the best SEO

Be authentic. Escape competition by going in niches.

I focus on writing for myself, my own learning. The internet is a large place. You will be able to attract audiences who appreciate your specific writing style and topics.

Looking to 2021

A question I found helpful to reflect on: what would I do if I could not fail?

Often, we stifle our growth and dreams because we fear looking stupid or we have high expectations of ourselves.

I look forward to publishing more work in 2021, even those that will make me look silly from time to time. After all, learning takes place only when I leave my comfort zone.

Terry Smith on Accelerated Share Repurchases

Terry Smith on Accelerated Share Repurchases

Spent my week reading Terry Smith’s new book: Investing For Growth. Terry is the chief executive & CIO for Fundsmith Equity Fund.

I have been a fan of Terry’s presentations and writing because of his wittiness, humor, and candidness.

One of the fund managers who keep it real.

Before I jump into what Terry has to say, it’s important to first start off with knowledge passed down by Warren Buffett on share buybacks.

Buffett on share buybacks

In Buffett’s 1999 letter, he highlights: “There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated.

Capital must always be first deployed for business needs. This comes in twofold.

First, expenditures that must be made to maintain its competitive position (e.g. remodeling of Starbuck’s stores).

Second, reinvesting for growth when the management expects will produce more than a dollar of value for each dollar spent (e.g. opening more Starbuck’s stores in China).

In other words, where return on invested capital exceeds cost of capital.

After ensuring that the business needs are taken care of, share buybacks create value for shareholders only when the current market price is below its intrinsic value, conservatively estimated.

Let’s illustrate this with numbers!

How buybacks increase or destroy value

Imagine you are own ABC Corp with 2 other friends, Joe and Julie. Let’s say ABC Corp’s intrinsic value is conservatively estimated at $3,000.

The 3 of you own an equal share of ABC Corp, at $1,000 each.

For some reason, Julie decided to sell her stake back to ABC Corp, intrinsically worth $1,000.

Scenario 1: ABC Corp buyback at 20% discount

If ABC Corp buybacks Julie’s stake at $800. ABC Corp’s intrinsic value would now be $2,200 ($3,000 – $800) after the transaction.

This means that Joe and yourself now own 50% each of ABC Corp, an increase from 33%.

The value of your ownership increased from $1,000 to $1,100 (50% X $2,200).

Share buybacks has created value for existing shareholders.

Scenario 2: ABC Corp buyback at 20% premium

If ABC Corp buybacks Julie’s stake at $1,200.

ABC Corp’s intrinsic value would now be $1,800 ($3,000 – $1,200) after the transaction.

Similar to scenario 1, Joe and yourself would now own 50% of ABC Corp.

But, the value of your ownership would have decreased from $1,000 to $900 ($1,800 X 50%).

Share buybacks destroyed value for existing shareholders.

Scenario 3: ABC Corp buyback at fair value

If ABC Corp buybacks Julie’s stake at $1,000, its intrinsic value would now be $2,000.

Both Joe and yourself would own $1,000 of ABC Corp. No change from before.

In this case, share buybacks does nothing for existing shareholders.

Terry Smith on Accelerated Share Repurchases

Ordinarily, share buybacks are usually done over weeks or months with multiple transactions. The amount of buyback done each day during this period depends on the volume of shares traded.

Hopefully, the share prices remain depressed during this period as the company buyback shares.

In accelerated share repurchases (ASR), the company does a significant share buyback programme in a single transaction with an investment bank or a small group of banks.

The investment bank(s) will make a short sale to the company by borrowing the shares from the market.

Thereafter, the investment bank will purchase shares to cover its short position. And of course, fees are involved in this.

A huge share buyback programme like an ASR is bound to generate share price rises at least in the short-term. No sane company would short shares knowing that they would need to cover up their position by buying at higher prices.

But this is exactly what ASR does. The investment bank would short shares at X dollars and buyback the shares at greater than X dollars. Of course the investment bank will not bear the losses of this short position.

On top of charging a hefty fee for providing this service, the losses it incur by covering its short position will be passed on to the company.

This is exactly what IBM did in May 2007. In a 118.8m share ASR, it paid an initial price of $105.18 per share for shares purchased from the investments bank’s short sales totaling $12.5b, and then another $2.95 per share or a total of $351m to cover the high price of $108.13 at which the banks eventually closed their shorts.

They have effectively agreed to write a blank cheque to the investment bank to cover the cost of short-selling its shares. When it comes to short-selling, the potential of loss could be ‘unlimited’.

Who knows how far the share prices will shoot up when the market knows that the company started an ASR?

Study management’s remuneration

Generally, when the management is overzealous in buying back shares in good times and in bad, we can trace the reasoning back to how managements’ bread are buttered

Many of them are filling up their pockets rather than shareholders’.

Two companies we are familiar with — Domino’s and Starbucks, have loaded up their balance sheet with debt to repurchase shares.

Today, let’s take a look at Starbuck’s leadership compensation plan.

Taken from Starbuck’s proxy statement

You will notice that management is paid based on largely 2 short-term factors (over 3 years): (1) Earnings Per Share (EPS) and (2) How Starbucks share price performs against the market.

Share buybacks would help to financially engineer EPS by reducing the number of outstanding shares. Also, continuously buying back shares will likely prop up the share prices due to increase buying demand.

Starbuck’s management unleashed a huge share buyback programme. Back in 2019, it committed to return $25b on an $80b market cap.

It financed this by loading up its balance sheet with $5b worth of debt and by selling to Nestle the rights to sell Starbucks consumer package goods in grocery stores (e.g. coffee capsules and bottled coffee) for $7.15b (fantastic deal for Starbucks in my opinion).

Here, we can see from long-term debt swell up on its balance sheet:

And the cash that came in from the Nestle deal (recorded as deferred revenue back then because Nestle made an upfront payment):

Some argue that the management did the right thing by taking on debt to buy back shares because of the record low-interest rates.

Of course in 2019, when all was going well, Starbucks had more than enough cash flow to cover interest payments.

But this put the company in a precarious position. In my opinion, there’s is no need to accelerate returns by taking on debt. Especially when it makes the company more fragile to black swan events.

This is akin to what Buffett said, “it’s insane to risk what you have for something you don’t need.” With its strong cash flow and proceeds from the Nestle deal, Starbucks was in a strong position to buyback shares. There’s no need to be that aggressive and take on debt.

And true enough, 2020 gave us the biggest of black swan in the form of COVID-19.

Not gonna lie, when Starbucks stores were shutting down early this year, the debt on their balance sheet made me sweat. I began stress-testing the company to find out how long can the company survive without revenue.

You can read more about it here.

Conclusion

Share buybacks increases value only if it is done below intrinsic value. Problem arises when management are incentivized based on short-term metrics such EPS and share price performance. Management could engineer the results by misallocating capital (share buybacks or worse, ASRs) at the expense of shareholders.


Thank you for taking the time to read my blog.

If you’re enjoying the content so far, I’m sure you’ll find 3 Bullet Sunday helpful.

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Return On Invested Capital

Return On Invested Capital

Shot-termism runs deep when managers plan, execute, and report their performance in earnings per share (EPS). For example, when a company acquires a target, managers and investors often focus on whether the transaction will dilute EPS over the first year or two.

This is despite research demonstrating that increased EPS does not prove value creation. In other words, deals that increase EPS and deals that reduce EPS are equally likely to create or destroy value.

Note: Buffett’s 1984 letter is helpful in understanding the concept of value creation.

So what drives value?

Value is driven by 3 things: growth, return on invested capital (ROIC), and the cost of capital (COC).

Not all growth are equal.

Value creation happens when ROIC > COC and a company invests for growth.

Mastercard is an example where ROIC significantly exceeds COC.

Value is destroyed when ROIC < COC and a company invests for growth.

Airlines is an example where ROIC persistently stays below COC

Value doesn’t change when ROIC = COC, it doesn’t matter if the company invests for growth.

High ROIC companies create value by focusing on growth (i.e. expanding), while lower ROIC companies create more value by increasing ROIC (i.e. downsizing).

Here comes the formula for ROIC: after-tax operating profits divided by the capital invested in working capital and property, plant, and equipment (PPE).

Note that Joel Greenblatt applies the formula slightly differently: before-tax operating profits divided by the capital invested in working capital and property, plant, and equipment (PPE).

This method is helpful for comparing earnings power across different time periods, without being affected by varying tax rates.

Operating profits

Operating profits is also known as earnings before interests and taxes (EBIT).

It is a ‘cleaner’ figure to measure the true earnings power of a company when compared to net income. It includes all expenses needed to keep the business running.

Example of an Income Statement

Going below operating income, we can see items such as interest revenue/expenses and extraordinary items. For example, sales of business assets would come below the operating income.

This income from selling business assets is not conducted in the normal operations of a business and does not reflect the ‘true earning power’ of a business.

You may refer to my earlier post— Finding the next multi-bagger by understanding operating expenses for deeper understanding.

Invested capital

Invested capital represents what the business has invested to run its operations—largely PPE and working capital.

Let’s use Costco as an example for this.

Costco (COST) Hits Record High After 'Impressive' Earnings - Bloomberg
Photo of Costco

To open a new store, Costco will have to buy shelves, cashiers, and perhaps land to build its store. This would constitute its PPE investments.

Working capital is money a business need to operate its business.

Generally, having a new store would require the business to lock-in additional money to stock up inventory.

If it offers credit terms (i.e. allows customers to pay in installments), more working capital is required. This is because they would be required to pay suppliers first while waiting for customers to pay them or they would be waiting for the inventory sitting on the shelves to be sold.

Oh, but Costco is rather different.

In fact, they are quite the opposite.

Before its customers start shopping, they collect a membership fee. Their customers are effectively financing their growth by injecting cash into Costco even before they start buying its goods.

Because of their size, they are able to negotiate favorable terms by paying suppliers approximately 1 month after they get the inventory. On the other hand, customers have to pay immediately when they purchase from Costco.

This means that Costco’s suppliers are also financing their growth when they’re able to delay payment to their suppliers.

Their inventory turn—how fast they clear their shelves—is also one of the best in the industry.

Capital doesn’t stay locked up in Costco for very long.

And when cash isn’t locked up in a business, it can be distributed to shareholders, buy back shares, or be reinvested for growth!

Working capital needs or the lack thereof is one of the most overlooked metrics amongst others.

Starbucks in recent years is also showing early indications that it will benefit from working capital improvements. With its membership—prepaid cards gaining wide popularity.

Coffee addicts lovers are effectively financing Starbucks growth by putting in cash before they make their purchase.

If you think Apple Pay, Google Pay, and Samsung Pay is popular, wait till you see ‘Starbucks pay’.

Starbucks's mobile payments system has more users than Apple's, Google's -  Vox

Conclusion

In conclusion, ROIC measures the earning power of a business. The lesser capital it requires to generate that additional amount of revenue, the more money is leftover to be distributed to shareholders.

High ROIC combined with growth and a strong moat will compound your capital nicely for years to come when you pay a fair price.

You read my earlier posts on this topic:


Thank you for taking the time to read my blog.

If you’re enjoying the content so far, I’m sure you’ll find 3 Bullet Sunday helpful. As an extension to the regular posts, I send out weekly newsletters sharing timeless ideas on life and finance.

I do not share these content elsewhere.

Join others and subscribe to our newsletter today to receive a free investment checklist!
Lessons learnt investing through market crashes

Lessons learnt investing through market crashes

“Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

– Sir John Templeton

For the past two months, since Feb 2020, the S&P has been trading like a penny stock, making extremely volatile movements of more than 5% on many trading days. It took only 6 days for it to reach correction (a decline of 10%) and 16 days to become a bear market (a decline of 20%). It was one of the fastest drawdowns in the market ever since.

The upswing was as intense as the downswing, with the market rebounding 28.5% since its bottom on 23 Mar 2020.

In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

– Charlie T. Munger

A look at previous crises

Historically, we experience a 10% market drop every 2 years. Since the 1950s, stocks have fallen 20% or more only 11 times (about once every 6 years). Including now, a decline of 30% or more has only happened 6 times; an opportunity that happens once every 12 years.

“The time to buy is when there’s blood in the streets.”

Investors should always expect the market to move up, down or sideways. We should not be surprised when the market has a sharp drawdown. However, when something this drastic happens, it will freeze most investors. Some of the most common statements I hear amidst this Covid-19 induced downturn include:

  • I may be catching a falling knife
  • Unemployment claims have never been so high before, there is too much uncertainty
  • Globally, the number of infected cases is still rising exponentially and we don’t see anyone travelling or dining out soon

These are all legitimate concerns, but in investing you either get a cheap valuation or a rosy outlook; you will never have both at the same time. You pay a very high price in the market for a cheery consensus. The important question investors should be concerned about is,

“Which companies will survive and do even better coming out from this crisis?”

Someone once said that the best time to buy is when your stomach starts to churn. And it is important for us to prepare a watchlist of high-quality companies so that we may take advantage of the downturn. As Howard Marks put it best in his recent memo: “The most important thing is to be ready to and take advantage of declines.”

The market has emerged higher from every crisis

Covid-19 is going to leave a mark, but it is going to come and go. If history is a good indicator, the stock market will increase over time as corporate profits rise. Despite ‘unthinkable’ disasters happening, America’s markets have displayed their resilience and it would be unlikely that Covid-19 will destroy their economic engine permanently.

As the saying goes, this too shall pass.

On average, US corporate profits rise 8% annually. But bear in mind that companies do not increase profits on a straight-line. There will be down years and up years, and what’s most important that we understand our companies to have the conviction to hold through downtimes.

Equally important is that we must not invest in cash that we need within the next 5 to 10 years and we must not invest our emergency savings. The market sometimes can stay irrational longer than you can stay solvent.

What do I do during a crisis?

I buy.

More specifically, I buy companies on my watch-list in tranches. There is no rule to this and I deploy my available funds based on probability of these events happening:

  • 20% market decline: Likelihood of occurrence is 15%, I will deploy 50% of my available funds at this stage
  • 30% market decline: Likelihood of occurrence is 8%, I will deploy 30% of my remaining funds at this stage
  • >40% market decline: It has only happened 3 times since 1950, I will be fully invested by this point.

Apart from deploying my available cash, I would also be selling lower-quality stocks in my portfolio and buying high-quality companies as the market throws them out. High-quality growth companies and cheap/ reasonable valuations seldom come hand-in-hand. And when the market gives the opportunity to be an owner of these companies, pounce on them!

As you sell your companies to buy high-quality companies in a downturn, it will inevitably be painful as you will likely have sold it at a discount. In moments like these, it is helpful to remember Warren Buffett’s saying:

I’d committed the worst sin, which is that you get behind and you think you’ve got to break even that day. The first rule is that nobody goes home after the first race, and the second rule is that you don’t have to make it back the way you lost it. – Warren E. Buffett

To sum it up, markets will go up in the long run and during a crash, there will be a lot of commentators predicting what will happen next. The most important thing is to have a watch-list beforehand and follow your game plan as the market provides you with opportunities to own great companies. Never invest in cash you would need in the next 5 to 10 years, you must stay in the game for this to work.

You can also follow my Facebook page for updates here!

Facebook’s Incredible Business Model – Part II

Facebook’s Incredible Business Model – Part II

In the second part of Facebook’s write-up, we will examine how its moat enables it to generate a high Return on Invested Capital (ROIC). We will also discuss its growth runway and what has changed for Facebook since the Cambridge Analytica incident.

A Compounding Machine

Facebook has consistently generated ROIC of ~30% on a before-tax basis. What this means is that every $100,000 invested in the business, it will give you $30,000 in operating income. Comparing this with buying a Condo for $1 million and it gives you $40,000 in operating income (rent less all expenses before tax), that would give you an ROIC of 4%.

There are many ways to calculate a company’s ROIC. Personally, I prefer Joel Greenblatt’s method of calculation. By using Earnings before Interest & Taxes (EBIT), it allows us to compare the true earning power of a company across time (different tax rates) and capital structure.

Joel Greenblatt’s ROIC formula from his book “The Magic Formula”

Interestingly, Facebook holds a lot of cash ($50 billion) in its Net Working Capital, indicative of its cash-generative capabilities. If we were to strip off that cash, its ROIC would go above 70% consistently for the past 5 years

A high ROIC is one factor that is important that I focus on when looking for quality companies. However, for it to be meaningful, a high ROIC must be accompanied by growth. The company must have sufficient opportunities to deploy capital at high rates for compounding to work its magic.

Can Facebook still grow?

Over the past 5 years, Facebook’s revenue growth per has averaged ~42%. It has since given guidance that growth would be expected to range around 20%, which is still an amazing feat given its size.

On a macro level, Facebook benefits from the tailwind of digital ad spending growth. Companies find that they are able to get a better bang for their buck by advertising on Facebook, compared to traditional media platforms such as newspapers and TV. Digital ad spending is now 53.6% of total ad market and it is expected to grow at an ~8% Compounded Annual Growth Rate (CAGR).

Rise in Global Digital Ad spending

Facebook currently seized about 20% of the market share and that figure has been stable over the years. Apart from a growing pie, Facebook has room to seize market share from other players in the digital ad market as they roll out new features (e.g. Stories, Watch Party, Dating etc) which increases their competitive advantage.

Facebook, Google and Amazon’s % share of digital ad spending

Cambridge Analytica Scandal

In 2018, the company was fined $5 billion for the misuse of users information during the Cambridge Analytica scandal. But what has happened since? Since then, the management has aggressively increased spending on R&D by 75%, Marketing & Sales by 109% and General & Admin by a whopping 315%, a pace far greater than revenue growth 73% over the same period.

These numbers are attributed to Facebook’s efforts to hire a lot more staff & increase its investment in security. I take the management’s willingness to act and invest in the long run very positively.

Increased regulation may sometimes inadvertently strengthen a company’s position. Like in the case of Philip Morris (otherwise known for its product Marlboro cigarettes), the regulation in the cigarette industry effectively prevented competition from entering. This protected their profit margins and allowed them to consistently generate high returns for their investors.

Likewise for Facebook, increasing regulatory requirements for social media may increase the barrier of entry for new entrants. As regulators and users increasingly demand higher security features and greater oversight from the platform.

To sum it up

As the leader in social media with a strong network effect, Facebook has successfully navigated the pivotal changes from desktop to mobile, and from posts to stories.

Whether Facebook is able to compound wealth for investors would very much depend on whether it is able to continuously widen its moat, generate high ROIC and continue to grow.

Before we end off, this how profitable Facebook is compared to its FANG peers:

And this is because the content on its platform are free.

Facebook’s Incredible Business Model – Part I

Facebook’s Incredible Business Model – Part I

This write-up will be broken down into 2 parts. In this first part, we will discuss Facebook’s business model and metrics for measuring its success.

Facebook probably has one of the best business models in the world. Even before it went public, the company grew its revenue by 57% and had 36% operating margins. Its business model is similar to a traditional media company, with advertising revenue as the key driver. Facebook has the largest readership base in the world (2.5 billion people) and to top it off, the readers are the ones providing the content for free.

What does Facebook Owns?

Facebook properties consist of 5 products. Most of us are familiar with them and would use 4 out of 5 products on its properties – Facebook, Instagram, Messenger and Whatsapp.

Among all the properties Facebook owns, the company’s 2 main revenue drivers are Instagram (acquired at a bargain price of $1 billion) and Facebook. Facebook’s priority is to continuously invest in these social media platforms.

Messenger and WhatsApp (acquired for $16 billion) are mainly for messaging and are more difficult to monetize. Especially for WhatsApp when they are trying to brand it as less intrusive with its encryption capabilities. However, it does make the platform ‘stickier’. The more functions your users rely on your platform for, the more engagement you will receive, and revenue will follow. Facebook currently has plans to integrate Messenger, WhatsApp and Instagram to increase its platform’s ‘stickiness’.

Oculus was acquired back in 2014 for $2 billion because Zuckerberg believes that Virtual Reality (VR) would be the next major computing platform. Though its success has yet to bear fruits in terms of widespread adoption, Zuckerberg believes that VR could be the next big revolution. It is comforting to know that the management is on its toes preparing for the next big wave. This parallels their massive pivot in strategy during 2011 as users shifted their preferences from surfing Facebook on desktop to smartphone devices browsing.

Network Effect – Exactly how many people are on Facebook?

Across the globe, Facebook splits its business into four geographies:

  • Rest of World
  • Asia-Pacific
  • Europe
  • US & Canada
Taken from Facebook Q4 2019 Results

With a rising MAU, the company now has approximately 2.5 billion active users on its platform. To put Facebook’s incredible reach in perspective, the world’s population is 7.8 billion, of which 4.6 billion have access to the internet. Due to censorship, let’s remove China’s population of 1.4 billion from the 4.6 billion pool of internet users. That would leave us with 3.2 billion people who could be users of Facebook.

This means that Facebook has captured 78% market share of its total possible users. Think about the amount of data they could collect on its users based on sign up details, photos, likes, friends, and when you log in to other platforms using your Facebook account (e.g. Spotify). It is no wonder their targeted advertisements generate much better returns for their advertisers.

Taken from Facebook Q4 2019 Results

And about 66% of its users check their App at least once a day.

Facebook properties have huge network effects, and the great thing about networks is that as the user numbers grow, their moat widens exponentially as it grows. The size of the platform acts like a magnet for both users and businesses to join. It is able to retain users because that is where all our friends are and likewise, it is difficult for businesses to leave because that is where all its customers are.

How valuable are you to Facebook?

Out of the 2.5 billion users, only 10% are from US and Canada, yet they generate close to 50% of Facebook’s revenue.

Taken from Facebook Q4 2019 Results

From here, we can see that US & Canada’s ARPU is at least 4x the worldwide average.

This leaves a lot of potential for revenue growth from its market outside of the US & Canada. The reasons Facebook gets a higher revenue from US & Canada are largely due to:

  • Price increases, this is likely attributed to the purchasing power of consumers. The recent article by WSJ suggested that ad rates may have fallen by 25% in Mar 2020 due to COVID-19 induced economic downturn, even though usage has increased by 50%.
  • The number of ads shown, mature markets tend to have a higher ad load.
  • Higher engagement, US & Canada users are more likely to share, like and comment. We can expect to see this increase as Facebook rolls out more features such as Live Stream, Watch Party, etc.
  • More ads clicked, with more targeted ads leads to more clicks and higher cost per click.

Interestingly, we can see that we as Singapore users “brought in” at least USD12.63 worth of revenue for the platform in 2019 and this figure is expected to grow over time.

In my next article, I will further discuss Facebook’s profitability, growth potential and the challenges it faces, including regulatory concerns surrounding the Cambridge Analytica incident. Stay tuned for Part two!