We Study Billionaires - The Investor’s Podcast Network - TIP355: Why Facebook Is A Value Stock w/ Bill Nygren & Mike Nicolas

Starting point is 00:00:00 You're listening to TIP. On today's episode, we welcome back Bill Nygren and Mike Nicholas from Oakmark Funds, which currently manages over 60 billion in assets. When we last had Bill and Mike on back in April of 2020, we were discussing Bank of America. And since then, Bank of America's stock price has risen over 100%. So I had to take the opportunity to discuss how they value the stock today. But the main point of the discussion is actually to take a deep dive into a potentially a surprisingly surprising value pick, and that's Facebook. In this episode we cover how Bank of America

Starting point is 00:00:35 is poised for growth over the long term and how they view it today, how Facebook is an asset light money printing machine with some moonshot R&D that is potentially undervalued, how Oakmark gets comfortable with companies like Facebook, Netflix, and Amazon as quote-unquote value stocks, the growth still ahead for Facebook, and much, much more. This was an incredibly insightful discussion for me since I've long written off Facebook as a stock that is overvalued. After this discussion, if you're like me, I think you'll find that you may want to take a closer look. So with that, please enjoy the always enlightening Bill Nygrin and Mike Nicholas. You are listening to The Investors Podcast, where we study the financial markets and read

Starting point is 00:01:19 the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors Podcast. I'm your host, Trey Lockerbie, and I am so excited to have Bill Nygren and Mike Nicholas back on the show. Welcome back, gentlemen. Thank you. Thanks, Ryan. So one reason I'm incredibly excited to have you guys back is because last time you were on the show, we were talking about Bank of America. And this was kind of back in Q4 of 2020.

Starting point is 00:01:57 And at that time, the stock was trading around $21. And, of course, this is kind of after the whole COVID pandemic that wrecked the market. and it's since risen to over $42 and 100% increase. So given the amazing performance, I feel that we have to spend a few minutes on it just to touch base on the stock to see how you're thinking about today's price versus the intrinsic value you set forth prior. Let me just kick it off. I don't think there are any stocks in the market today that we're as excited about

Starting point is 00:02:28 as we were last December. The whole market is up. Our portfolio has done significantly better than the market. So as prices go up, we think opportunity is less than it was when things were really cheap. And the financials are no exception to that. Most of them went down a lot in the first two quarters last year. And since November, they've come back a lot. But in our opinion, they've kind of gone from real cheap to cheap.

Starting point is 00:02:55 And Mike can share more of the detail on Bank America, but the story will be the same for half a dozen financials in our portfolio. They're not as cheap as they were nine months ago, six months ago, three months ago, but relative to really long-term history, we still think the banks and other financials are quite attractive today. Yeah, it was a pretty stressful environment last time we spoke, and we argued that the company had built an enormous amount of capital since the global financial crisis and that the company's underwriting standards had improved significantly under CEO Brian Moynihan, such that we thought the bank was better suited to absorb a pretty severe downturn, like the one we've recently experienced.

Starting point is 00:03:34 And COVID was certainly an opportunity for them to prove it. And so far, they've done an admirable job in our view. And despite massive disruption from the pandemic and a zero rate environment and the inability to repurchase stock for much of the year, Bank of America was still able to generate nearly $2 a share of earnings last year. They ended the most recent quarter with almost 10% of their market cap and excess capital above their regulatory requirements. And we would expect all of this to be returned to shareholders over time.

Starting point is 00:03:58 And deposits have skyrocketed, but loan demand remains very weak still, such that Bank of America is operating a loan to deposit ratio of 50%, which is very low by historical standards. So there is a material amount of cheap, unused funding capacity that can be deployed once the economy improves or loan demand improves as well. But as Bill said, most of our high-level assumptions remain the same today as they were the last time we spoke. We still think they're capable of generating a load of mid-teens return on, on-time-term. tangible common equity over a cycle, and that implies the normal earnings power of the bank

Starting point is 00:04:33 is well north of $3 a share. With many of the shorter term concerns that we discussed with you guys last year, having improved quite a bad debt expense, long-term interest rates have improved, B-head wins are beginning to abate. The outlook is much healthier than it was, and that is more reflected in the stock price. And the time last year, I think Bank of America was trading right around its tangible net asset value. And today, it's closer to 1.8 times that metric. But at roughly 11 or 12 times our estimate of normal earnings, it still seems reasonably attractive in our view, but nowhere near the opportunity we saw last year. When we last talked to you, we were talking about how the S&P was at about 20 times earnings that over a generation, banks have averaged about three quarters of the S&P multiple. So we would have argued that they should be creating more like 15 times earnings if the S&P's at 20.

Starting point is 00:05:22 Now the S&P is at 22. If anything, relative to a year ago, big banks' competitive positions have even improved as economies of scale keep growing. So they're not at single-digit PEs anymore, but we would say with the market where it is, they should be trading 16, 17 times earnings. And that still gives a pretty good return if you see banks go up to that kind of P.E. ratio. So I didn't entirely miss out on this gain because I do own some Berkshire Hathaway. And as we noticed from the meeting that Buffett just held, he's now consolidated all of his bank position into

Starting point is 00:05:59 Bank of America. And I'm just kind of curious what your thoughts are on his position and kind of letting go and totally consolidating into this one stock. I don't think we have any special insight into what Warren is doing in his portfolio. Clearly, there's a lot of overlap in the thought process of how we try to identify attractively valued companies that are well managed and have very long-term holding periods. I think if you really pressed us, we'd say Bank America is our highest quality financial that we own, but there are other financials that we think that don't trade at the same multiple that Bank America does. They're cheaper than Bank America that we think make just as good an investment. So we're always glad to be invested

Starting point is 00:06:43 side by side with him, and we're glad that he's there in Bank America. Well, I say that I didn't entirely miss out, but this stock in particular was just screaming at us on our stock screener. And I was overlooking it because I think I was getting a little bit caught up in this macro thought that we're in this low-interest environment still, which I want to talk about a little bit more. But there's this whole movement of defy entering the space. And if you think about the fact that banks are really not providing much, really any yield on holding your money, then where does the value of using a bank come from? And it seems to come from just its ability to be a payment platform, the way that you kind of are able to wire from business to business or person to person. But there's a lot of new entrants into the space trying to capture that with Square and PayPal and a few others. What is your general thought on the disruption of traditional banks?

Starting point is 00:07:39 Yeah, I think Square and PayPal have done a really good job of building out their payments and their digital banking capabilities. But when you think about somebody like Bank of America, it's a very heavily diversified financial institution. And it does provide more value than just a platform for consumer payments in a low rate environment. You know, in addition to its payment capabilities, Bank of America extends loans, credit cards, mortgages, auto loans. They advise individuals on retirement and financial planning matters. They store and protect your assets. They provide free digital tools to manage your finances, pay your bills electronically, transfer money on a B2B basis via Zell.

Starting point is 00:08:16 And on the other side of the house, the Commercial Bank of America also provides several valuable services. They raise capital for businesses. They make markets and provide liquidity for various financial instruments, stocks, bonds, commodities. They stepped in to provide massive liquidity to commercial clients at a time when credit line draws were occurring at really breathtaking levels last year. They supported small businesses.

Starting point is 00:08:37 It's the largest lender within the PPP program. So companies like Square and PayPal have clearly done an impressive job in payments and even beyond in some regards. But many of the services that Bank of America provides today are not necessarily being served by a Square or PayPal. And given the balance sheet intensity and the valuation multiple ascribed to some of the traditional financial institutions versus the fintechs, I'm not so sure that they're that enticed to enter some of these other markets. Just throw in it at a more high-level comment rather than Bank America specific. If you think about a lot of the fintechs, if they end up losing out, the downside support is almost nothing. There aren't meaningful assets.

Starting point is 00:09:19 There aren't necessarily businesses that other people would want to purchase. If you took the worst-case scenario for banks and they start losing customers over time, most of these banks are going to have in the next three to five years a book value that's as high as the current. stock price, and they could slowly liquidate at somewhere near their book value. So even in the Death Star scenario, you still have a pretty good downside protection, we think, with most of the banking industry. That's a really great point. And another kind of macro thought I had about Bank of America was the fact that interest

Starting point is 00:09:56 rates still are very low. And it's easy for an investor to understand that this low interest rate environment negatively affects banks because banks. because banks generate loans and then they generate revenue by collecting interest on the loans. The interest is essentially the top line revenue in this way. And so last time you were on the show, you enlightened me, at least, to the fact that Bank of America has evolved to the point where 50% of their revenue nowadays is coming from fees, which is all well and good.

Starting point is 00:10:24 I'm just kind of curious, consumers don't love fees. And there's a lot of entrance and competition entering, especially trying to be even lower cost on the fee side of things. So I'm wondering how you look at Bank of America's purchasing power when it comes to fees when there's other competitors entering the space. Yeah, I wouldn't say that Bank of America has necessarily pricing power on fees. And I think this was largely the case before some of the new entrants became so popular. However, on something like deposit pricing, we do believe that Bank of America has shown the ability to have some pricing power historically. We would expect this to be the case going forward. It's just not that

Starting point is 00:10:59 evident in today's zero rate environment. But if short rates do rise, we would expect the rate paid on their deposits to go up much less than interest rates would, which of course would benefit margins. So the ability to price their deposits below market is mostly a function of the additional value that these banks provide that we discussed a lot last time. And it also helps that nearly 60% of the consumer deposits are primary checking accounts, which just don't churn very much. So, you know, to the extent that they have any sort of pricing power, purchasing power, I think it would be more on the liability side of the balance sheet as opposed to fees at this point. The 50% that they get in fees, Mike, what are the biggest sources?

Starting point is 00:11:36 Yeah, it's smart trading, investment banking, investment management, parts of wealth management. So these are largely areas where I think you see less encroachment from some of the, you know, neobanks or some of the fintechs. And I think people are starting to understand that there really is no such thing as free. Free just means the costs are more hidden to them. And I'm not convinced that that model wins out. Yeah, there's no free lunch, as they say. Right.

Starting point is 00:12:02 So I'm curious. Last question on Bank of America is just, you know, since it's risen over 100% since we last talked about it, how does that affect your portfolio? Do you guys de-risk at that point? Do you rebalance? How do you kind of look at it now that it's gained so much? The way we think about position sizes in the Oakmark Fund, it's meant to be a diversified fund that will have about 50 to 55 holdings most of the time. Cash is never a big number for us,

Starting point is 00:12:29 usually mid-single digit. So if you think about that, it means the average position is just shy of the portfolio. The way we think about position sizing, we never buy something after it crosses 3% of the portfolio, and we trim it when it crosses 4, just believing that nothing should really be more than twice a typical position in the portfolio. Bank America's done well enough that we have had to trim it a little bit, but we still think it's an attractive stock and competes pretty well with the rest of our approved list. So it's still a very important holding for us. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight,

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Starting point is 00:17:13 Back to the show. All right. Well, the real reason we brought you back on today's show is to talk about another really fascinating company called Facebook. So I want to dig into this a little bit with you because they just released their Q1 numbers and they are astonishing. The free cash flow, for example, has been growing 27% over the last five years. The top line revenue is growing at 37%. I mean, these are just incredible numbers. So let's start with a highlight or like an overview of Facebook, what drew you to the stock? I know that there's a reason these big fang companies keep going up and up,

Starting point is 00:17:48 but I'm curious to see how you look at it from a value perspective. Yeah, I was thinking back to our last conversation with Stig, and he reminded us on that call that Bank of America's MPS score was nearly as bad as Facebook. So naturally, you guys requested to be discussed Facebook this time. But I can assure you, we don't intentionally screen for businesses that's corporally on this metric, but it was one of the most heavily scrutinized companies on the planet. the figure really doesn't surprise us. You know, seemingly everybody hates Facebook.

Starting point is 00:18:16 They just can't necessarily agree to why. But, you know, what attracts us to the company? Facebook's business model is one of the more attractive we've come across is unlike most media companies. Its content is primarily generated by its own user base. And today, the vast majority of the company's revenues are being generated from advertisers that are looking to reach and target the billions of people that use at least one of its services every day.

Starting point is 00:18:39 And, you know, the company benefits from powerful network effects and from that regular targeting capabilities for advertisers. You know, stepping back, Facebook built the infrastructure that really underpins what I would consider the richest and most comprehensive database of humans on the planet. And it's typically updated in near time. And most everyone with internet access in the world, excluding China, of course, where they don't compete, have chosen to use one of its services quite regularly. People use its services because they provide value, you know, the ability to stay connected

Starting point is 00:19:07 with family and friends, for product discovery, increasingly, for news, for entertainment. And that network has really strengthened considerably over time. As a result of these business attributes, Facebook generates very high operating margins with relatively low marginal cost for incremental user. It does continue to go rapidly. But to answer your question directly, these types of hyper-normal growth rates probably can't be sustained forever. During its most recent quarter, as you mentioned, the company grew its organic advertising

Starting point is 00:19:35 revenue by north of 40%, which given the size of the existing revenue base, is much stronger that I think either Bill or I would have told you a couple of years ago in terms of what was capable. The law of large numbers will eventually kick in, and we should expect these growth rates to accelerate perhaps meaningfully over the coming years. But even under this scenario, we believe the stock remains quite attractive. And I would say when we look at Facebook, we see multiple businesses and assets like their cash, WhatsApp, Oculus, the augmented reality business that they have, in total.

Starting point is 00:20:11 total, those companies are losing money today. So we think that you maybe get something like a quarter of the share price in businesses that aren't currently profitable. So what that means is the PE on the base business that looks like it's a little bit higher than the market. After you make that adjustment, we think Facebook's really selling at a discount PE if you're just looking at the core Facebook and Instagram businesses. And you hear a lot of arguments about how long will it take for Facebook's growth to slow

Starting point is 00:20:41 down to like an S&P growth number. But nobody really wants to argue that Facebook is going to be a worse company than the S&P. Yet you can buy it at a discount multiple. It just doesn't make sense to us that you have that opportunity. Well, I'm glad you brought up the other revenue streams that they bring in because they brought in Q1 over $700 million of other revenue, quote unquote, so almost a billion dollars of revenue that's outside of ad generation that they do. You mentioned about losing earnings on this portion. What potential do you see in those businesses? How much do you forecast their growth into the equation?

Starting point is 00:21:20 That other segment is primarily Facebook reality labs, and that's most notably Oculus. Today, the non-advertising revenues make up a real trivial percentage of the total revenue base of the company, but certainly over a much longer time horizon, Mark Zuckerberg has talked about and believes that virtual and augmented reality could really become the next major computing platform. And some of the recent success that you cited is clearly giving them more confidence in the technology and the potential for consumer adoption. So they're investing an enormous percentage of their R&B budget into this. What's interesting just kind of getting back to Bill's points is that the reality lab scheme at Facebook now accounts for, by some estimates, nearly 20%

Starting point is 00:22:00 of their total employee base. Yet the revenue being generated by that division amounts to just a low single-digit percentage. We've seen third-party estimates that suggest Facebook could be losing something in the neighborhood of six to seven billion a year from reality labs, which helps to explain a lot of the margin leakage that we've seen in this business over time. Just for some context, Facebook had a 50% operating margin in 2017 on a $40 billion revenue base and looking forward to next year, they're projected to grow to 140 billion of sales, but the margins are expected to be down 10 percentage points. So what's going on here?

Starting point is 00:22:32 On the surface, the margin degradation would almost seem to conflict with what we were talking about earlier about the low incremental cost for new user. but this drag is at least in part due to higher capital intensity and certainly increased content moderation costs, but a lot of it is due to their belief that many of these investments that they're making across the income statement will contribute meaningfully to value over time and specifically reality labs and WhatsApp. It's hard to know exactly how big this could become, but to us, for most companies, you don't get a free call option on a market leader that's potentially developing breakthrough

Starting point is 00:23:08 technologies like this. And we kind of look at it like this. If it never takes and they were to close down reality labs, we could see billions of annual losses potentially evaporate. You know, margins would call up significantly and reported metrics would look even more compelling than the headline numbers. But if it hits and we're eventually communicating or gaming or consuming other forms of content and more of a virtual or augmented setting, it could prove to be an immensely valuable asset. Now, and this isn't the first time that we've seen. the company make the decision that rather than collect current earnings for an asset, they'd rather grow scale because they think it increases their moat.

Starting point is 00:23:48 We've seen that with YouTube inside of Alphabet, even Amazon with their basic retail business. They've decided to not capitalize as much on pricing as they could because they wanted scale. So the idea that WhatsApp could grow its scale faster and develop a moat at the expense of not reporting earnings, for a few years is, I mean, that's been a successful formula for a lot of venture cap businesses. So it's not too hard to imagine that somewhere down the road after the company monetizes it, but that becomes a real significant free cash flow generator. We've seen it with cash at companies.

Starting point is 00:24:26 When we first bought Apple 12 years ago or so, we sold it last year, so we don't own it anymore. One of the big knocks on them was they were just building this monstrous pile of cash. Then they started repurchasing shares with it. Facebook's repurchasing shares, Alphabet's repurchasing shares. So these assets that right now aren't generating a lot of cash flow, we think it's just a matter of time until they become really important, valuable assets. Well, and Facebook spent over a billion dollars on this R&D in Q1 versus 2020. And just from the outside looking in, it appears that Facebook may have regulatory challenges

Starting point is 00:25:05 by trying to continue to grow through acquisition. So instead, they might need to continuously fund internal development like this. Sometimes stereotypes exist for a reason, and the stereotype that a large company loses its ability to innovate over time, given vast amounts of bureaucracy, et cetera. Do you agree that this might be the driver for the R&D spend? And if so, is there any present or inherent risk to the future growth that they have to continue to grow by investing internally in this way?

Starting point is 00:25:35 I think we would certainly agree that growing via M&A will be very challenging going forward, given the heightened regulatory scrutiny on the company and big tech in general for that matter. It is unclear whether some of these massive investments will play out, but moonshots like this do have the potential to create asymmetric outcomes. One of the benefits that Facebook has is the ability to deploy nearly 20 billion a year into R&D. Not every company has this type of potential. But historically, even thinking about some of the acquisitions they've made, like Instagram, those required a lot of R&D dollars by Facebook to get them to where they are today.

Starting point is 00:26:12 People sometimes forget that Instagram had no revenue and it was originally acquired by Facebook. So we clearly believe they have a lot of work ahead of them in order to prove that some of the innovation spend that's running through today will ultimately earn a fair return. But similar to our view on Alphabet, we don't believe these kind of other bets need to pay off in spades in order for the business to grow at attractive rates. We also don't necessarily believe that the increase in R&D is a function of their inability to acquire other companies. They've always spent enormous sums on this line on even prior to the kind of implicit restriction on M&A. If Facebook, our alphabet, made the decision to not do this internally,

Starting point is 00:26:51 but invest large sums in venture capital, you wouldn't have the losses going through the income statement. Investors would look at their venture capital investment as an half, They're doing it internally because it benefits the whole company. As basic search or the Facebook platform growth starts to slow down, hiring engineers is still one of their biggest challenges. And because of some of these other areas that companies like Alphabet and Facebook are investing in, it helps make hiring easier for them. So we think there's a tremendous advantage to them doing this internally as opposed to

Starting point is 00:27:29 externally. And like any venture capital investment, some are going to pay off big and some won't, but we have no reason to believe that either of these companies is not effective at the way they're deploying these dollars. And, Trey, most street analysts don't make the adjustment the bill was referring to where they add back losses are certainly not necessarily giving them credit for what they're spending on. So implicitly, they're ascribing a highly negative number to something that we think are a fairly promising portfolio of potential other bets. Yeah, a lot of people forget that when Amazon, for example, when public, AWS didn't exist, right? So a lot of these spawning efforts on companies in this way are very fruitful over time.

Starting point is 00:28:13 I'm curious maybe 10 years from now, you know, what do you think the spawning looks like for something like Facebook? It's hard to say. If I go back to when we owned Amazon, we were one of the few value investors that thought it looked cheap and we bought it because it was selling at a smaller percentage of sales than bricks and mortar retailers that they were slowly putting out of business. The reason we ended up selling it is AWS grew so fast and other analysts were putting such high values on it. We had a hard time getting comfortable with how much AWS might be

Starting point is 00:28:48 worth. I could envision a scenario with Facebook that's the same where something that they do with augmented reality, building it into basic computing, takes off. Other people understand it faster than we do. And instead of implying the negative value, we think we're getting paid to take it today. There's probably somewhere down the road that other analysts are going to pay more for augmented reality than we get comfortable paying for it. And we could look back on it and say, you know, we sold it off too soon, but at a number that's much higher than today's price.

Starting point is 00:29:24 I'm glad you touched on how much cash Facebook has. And again, the ability to even spend 20 billion a year on R&D is incredible. They're sitting around $65 billion in cash on the balance sheet right now. How do you feel about that? And they didn't deploy as much maybe as they should have on R&D in that way. But they're sitting certainly on a ton of cash. Do you feel like that's any kind of drag on the company? What a high class problem to have that Facebook can be turning out the kind of growth

Starting point is 00:29:50 that it's reported over the past year. and its business model is so capital light that its big problem becomes it's piling up much more cash than it can deploy. Our belief in any stock that we own is that it's undervalued. We wouldn't own it otherwise. So we get excited when we see management willing to take some of that capital and grow by reducing the denominator, by share repurchase. And we're pleased to see that Facebook is starting to make that a meaningful part of their capital deployment strategy. Well, and one of the other benefits, I guess, is the fact that there's only about 30 billion of liability, so they could just use half the cash and wipe out all the liabilities on the balance

Starting point is 00:30:31 sheet, which is also a good place to be. Well, and those liabilities are just operating liabilities. Effectively, the company doesn't have debt. So there's no reason to pay off the free liabilities that are there. We're thrilled with the set of problems that they have, in quotes. Generating more cash than they can rapidly deploy is a great problem. want to have. At the last Berkshire Hathaway shareholder meeting, Charlie Munger said something, I'm paraphrasing, but it was something like paying $1 over intrinsic value in share buybacks is

Starting point is 00:31:03 highly immoral. You know, and buying $1 under intrinsic value is maybe the most moral thing you can do. So there's a very fine line with share buybacks. And Facebook spent nearly $4 billion in the last year on share buybacks. I imagine you agree that it was undervalued throughout that time. But What would change your mind if you start seeing their buybacks continue to grow aggressively and maybe it goes against the valuation that you have in mind? First, I'd say, I think even Charlie would say that you probably can't define intrinsic value down to the last dollar. You're trying to get in the right ballpark.

Starting point is 00:31:41 And when a company is demonstrably beneath intrinsic value, share repurchase, becomes a better alternative than anything other than reinvesting where you're competitively advantage. We won't own Facebook when we don't think it's cheap. So we're happy to have them buying back stock through the entire time that we own it. And somewhere long after we've sold our stock, if they're still buying it, either they are reducing value per share by doing that or we misjudge what it was worth. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your

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Starting point is 00:35:17 distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund fund fund's prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. Well, speaking of the ethics around Facebook and the culture there, you mentioned the net promoter score being very low. I mean, I would say that Facebook does not have sort of a brand halo, right? It has, obviously it's recognized for being just a behemoth and a great business model,

Starting point is 00:35:53 but there are some gray areas around the ethics. So how can investors get comfortable around that aspect of the business? I think it's an amazing accomplishment they've had that they managed to get people on the left hand right equally offended with them. The left thinks Facebook cost them the 2016 election and the right thinks that they cost them the 2020 election. I think they've acknowledged this, Trey, and they are working hard specifically on Facebook, the blue app, which seems where most of the concerns are really surfacing. I mean, Instagram does seem to have a fairly good halo and really the use cases for some of the messaging apps are quite different. But they certainly are investing a lot to

Starting point is 00:36:32 try to improve some of the concerns that have been raised by politicians and media outlets on the platform. And they're spending enormous sums and using AI to try to take down hate speech and anything else that they don't want on the platform. They don't want this type of information on their services. It's not something that necessarily is good for engagement. And advertisers certainly don't like to advertise against or mirror something like that. So I think the alignment is there, but it's a monumental task given the number of users and then as much activity as occurs on these platforms. I think the privacy issues are really interesting one.

Starting point is 00:37:10 I'd throw the question back to you. If you presented the Facebook users, the option of would you rather see ads that are targeted to your personal interests or pay $10 a month and not give them any information to use Facebook? what percentage of their customers do you think would say I'd much rather pay the cash? I think it's pretty close to zero. I think it's a great point. Let's talk about their users a little bit.

Starting point is 00:37:36 They have over 2.8 billion monthly active users at the moment. It's almost a third of the global population at this point and appears to continue to be growing. What is your target MAU monthly active user over time? And how do you see their growth maybe slowing down? We don't have a specific target for MAUs, but you're correct. Eventually, you know, the number of people with internet access in the world, excluding China, will become the gating factor for user growth. We still think there's room.

Starting point is 00:38:07 I think that growth rate will continue to accelerate as we've seen over time. One important question we ask ourselves a lot is, what's the true addressable market for Facebook, given that they have so many users today? And it is such an attractive platform for advertisers. And, you know, many people define that as the traditional, advertising pie, maybe something defined by e-marketer, but the true size of the revenue pool, given their user base, is likely much larger. We think this narrow definition really understates the opportunity. Bigger picture, digital advertising really has the potential to extract dollars

Starting point is 00:38:40 from non-advertising budgets, too. And this is often referred to as below-the-line advertising and includes things like promotional spending or product placements and slotting fees and trade shows, even rent. As more retailers transition their businesses online, we subscribe to the notion that Facebook and Alphabet for that matter have really become the new rent for the digital economy. They kind of act as landlords for prime digital real estate. So if we incorporate some of these other aspects into their market opportunity and their addressable market, we think the true figure could be many multiples of how people define digital advertising today. With three and a half billion people using at least one of their services every month. I'm not sure how many more

Starting point is 00:39:25 users they need to grow at this point. I think the bigger issue is the penetration of the true addressable market is still quite low, and they need to figure out additional ways to continue to monetize those users. And don't forget, given where Facebook stock is priced, if its growth slows to that of an average S&P company, it's a cheap stock. Let's talk about the pricing power too, because they actually did increase their price by 30% over the last quarter. I think they actually increased the ads by over 12%. You're right, that even if the MAUs start to slow, they still have the ability to make

Starting point is 00:40:01 more money off of the users they currently have. The price for ad unit did show considerable growth last year, but it's important to remember that advertisers bid for ad units on Facebook in an auction. Facebook doesn't directly set the price for those, but they can certainly influence it. The supply of ad units has a direct impact on the price for those ad units. So impression growth is inversely correlated with pricing growth. And you can see these dynamics over various points in Facebook history if you map the two. Of course, pricing is ultimately driven by the return on ad spend that's being generated by advertisers.

Starting point is 00:40:37 And we would expect revenue growth for the remainder of this year, at least, to be more driven by price. I think they've talked about that, which certainly implies less impression. growth, assuming they don't unleash a significant amount of new inventory, and we do believe they have it, we would expect that pricing to remain strong. But more importantly, I think the breadth and depth of the data should continue to make them one of the most attractive places to advertise, and that should show up in pricing. Do you have any insights into the demographics of the MAUs at all? I'd be curious to know if the younger generations, like the Gen Ziers, if that growth is there,

Starting point is 00:41:11 or if it's more just growth on the millennials and basically. baby boomer generations? It's mostly survey data that we work with. Facebook doesn't disclose a lot of cohort data by that. But I'm sure as we read the news, Facebook is not as popular with millennials and Gen Z so much as it is, as it tends to be with some of the older demographic. And don't forget, when you're buying Facebook, the company, you're getting Facebook and Instagram.

Starting point is 00:41:39 Instagram skews younger. I don't know what it is, maybe a third of revenues. and probably more of profits because you don't have to worry so much about controlling what gets said on Instagram. So that business, if that were a standalone business, that would sell at a much higher multiple than the company does today. Speaking of another tech company, Apple recently made the decision to no longer track personal data in certain ways.

Starting point is 00:42:07 So does that affect Facebook's effectiveness for targeting ads in any way? Does it have any effect on Facebook? I think for advertisers to shift their budgets to other platforms, they'd certainly have to see better relative targeting capabilities or better reach or better engagement. And we think that'll be difficult to do for most competitors. We still expect, even with iOS 14.5 that you're referring to, which will require users to really opt in to be tracked across third-party platforms,

Starting point is 00:42:37 we still expect their return on ad spend to be superior to most digital and certainly offline mediums. There's seemingly a new ad-targeting headwind, or at least a new competitive concern to be aware of every year. I mean, I can think back to the transition of mobile was expected to leave them in the dust. The California Consumer Privacy Act was expected to really impair targeting. Then there was GDPR in Europe, and now it's Apple with IDFA. As people opt out, it certainly will present some challenges for advertisers and therefore Facebook.

Starting point is 00:43:06 But historically, I think if there's one thing that the company has proven, And so they've done a really impressive job of both anticipating these changes and adapting to them without really any noticeable impact to the business fundamentals. And we will think they'll continue to do that. And they still have as good of targeting capabilities as anybody. And I think they've publicly stated that they believe this transition will be manageable for them. One of the keys is having the first party data. And that really allows you to build a real defensible digital advertising business.

Starting point is 00:43:37 And Facebook has it in mass. And we continue to expect them to remain a force in digital advertising, even if some of their off-site targeting and attribution capabilities proved to be a little weaker than they once were. But, you know, somewhat ironically, you know, increased privacy regulation has, at least thus far, seemed to actually further entrenched the walled gardens with the first-party data like Facebook. If Facebook needed to, they always have the option to say, if you want to opt out on tracking, that's fine, but then you'll have to pay X dollars a month. Presented with that choice, I don't think people would opt out. So one thing I'm incredibly fascinated by with Oakmark is your ability to look at these big tech companies, you know, in a value sort of way, as you mentioned, being early into Amazon and now looking at Facebook and making me take another look at Facebook personally.

Starting point is 00:44:28 How do you justify this? Is it just that if I look at Buffett taking on its Apple position, is it just that the companies are getting to this point where they are now the incumbents that are hard to disreferral, and the moat and the staying power has matured to a certain point where you can get comfortable around this idea that, yeah, it's tech-oriented, but the disruption is probably very low. Well, I think to call these companies tech companies is a bit of a misnomer. Amazon's a retailer, Facebook, and Alphabet are basically media companies selling advertising. Netflix is a media company.

Starting point is 00:45:05 But to make them qualify as value stocks has never been that much of a challenge for us. We owned Apple for 12 years where it never sold it a premium to the S&P multiple during that time. And it was kind of odd the number of questions we would get about how can a value investor own a company that's growing this rapidly? And we would always say, we own it because the P.E. is low. We think it will continue growing maybe not as fast as it has historically. but growing at a number that justifies a higher price. With alphabet, with Facebook, with Apple, the question always was, if you cut it down to the core business, the market price is a below market multiple.

Starting point is 00:45:48 You really think this is a worse business than average. And that has made all of them very simple for us. Netflix was probably the more complex one, but it was so similar to our history in cable stocks where cable companies were losing money, have negative book values back in the 80s. But we saw an active private market that was paying $1,500 to $1,500 a subscriber. Why were they doing that? Because customer acquisition costs were really, really high in the early days of the cable industry.

Starting point is 00:46:19 And the private equity firms or the companies that were rolling up the industry understood that those costs weren't going to be permanent. Netflix, when we bought it, was valued significantly below $1,000 a subscriber. A thousand to sub is about what we think AT&T paid in the Time Warner deal for HBO. Why is Netflix not earning a better profit? Because they're charging less for their service than they could. When you look at, one of the things we did is we looked at surveys of people that have multiple monthly subscriptions. So they subscribe to Spotify or XM or HBO, Netflix.

Starting point is 00:46:57 And you'd look at the prices of the others were all $15 to $20 a month, and Netflix was like $11. But then you ask people to rank order which one is the most important service to them, and Netflix always won. We looked at it and said, if Netflix charged a market rate for their product, instead of this low rate that was allowing them to grow at such a supernormal rate, they would actually sell beneath the market PE ratio.

Starting point is 00:47:23 We haven't needed to do a lot of mental gymnastics to get to a point of saying, these are really cheap businesses. Great point. So speaking of cheap businesses, let's talk about how cheap Facebook is today, in your opinion. I'm just kind of curious to get a general intrinsic value assessment of sorts on Facebook and how it kind of compares to where you see it going from here. The investment thesis is pretty straightforward, as Bill had mentioned. I mean, the stock trades for around 300 bucks today, a share. And, you know, we expect this business to have about north of $40 a share

Starting point is 00:47:57 of net cash and investments on its balance sheet by next year. That cash, as we spoke about, earns next to nothing today. So even using consensus forward EPS estimates for Facebook, is trading for less than 17 times next year's earnings, X cash. The market as a whole trades for 22 times. So we don't believe a business. like this deserves to trade below a market multiple. But remember, within there, there are billions of dollars of losses that are further inflating what's already a low market P.E. multiple for a business like this. And we believe they'll either be monetized or eventually, at least in the case of ARVR, we turned off. They're investing well ahead of business growth and many of these investments are

Starting point is 00:48:38 going to take some time to pay off. But adjusting for this spend, we think Facebook's P.E. multiple would grind down much, much further. So really, just looking at the company from that perspective, it really looks like an outlier with a low statistical valuation, very high projected growth rates, an extremely strong existing competitive position. There is a tremendous amount of fear and skepticism built into this valuation, which we think is a source of our opportunity. What could it be worth? Hard to say. Would it surprise me to see a trade at 30 times earnings at some point? Not necessarily. I certainly think it's worth more than a market multiple. If you carved Facebook down to just Facebook and Instagram, and you ran with a balance sheet that had no net cash and no debt on it, it seems crazy to think that could sell beneath the market multiple.

Starting point is 00:49:22 Like Mike said, I think it's such an advantaged economic model that it's pretty easy to see that it could be 30 to 50 percent higher than the market PE. And after you account for the other businesses in the cash today, we believe you're getting Facebook and Instagram, but a significant discount to the market. Well, it's interesting to hear you guys talk about this kind of PE relativity, right, to the overall market. And not so much anything like, you know, discounting future cash flows and that sort of thing and looking for a specific discount rate. Is that kind of a fair assessment? Basically, that's not the typical way your approach here? We do discounted cash flows.

Starting point is 00:50:01 We do relative PE multiples. We do acquisition multiples. and we'll get like four different models and then try to figure out why they're coming up with different conclusions and use all of the models to inform us to our best guess of business value. One of the ways we look at Facebook

Starting point is 00:50:20 has nothing to do with what the market multiple is. It's to say how much of a premium would have investor in Facebook need to earn relative to a government bond to take the risk of owning the equity. And even after we mark up government bonds to a level that's higher than where they trade today to where we think, because we don't think investors will forever accept the negative real return to invest in the bond market.

Starting point is 00:50:45 So you say that if inflation is going to be 2%, and a 7 to 10 year bond will be three, Facebook's a below average risk company, so maybe an investor would want to earn 6% owning Facebook. Then you project out seven years and then a growth rate after that, it's hard to come up with a number that's much under 500. it. And looking at the PE relativity, the relative PE multiple, when does it get expensive? You mentioned kind of 30 to 50% over the market. Is that sort of the time for any stock that you're looking at to kind of say, okay, this is getting a little heated for us? We don't think of it quite that way. I think the biggest difference between us and fundamentally based growth investors is when we

Starting point is 00:51:29 think our crystal ball gets too hazy to be of any value to us. For us, that's about seven years. No matter how good a business is, we don't want to be paying a premium to the expected market multiple seven years down the road. Interesting. Where did the seven years come from? Asking our analysts to forecast out in detail two years and then in less detail, five years longer than that. And having been doing this for 30 plus years, we haven't found a reason to go either direction from that seven years. A lot of the younger kids today will say, boy, these business models today are so competitively advantaged, the moats are so great, it's obvious that they can last, they can grow supernormal rates a lot more than seven years. But I'm old enough

Starting point is 00:52:18 to remember when that argument was last used for newspaper, or for pharmaceutical companies, that seven years down the roads, their patents had expired and earnings were less than half of what expectations had been. There's some value investors that will only look backwards. They won't look forward at all. They're growth investors that'll look out 15 to 20 years. We're kind of in the middle of that and pretty comfortable in that range. I like it.

Starting point is 00:52:43 It reminds me of Buffett's comments at his meeting where he was talking about 30 years ago or so there was a list of top 20 stocks and none of those companies are in the top 20 today. Is Facebook something that, of everything you've looked at, you could see 20 to 30 years from now being in the, I'm asking you an impossible question, but I'm just curious, you know, of all the companies you've looked at, does it have the staying power that you think it might? I remember a CEO who got fired for not buying MySpace because that was going to be the winner and last for 30 years. I don't think we would hold Facebook out as being the company that is most likely to be the same business it is 30 years from now. We own ADP. They've been a leader

Starting point is 00:53:27 for a long time. Put them in that category where maybe, maybe I'd want to bet on them for more than seven years or a master card or booties. But our track record's not good on that. The market's track record is not good on that. The businesses that earn really good returns today that you see no possibility of being disrupted for exactly the ones that some kids who's in an entrepreneurship class in business school is looking at as a candidate to be disrupted. I just don't think it's safe to look out a lot farther than that.

Starting point is 00:54:00 I think it's very wise. So this has been a lot of fun. I've certainly learned a lot, especially about Facebook, which has not been on my radar, to be fair. I've been owning a basket at the QQQQ fun just because a lot of these tech companies, I've kind of subscribed to the idea that I don't understand them.

Starting point is 00:54:17 But you are kind of helping me look at this in a different way by saying, it's time to retire the tech company title. These are just companies now. They're not, or internet companies as they were, you know, back in the early 2000s. I think that's the right approach. Before I let you go, I want to make sure I give you an opportunity to handoff to Oakmark funds, to any of your platforms or any other resources you want to share with the audience. I'd point people first to our website, oakmark.com.

Starting point is 00:54:43 All of our quarterly reports are there. I've written a quarterly commentary every year for getting to be too long now, I don't know, 25 years plus. I think the fastest way to learn about us is to spend some time and read a few years' worth of those reports and see how consistent the thought process is. We are on social media, so you can follow us on Twitter. We're not in the camp that believes we have to have something to say every day. So when you see a tweet from us, you might even forgotten you'd follow us. But we usually do try to highlight new information that's up on our website through our Twitter account. Fantastic. Well, Bill, Mike, I really enjoyed having you back on the show, and I hope we can do it again soon.

Starting point is 00:55:29 Thanks, I appreciate it. Thanks, Trey. It was great to be with you today. All right, everybody. That's all we had for you today. If you're loving the show, go ahead and follow us on your favorite podcast app. Definitely get in touch with me on Twitter at Trey Lockerbie, T-R-E-Y, L-O-C-K-E-R-B-I-E. And I cannot emphasize this enough if you haven't already done so.

Starting point is 00:55:49 Google T-I-P-P-F Finance to check out our T-I-P-P-FINance tool. Had you used the T-I-P-P finance tool a year ago, you would have seen that Bank of America was really jumping out as a potentially undervalued stock that I, unfortunately, didn't take advantage of. But you can, moving forward, with our stock screeners. ahead and check that out at theinvestorspodcast.com. And with that, we'll see you again next time. Cheers. Thank you for listening to TIP.

Starting point is 00:56:19 Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to The Investorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP355: Why Facebook Is A Value Stock w/ Bill Nygren & Mike Nicolas

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