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
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