Saturday, July 26, 2014

Investment Advice from the Federal Reserve: Unusual, unwise and unseemly!

On July 15, Janet Yellen made news with her semiannual policy testimony to Congress, with her views on interest rates, bubbles and the debt market. After making clear her intentions to continue with quantitative easing (QE) and keep rates low, she also provided her thoughts on whether the Fed’s policies were creating a market bubble. While she said that valuations were not in bubble-territory for stocks overall, the Fed report that was released in conjunction with her testimony suggested that “valuation metrics in some sectors appear substantially stretched– particularly those for smaller firms in the social media and biotechnology industries”. While the Fed (or any central bank) does sometimes make generic (and opaque) statements about overall market valuations, it is unusual for it to be this specific about individual sector valuations. In my view, it not only over stepped its bounds but strayed far from its expertise, which is not valuation.

Is social media over valued?
Those who have been readers of this blog know that I am fascinated with both the valuation and pricing of social media stocks. On Facebook, I thought the stock was priced too high at the initial offering, friended it after the market overreacted to early negative earnings reports and unfriended it after a price run up (and perhaps too early). On Twitter, I have been consistently skeptical about the reach of the company's business model, arguing that their advertising model restricted them to being a lesser player (even if successful) in the overall online advertising market. 

My “conservative” valuations of Twitter and Facebook should make clear that I am not a social media company cheerleader, but I was perplexed by the Fed’s contention that the valuation metrics it was looking at suggested that social media and biotech stocks were over valued. What are the metrics that are being used to make the judgment? Clearly, they cannot be the conventional pricing ratios that investors use, such as PE ratios or an EBITDA multiples, since neither is particularly effective at assessing companies in a young sector. Perhaps, it is some version of a revenue multiple (EV to Sales or Price to Sales), but there again looking at what multiple of current revenues a company trades at, when those revenues can double or triple over the next two years is not indicative of valuation. As I see it, the only metric that consistently explains differences in market prices across social media companies is the number of users at each of these companies, and I used this relationship to explain why Facebook would pay $19 billion for Whatsapp. It is possible that the Fed has come up with a creative way of explaining what the “right” value per social media user should be, but creativity in valuation has never been (and will never be) the Fed’s strong suit.

There is a case to be made that social media company are collectively being over valued and that case does not rest on valuation metrics or multiples. It stems from a common phenomenon in young sectors, where investors in individual companies price their companies on overall market potential but either misassess or ignore the fact that the overall market is not big enough to support all of them (and new entrants). This is the point I was trying to make in my post on micro and macro mistakes, where I used the pricing of social media and young tech companies that are in the online advertising space to back out implied future revenues and argued that if the market is right on each individual company, the collective market share of these companies would be well in excess of the total online advertising market a  decade from now. Note that even if you buy into this argument, you may still invest in an individual social media company (Facebook, Twitter or Linkedin), since the winners in this sector can yield superlative returns, even if the sector goes through a correction. The analogy would be to investing in Amazon during the dot-com boom and holding through the carnage of the dot-come bust; an investor who bought Amazon at is absolute peak in late 1999 and held through 2014 would have quadrupled her money and generated a compounded annual return of over 11% a year. With biotechnology companies, making judgments about overall valuation is even more fraught with danger because the pricing of these companies is a probabilistic exercise (dependent upon the drugs that are working their way through the FDA pipeline and their blockbuster potential) and comparing pricing across time is close to useless.

In short, the Fed’s solicitude for investors in these high growth sectors is touching but investors in social media and biotechnology companies are grown ups, playing at a grown up game, i.e., trying to pick the winners in a sector that they may believe is over valued. They may be suffering from all of the behavioral quirks that get in the way of investment success, including over confidence and a herd mentality, but it is their choice to make. 

The Fed as Market Guru and Sector Prognosticator
Some of the fundamental parameters (interest rates, the term structure, economy growth) that drive both asset allocation and security selection are affected by Fed policy, with changes creating winners and losers among investors. If you view investing as a sport, the Fed’s role is closer to that of an umpire or a referee than it is to being a player. Thus, statements about specific sectors, such as those made in the most recent Fed reports on social media and biotechnology, come dangerously close to game interference. In fact, if you buy into the Fed’s contentions that the overall market is not over valued, but that social media and biotechnology are, is there not an implicit message that there must be some other sectors that are under valued? If investors believe the Fed, should they be selling their social media and biotech holdings and buying stocks in other sectors? 

Even if you accept that the Fed should be doling out investment advice, I think that it is on particularly shaky ground at this junction in history, where there are many who believe that it has kept interest rates at “abnormally” low levels for the last five years (with QE1, QE2, QE3..). I have disagreed with those who attribute monumental powers to the Fed in an earlier post where I compared the Fed Chair to the Wizard of Oz, and argued that rates have been low for the last five years more because of the fundamentals, i.e., anemic growth and low inflation, than because of Fed policy. The crux of this argument is captured in the graph below, where I compare the actual ten-year bond rate to a fundamental interest rate, computed as the sum of real growth in GDP and expected inflation:
Ten-year T.Bond rate versus Fundamental Interest rat (GDP Growth + Inflation)
As you can see, the Fed’s role over the past five decades has been more as a tweaker of interest rates than as a setter of rates, but it is undeniable that the Fed can affect rates at the margin. In particular, the Fed’s quantitative tightening (in 1980 and 1981) and easing (in both the 2002-06 and 2010-13 timing periods) have had an effect on interest rates. In the figure below, I try to capture the Fed effect by looking at the difference between nominal 10-year T.Bond rates and the fundamental interest rate:
The Fed Effect = T.Bond rate - Fundamental (Negative = Fed Easing, Positive = Fed Tightening)
Note that negative values are loosely indicative of a "easy money" and a positive values with a "tight money Fed" and you can make the argument that the Fed's actions have kept rates lower than they should be, at least for the last three years.

If you accept the notion that the Fed controls interest rates (that many investors believe and Fed policy makers promote) or even my lesser argument that the Fed has used its powers to keep rates below where they should be for the last few years, the consequences for valuation are immediate. Those lower rates will push up the valuations of all assets, but the lower rates will have a higher value impact on cash flows way into the future than they do on near-term cash flows, making the over valuation larger at higher growth companies. Consequently, a reasonable argument can be made that the Fed has been an active participant in, and perhaps even the generator of, any bubbles, real or perceived, in the market. In my post on market bubbles, I did agree with Ms. Yellen on her overall market judgment (that traditional metrics are sending mixed messages on overall market valuation) and used the ERP for the market, as she did, to back my point. In particular, I noted that the implied equity risk premium for the market at about 5% was high by historical standards (rather than low, which would be a indicator of overvalued stocks). However, breaking the ERP down into an expected stock market return and a risk free rate does point to an overall disquieting trend:
The Fed's role in Equity Risk Premium Expansion
Note that all of the expansion in ERP in the last five years has come from the risk free rate coming down and not the return on stocks going up. In fact, the expected return on stocks of 8% at the end of 2013 is a little lower than it was pre-crash in 2007 and if the risk free rate reverts to pre-2008 levels (say 4%), the ERP would be in the danger zone. Put differently, if there is a market bubble, this one is not because stock market investors are behaving with abandon but because the Fed has kept rates too low and the over valuation will be greatest in those sectors with the highest growth. 

Given this history, a Fed (Chair, Governor or Staff report) complaining about frothy valuations and exuberant investors is akin to a bar-owner, who has been serving free beer all day, complaining about all the drunks on the premises. If the Fed truly believes that it has the power to keep interest rates low and that there is a market bubble, the solution is within its reach. Stop the quantitative easing, let interest rates find their natural level and the bubbles (if they exist) will take care of themselves.  

The Fed as Economic Custodian
There have been a few commentators who have argued it is in fact the Fed's job to not only keep its eye on market and sector valuations and actively manage bubbles. I disagree for two reasons.
  1. The Fed does not have a great history as a bubble detector. I am sure that I will be reminded of Alan Greenspan’s comment on irrational exuberance in markets, but few remember that the comment was not made in 1999 or 2000, at the peak of the boom but in 1996. Investors who listened to Greenspan and got out of the market then would have been net losers even a year after the crash. 
  2. Even if the Fed is in the business of bubble detection, let me pose the same question that I did in my earlier post on bubbles: what’s so bad about a bubble? The bursting of the dot-com bubble created losses for those who invested in the stocks, but looking back at the 20 years since these companies entered the market, not only have dot-com companies created substantial value (for themselves and the economy) but have changed our day-to-day lives.  It is true that the 2008 market crash created much larger economic costs and damage, but it was less because it was a bubble bursting and more because it was the bubble was centered in the financial services sector. Banks, investment banks and other financial service companies are creatures of the Fed and it is the one sector where the Fed does have both better information than the rest of the market (on the assets and risk in banks), and a clear economic interest in monitoring pricing and behavior. Even within this sector, though, I think that the Fed should be less concerned about pricing bubbles and more concerned with banking behavior. The Fed and banking regulators already have the capacity to monitor and restrict the investment (through risk constraints), financing (through regulatory capital needs) and dividend policies of banks (with veto power over dividend and buyback decisions) and I think that they should continue to do so. As for the rest of the market, is should be neither the Fed’s role nor its responsibility to keep investors from mispricing securities and facing losses, if they do.
The Fed as Nanny
The argument of whether the Federal Reserve should allow interest rates to rise in the face of a bubble is an age-old one that gets refought every generation. Benjamin Strong, the governor of the New York Federal Reserve from 1914 to 1928, is said to have argued against letting interest rates rise in his time, using the analogy of investors as children and saying that raising interest rates to puncture a  bubble would be like punishing all the kids because a few are misbehaving. That quote may be dated but I think it captures the mindset of many of today's Fed policy makers, with investors being viewed as children and the Fed acting as a super nanny, keeping its unruly and undisciplined charges from misbehaving.  It is time for the Fed to stop playing Mary Poppins and started treating investors as grown-ups, capable of making mistakes and living with the consequences, and for investors to stop looking to the Fed for guidance and counsel.

Wednesday, July 16, 2014

Possible, Plausible and Probable: Big markets and Networking effects

I do not know Bill Gurley personally, but I do know of him, and I was surprised, sitting in Vienna airport waiting for a connection home on Friday morning, to get an email from him. In the email, he graciously gave me a heads-up that he was planning to post a counter to my Uber valuation and that it would not pull punches. A little while later, I started getting messages from those who had read the post, with some seeking my response and some seeming to view this as the first volley in some valuation battle. I read the post a few minutes later and the first person I wrote to after I read it was Bill Gurley and I told him that I absolutely loved his post, even though it was at complete odds with my assessment of the company, for two reasons.
  1. Like anyone else, I like being right, but I am far more interested in understanding Uber's valuation, and the post provided the vantage point of someone who not only is invested in the company but knows far more about it than I do.  Rather than berating me for not getting "it" (technology,  the new economy, progress) or abusing valuation as a tool from the middle ages, the post focused on specifics about Uber and the basis for its high value. 
  2. In this earlier post of mine, I argued that good investing/valuation is the bridge between numbers and narrative and that neither the numbers nor the narrative people have an automatic right to the high ground. Bill Gurley's post brought home that message by laying out a detailed and well-thought-through narrative, backed up by numbers. 
Mr. Gurley's narrative lends itself well to a more grounded discussion of Uber as a company and I am grateful to him for providing it. As a teacher, I am constantly on the lookout for "teachable moments", even if they come at my expense, and I plan to use his post in my classes.

Dueling Narratives
In my post on Uber's value (and in the Forbes and 538 versions of it), I laid out my narrative for Uber.  I viewed Uber as a car service company that would disrupt the existing taxi market (which I estimated to be $100 billion), expanding its growth (by attracting new users) and gaining a significant market share (10%). The Gurley Uber narrative is a more expansive one, where he sees Uber's potential market as much larger (drawing in users who have traditionally not used taxis and car services)  and much stronger networking effects for Uber, leading to a higher market share. In many ways, this is exactly the discussion I was hoping to have when I first posted on Uber, since it allows us to see how these narratives play out in the  numbers. In the table below, I contrast the narratives and the resulting values:

You can download the valuations by clicking here. (Uber (Gurley) and Uber (Damodaran)).

Given that the values delivered by the narratives are so different, the question, if you are an investor, boils down to which one has a higher probability of being closer to reality. If you had to pick one right now, I think Mr. Gurley's has the advantage over mine for at least three reasons. The first is that  as a board member and insider, he knows far more about Uber's workings than I do. Not only are his starting numbers (on revenues, operating income and other details) far more precise than mine but he has access to how Uber is performing in its test markets (with the new users that he lists). The second is that as an investor in Uber, he has skin in the game, and more at stake than I do and should therefore be given more credence. The third is that he not only has experience investing in young companies, but has been right on many of his investments.

Does that mean that I am abandoning my narrative and the valuation that goes with it? No, or at least not yet, and there are three reasons why. First, it is difficult, if not impossible, for someone on the inside not to believe the best about the company that he directs, the managers he listens to and the products that it offers. Second, an investor in a company, especially one without an easy exit route (at least at the moment), is more attached to his or her narrative than someone who has little to lose (other than pride) from abandoning or altering narratives. Third, as Kahnemann notes in his book on investor psychology, experience is not a very good teacher in investing and markets. As human beings, we often extract the wrong lessons from past successes, don't learn enough from our failures and sometimes delude ourselves into remembering things that never happened. I am not suggesting that Bill Gurley is guilty of any of these sins, but I am, by nature, a cautious convert and I will wait to buy into his narrative, compelling though it may be.

The Acid Test: Probable, Plausible and Possible
As I noted at the start of this post, I liked Bill Gurley's post because it offers a coherent narrative that leads to a higher value. The narrative has two key building blocks and I think that there is much to be gained by taking a closer look at them. The first is that Uber is pursuing a much larger market than just taxi service and that it may very well redefine the nature of car ownership. The second is that Uber will have networking effects that will allow it to capture a dominant market share of this larger market, well above the 10% that I estimated in my original value.  In the sections below, I hope to stress test these assumptions, more as a friendly observer than antagonist.

Market Breakthrough
Companies like Amazon, Google and Netflix owe their success and immense market values to their capacities to redefine markets (retail, advertising and entertainment respectively) and it is true that in these and other cases, investors and analysts have under estimated these capacities and have paid a price for doing so. Unfortunately, it is also true that there have just been many cases where managers and investors have over estimated the capacity to expand markets and lost money in the process.  The Gurley narrative for Uber makes a good case that the convenience and economics of Uber will expand the car service market initially to include light users and non-users (suburban users, rental car users, aged parents and young children), but it does have three key barriers it has to overcome:
  1. Reason to switch: Uber has to provide users with good reasons to switch from their existing services to Uber. For taxi services, the benefits from using Uber are documented well in the Gurley narrative. Uber is more convenient (an app click away), more dependable, often safer (because of the payment system) and sometimes cheaper than taxi service. However, the trade off gets murkier as you look past taxi services. Since mass transit will continue to be cheaper than Uber, it is comfort and convenience that will be the reasons for switching. With car rentals, Uber may be cheaper and more convenient in some senses (you don't have to worry about picking up a rental car, parking it or worrying about it breaking down) and less convenient in others (especially if you have multiple short trips to make). With suburban car service (the aged parents, the dating couple and school bound kids), the problem that Uber may face is that a car is usually more than just a transportation device. Any parent who has driven his or her kids to school will attest that in addition to being a driver, he or she has to play the roles of personal assistant, private investigator, therapist and mind reader. As for date nights, whether Uber succeeds will be largely a function of how much the car itself is an integral part of the date, especially with younger couples.
  2. Overcome inertia: Even when a new way of doing things offers significant benefits, it is difficult to overcome the unwillingness of human beings to change the way they act, with that inertia increasing with how set they are in their ways. It should come as little surprise that Uber has been most successful with young people, not yet set in their ways, and that it has been slower to make inroads with older users. That inertia will be an even stronger force to overcome, as you move beyond the car service market. The articles that point to young people owning fewer cars are indicative of larger changes in society, but I am not sure that they can be taken as an indication of a sea change in car ownership behavior. After all, there have been almost as many articles on how many young people are moving back in with their parents, and both phenomena may be the results of a more difficult economic environment for young people, who come out of college with massive student loans and few job prospects.
  3. Fight off the status quo: The empire, hobbled and inefficient though it may be, will fight back, since there are significant economic interests at stake. As both Uber and Lyft have discovered, taxi service providers can use regulations and other restrictions to impede the new entrants into their businesses. Those fights will get more intense as car rental and car ownership businesses get targeted.
In summary then, the difference in market size in the narratives boils down to a simple calculus of what is probable, what is plausible and what is possible, a distinction that to me is at the center of value:

Not everything that is possible is plausible, and not all plausible opportunities make the transition to the probable.  As I see it, the divergence between the my narrative and Bill Gurley's are captured in where we draw the lines between the probable and the plausible and the value that we attach to the possible. At the risk of mischaracterizing Mr. Gurley's thoughts, I have tried to contrast these differences:

Here again, Bill Gurley has two advantages to work with. The first is that as an investor and insider, he has access to information on Uber's experiences and experiments in its frontier markets (mass transit and suburban users), that may have led him to shift these markets from the plausible to the probable. The second is that as a board director and advisor to management, he is in a position to influence Uber's potential in these markets. For all we know, the Uber Momcar and the Uber Datecar have been already conceived, market tested and are ready to go.

I think Bill Gurley and I agree on the car ownership market  more than we disagree. I see it as a possibility right now and attach an option value of about $2-3 billion to it, partly because it is in the more distant future and partly because Uber's business model in this market is unformed. From Bill Gurley's description of the market, I think he sees it as a possibility as well, though I think he attaches a larger value to it than I do. The reason for the higher value is that it is a conditional possibility, with the likelihood of it happening increasing with the success that Uber has in the car service market. 

Network Benefits
The second part of the Gurley Uber narrative rests on the company having network benefits that allow it to capture a dominant market share. As Mr. Gurley notes, a networking effect shows up any time you, as a user of a product or service, benefit from other people using the same product and service. If the networking effect is strong enough, it can lead to a dominant market share for the company that creates it and potentially to a  ‘winner take all’ scenario. The arguments presented in his post for the networking effects, i.e., pick up times, coverage density and utilization, all seem to me to be point more to a local networking effect rather than a global networking one. In other words, I can see why the largest car service provider in New York may be able to leverage these advantages to get a dominant market share in New York, but these advantages will not be of much use in Miami. There are global networking advantages listed, such as stored data that can be accessed by users in a new city and partnerships with credit car, smartphone and car companies, but they seem much weaker.

In fact, if the local networking advantages dominate, this market could very quickly devolve into a city-by-city trench warfare among the different players, with different winners in different markets. Thus, it is possible that Uber becomes the dominant car service company in San Francisco, Lyft in Chicago and a yet-to-be-created company has the largest market share in London.  For the Gurley Uber narrative to hold, the global networking advantages have to become front and center and here again, it is possible that I am unaware of a management initiative designed to do exactly this. 

The Verdict Awaits

I know that this may be hard to believe but I have less of an interest in making the case that Uber is over priced than I am in understanding what it is that drives its value. I have learned a great deal about why Bill Gurley is so excited about the company but I am inherently cautious, not because I don’t find his arguments to be plausible, but because I have seen how often the plausible does not make the transition to the probable and how frequently the probable fails to show up in the actuals. That quality may make me a bad venture capitalist but I am sure that there are plenty of good ones out there to take up the slack.