4 Important Lessons on Investing

MySpace, king of the social networks just a few short years ago, sold for a paltry $35 million this week.  News Corp. bought MySpace for $580 million in 2005, which pencils out to a 94% loss.  There have been a number of recent blog posts debating the market value of Twitter and Facebook.  I believe they are worth way less than current estimates, because members could leave at any time, taking the revenue with them.  The recent fire-sale of MySpace clearly illustrates this problem.  I won’t invest in Facebook, Twitter or most other online businesses and here are 4 important reasons why.

1. Earnings = Value

MySpace is for Losers

Image by Bitterjug

Warren Buffett says he likes to invest in companies that have a “moat” around them.  In other words, he likes to invest in companies that have an insurmountable competitive advantage.  The reason this is so important is because investors can count on the future earnings.  Companies with no competitive advantage may see their earnings disappear suddenly and the market value will disappear with it  Even worse are companies with no earnings.  There were a lot of companies like this during the dotcom era and most of them are long gone, along with the investor’s money.

Example: Google created the first search engine that returned relevant search results.  Anyone who has used an older search engine like Alta Vista understands how much better Google is.  Anyone who hasn’t takes their amazing technology for granted.  But, that’s not the reason Google’s stock soared while the other search engines went out of business.  Google figured out how to earn revenue from their search engine, without selling out their users.  Their Adsense and Adwords campaigns changed the game of paid search forever.  By using a fremium revenue model, with clearly identified free and paid search results, they make billions.  And, their huge earnings justify their huge market cap.

2. Customers = Revenue

I rarely invest in social networks or other online businesses.  The reason is that online businesses can be quickly replicated and displaced.  There are no factories, patents, products or infrastructure to protect earnings and retain customers.  Online customers are fickle and highly price conscious.  Dozens of competitors are only a click away.  Customers are the lifeblood of a business, because they generate the revenue.  Without their customers, all a company has left are expenses.  Some companies, such as banks and telecom providers are often abusive to customers.  This is dangerous for investors, because customers will defect as soon as new technologies or competitors are available.

Example: Blockbuster recently filed for bankruptcy after dominating the video rental business for more than a decade.  There are many reasons for their spectacular downfall, including the inability to adopt new technology, such as video streaming.  But, their rapid decline seems to have started with the immensely unpopular late fees.  Customers felt they were being taken advantage of by Blockbuster, who used the high late fees to pad their bottom line.  As soon as more consumer-friendly options appeared, such as Netflix and Red Box, customers abandoned Blockbuster in droves.

3. Trendy = Treacherous

Corporate conglomerates are about as boring as a box of rocks.  But, when you invest in one, you aren’t investing in pet rocks.  Flashy, hot and trendy companies are exciting to invest in.  But, they are also very risky for the bottom line.  They often disappear as quickly as they came.  Think about all of the hot companies from 10 years ago.  How many are still in business?  Of those, how many are still worth a fraction of what they once were?  Not many.  Using social networks as an example, think about AOL, Geocities, Friendster and MySpace.  Who will still be on Facebook and Twitter in the future?  Other types of companies to watch out for are retail, clothing and restaurants.  Customer tastes change quickly.

Example: General Electric (GE) was founded in 1890 by Tomas Edison.  It is the only company remaining from the original 12 Dow Jones Industrial companies.  Although it was originally founded as an electric company, most of its revenue now comes from its financial and media empires.  It is also involved in aviation, locomotives, appliances, oil & gas, nuclear power and renewable energy.  Profits for GE in 2010 were $14.2 billion on revenues of $150 billion.  They have $79 billion in cash and are ranked by Forbes as the second largest company in the world.

4. Premium = Profits

The absolute worst thing any company can possibly be is the lowest cost provider.  Margins are razor thin, which increases the risk of going out of business.  Customers have no loyalty and products have no particular appeal.  Investors should avoid low-margin companies and instead invest in companies with premium products or services.  These companies have a loyal base of customers and products that are unique or innovative.  Customers will happily pay a premium and the earnings and stock prices reflect this.

Example: Apple Inc. recently became the largest technology company by market capitalization in the world.  There is no big secret to their success.  Their products are slick, reliable, popular and often technologically superior to others.  Users are fiercely loyal and competitors are envious.  Their products are expensive and their gross margins are high.  But, the products continue to sell and their stock price continues to rise.

The Bottom Line

The bottom line is that stock market investing is risky enough without buying flash-in-the-pan companies.  By investing in companies with stable earnings, premium products and loyal customers, you will avoid losing your shirt on the next MySpace.

“Never invest in a business you cannot understand.”

Warren Buffett – Billionaire Value Investor

Recommended Reading

Balance Junkies – What’s Next for the Markets?
Buy Like Buffet – Whatever Happened to MySpace?
Online Investing AI – Trading Strategies: Warren Buffett

This post was featured on the Carnival of Personal Finance over at Prarie Eco Thrifter.  This is by far the classiest Carnival on the net.  Check it out.

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17 comments to 4 Important Lessons on Investing

  • Boring is often sustainable. Remember back to the late 1990’s? The market was flying high with tech stocks making people paper profits hand over fist. It was the dawn of a new era..

    I had a professor in graduate school who clearly wasn’t impressed, and was more confounded by the whole thing. He made a comment about how it might be a good idea to “short the whole market” if you could. Many people thought he was so old and out of touch, as they were puzzled by his comments.

    Well, he was right to be suspect. For too many companies, there weren’t the earnings, or customers, or other necessary factors to substantiate being good investments.

    There’s something to be said for stable companies with stable earnings and a sustainable competitive advantage.

    Good post.

    • People thought Warren Buffet was out of touch as well for avoiding tech stocks. But, he thought the valuations were ridiculous based on the earnings and he was right.

      I worked for a startup during the dotcom era and I rememeber talking to Engineers and Programmers about tech stocks. One of them was buying Intel and Cisco like crazy. I told him a P/E ratio of 80 was way too high for these stocks. My own portfolio dived 40% during the crash. But, I held onto everything and participated in the recovery. I’m sure he lost a fortune.
      Bret recently posted..4 Important Lessons on InvestingMy Profile

  • I’m dismissive of the “field of dreams” approach to business ideas. If you don’t have a monitization strategy from day dot i think your in trouble. Also myspace was freaking enormous and was unable to change once it got eaten by newscorp. I think if it had been more agile it might still be around.
    Bankruptcy Ben recently posted..So are Republicans insane or is it just me?My Profile

    • Ben,

      It’s amazing how many companies were competing for eyeballs instead of profits, during the dotcom era. Some foolish companies, such as MySpace, still think this is a legitimate business plan. If investors would stop falling for this scam, companies would get real about profits and earnings from day one.

      As for MySpace, it quickly became the teen network, while Facebook became the adult network. As soon as most of the teens opened Facebook accounts to interact with adults, MySpace was toast. Plus, NewsCorp is a dinosaur. They put in a 70 year old paper-media CEO to run MySpace. They may as well have just shut down the servers from day one, to save the energy.

      Bret recently posted..4 Important Lessons on InvestingMy Profile

  • Bret, I have invested for so many years, and even with impeccable and thorough research, every investor has some losers. Very nice article.
    Barb Friedberg recently posted..HAPPY JULY 4th – Secrets to HappinessMy Profile

    • Barb,

      I have sure had my share. A homebuilder and some unranium mining stocks come to mind. But, investors don’t have to be right every time, just more often than they are wrong.

      I hope your big move is working out.

      Bret recently posted..4 Important Lessons on InvestingMy Profile

  • Welcome to Tech bubble 2.0! Anyone thinking about investing in any of these fads is crazy. The upcoming IPOs will exist purely to provide all the VCs with an exit before people realise all this ‘social’ nonsense isn’t actually generate any PROFIT.

    Thanks for this, Bret. You’ve done a great job at applying proper investment principals to these crazy tech companies. It’s refreshing to see someone talking sense. When I tell people that these companies have completely unrealistic valuations and will ultimately collapse, they just look at me like I’ve missed the point…Well, people like you and me called the bad MySpace deal at the time and we’re calling it again here too :p

    • I am amazed at how many people are hovering over the Facebook IPO and trying to buy private shares through Goldman Sachs. The only opportunity I see is one of those Greater Fool plays, where you buy and resell the shares right at the IPO. I definitely wouldn’t be holding them into the future.
      Bret recently posted..4 Important Lessons on InvestingMy Profile

  • Nice article, Bret. I like Buffett’s maxim about investing companies that have a “moat” around them. Certainly goes to explaining his investment in Burlington Northern Santa Fe railroad.
    101 Centavos recently posted..Oil Leaks and ExpertsMy Profile

    • Centavos,

      I was surprised by his huge investment in BNSF when it happened. But, it makes a lot of sense, considering how efficient rail transportation is. It’s virtually impossible to launch a competing railway now days. So, they practically have a transportation monopoly, unless someone wants to pay a lot more to ship by truck.

      More important are the company’s assets. They have miles of track, thousands of cars, locomotives, land, yards and facilities. What does a company like MySpace have? They have some servers and programmers. That’s not a very deep moat.
      Bret recently posted..4 Important Lessons on InvestingMy Profile

  • Very nice article Bret! Good point here: “The bottom line is that stock market investing is risky enough without buying flash-in-the-pan companies. By investing in companies with stable earnings, premium products and loyal customers, you will avoid losing your shirt on the next MySpace.” I totally agree. I’m afraid that in time the most popular websites will lose their charm when a new and better website comes out again in the market. And the never ending cycle continue.
    Rizzi@Re Mentor recently posted..Real Estate InvestingMy Profile

    • Rizzi,

      It has been interesting seeing how popular Facebook has become. I wonder if it will have some staying power or if people will get bored and move on. Another possibility is that they will try to charge for membership or they will violate everyone’s privacy and cause a backlash. Either way, I’ll invest my money somewhere else.
      Bret recently posted..4 Important Lessons on InvestingMy Profile

  • I liked your comment — in the comments section — about how ridiculous it is to put a 70 year old who made his fortune in traditional media (newspapers, major television stations) in charge of MySpace. As someone who came out of the journalism industry and into the blogosphere, I can tell you … most people within that industry have a poor understanding of how the internet works, much less how to make a profit online.
    Paula @ recently posted..A Coupon is BornMy Profile

  • My take on most internet companies is that they will be short-lived– like shooting stars, fading away as a better idea comes along to replace them…… in short, they have no mote, no customer loyalty, and most don’t really even have a product that can’t be replicated or bettered by a group of talented teenagers hacking away in their basement. I like Buffett’s quote about how valuing a stock is very much like valuing a bond…. you have to estimate the future earnings steam and discount by an appropriate value to determine intrinsic worth.
    The Biz of Life recently posted..Quote of the Day: Matt RidleyMy Profile

    • Earnings are everything. It’s not just Warren Buffett who figured this out. Almost all of the great investors concentrated on fundamentals and avoided the trendy companies and technical indicators.

      I am in the computer business and have been for 25 years, so I have definitely seen them come and go. I am transfixed on what is happening to Cisco right now. I have always thought their products were insanely overpriced and unnecessarily complex. But, IT people are cautious, so Cisco had a virtual monopoly. I’m just surprised it took this long for customers to start switching network companies, since switches and routers are a commodity.
      Bret recently posted..Happiness is Doing it YourselfMy Profile

  • […] was a solid business. His main argument was that Facebook was not diversified enough and mentioned his post about 4 investing lessons (not only is Bret a great and interesting commenter on here but he does have his own blog). Today I […]