The Question on Every Investor's Mind: Short-Term Headwind or Structurally Impaired?
Connecting Buffett's 1980 letter to recent selloffs of $FB, $NFLX, and $PYPL
The most interesting part of Buffett’s 1980 letter was a lengthy discussion about evaluating whether businesses have short-term solvable problems or are structurally impaired. Given the market often reacts the same way to both scenarios, it’s important to look under the hood and think more deeply about what’s going on because it can represent attractive opportunities as an investor (to either sell quickly or double down).
The setup for the discussion is a classic Buffett quote:
Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.
He uses GEICO to illustrate his statement:
GEICO may appear to be an exception, having been turned around from the very edge of bankruptcy in 1976. It certainly is true that managerial brilliance was needed for its resuscitation…But it also is true that the fundamental business advantage that GEICO had enjoyed - an advantage that previously had produced staggering success - was still intact within the company, although submerged in a sea of financial and operating troubles.
GEICO’s competitive advantage was being the low-cost insurance provider, made possible by their marketing genius which led to lower customer acquisition costs, the name of the game in insurance - pay attention to all the ads you’re served when watching TV!
GEICO was designed to be the low-cost operation in an enormous marketplace (auto insurance) populated largely by companies whose marketing structures restricted adaptation. Run as designed, it could offer unusual value to its customers while earning unusual returns for itself. For decades it had been run in just this manner. Its troubles in the mid-70s were not produced by any diminution or disappearance of this essential economic advantage.
As Buffett highlights, the important thing to evaluate is whether the company’s fundamental business advantage is impaired, or if it’s simply struggling with near-term operational/financial challenges.
While Buffett may have been referring to more drastic company situations (bankruptcy, for example), I think the market is having a similar debate about a number of companies that have seen steep drawdowns over the past two weeks.
Facebook,
Netflix,
and PayPal come to mind:
In each case, I think the only rationale that justifies the magnitude of these sell-offs is that investors believe these companies’ respective competitive advantages have been impaired. Another way to frame the debate, “is company X’s consumer value proposition getting stronger or weaker?”
For Facebook, Apple’s App Tracking Transparency (ATT) changes have made it harder for businesses advertising on Facebook to accurately target potential customers and measure the effectiveness of their campaigns. You could argue Facebook’s value proposition to advertisers is weakening. If you’re not going to advertise on Facebook, where do you go instead? Exactly, Google:
Not only is Facebook struggling with the ATT impact, it’s also facing increasing competition from TikTok, especially among younger users. Investors are wondering whether Facebook’s network effects can reverse and lead to a downward spiral of users leaving the platform.
The icing on the cake is that despite Zuckerberg’s best efforts in branding, investors appear increasingly uninspired by the company’s ambitions to build the next computing platform. More accurately, uninspired by the heavy investment required to make a bet whose outcome is far from certain.
In short, my argument is you don’t lose $230B in market cap in a single day because of a short-term revenue headwind. You lose it because investors assume your competitive advantage period (CAP) has just shrunk materially (from The Gorilla Game by Geoffrey Moore):
In the case of Netflix, the concern is competition from a plethora of streaming competitors. Is Netflix’s offering truly differentiated? As more streaming options enter the market, is Netflix’s value proposition getting stronger or weaker?
For PayPal, competition concerns abound: OS-native payment options (Apple Pay, Google Pay) and BNPL competition (Affirm, Afterpay, etc.) to name a few. With the emergence of these players, is PayPal’s value proposition to consumers and merchants getting stronger or weaker? The market says weaker because OS-native solutions, for example, are more frictionless for consumers, which leads to higher checkout conversion for merchants.
In going through these three examples, my intent is simply to make an argument for what the respective stock reactions imply investors and the broader market are concluding. It’s not to indicate my conclusions or influence what you should conclude.
Ultimately, as an investor you have to do your own work and make a judgement to avoid alienating yourself to the opinions and vicissitudes of the crowd.
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