- Too many people love tech.
- Not enough people love free cash flow.
- "Competition is the enemy of competence".
The first time I saw the movie, Napoleon Dynamite, I walked out of the theater before the final wedding scene. This caused me to miss Napoleon's brother Kip singing "Always and Forever" to his new bride, LaFawnduh. The key line in the song was, "I love technology, but not as much as you, you see!" Kip found LaFawnduh "in a chat room," which indebted him to technology.
It seems to us that the US stock market, as represented by the S&P 500 Index, falls in love with technology even when it is not finding LaFawnduh. The newness and wonderment associated with technology creates a disconnect with the purpose of a business. For the sake of our discussion, LaFawnduh is revenue which generates profit and free cash flow. We believe the purpose of a business is to meet an economic need and to profit the owners in the process.
At Smead Capital Management, we have noticed lately that clouds, eye balls, tweeted selfies and a wide variety of aspects of technology have become the stars of the show. It appears that profits and free cash flow have taken a deep back seat to the excitement over what could be, but might never be. In a way, Kip loves the possibilities of technology more than he loves LaFawnduh, the wonderful byproduct of his time spent with technology.
An extreme historical example might be helpful. In 1999, there was a public company called eToys. US investors at the time were jacked up about the possibilities of the worldwide web without any long-term evidence of who might survive. eToys had about $41 million of sales and was losing millions of dollars. It had an $11.4 billion stock market capitalization near its peak. At the same time, Toys-R-Us had $11 billion in revenue, a $300 million profit and a $2.5 billion market cap. At the time, it seemed the stock market loved the possibilities of the Internet more than it loved profits and free cash flow (LaFawnduh).
Does the current affection for technology hint at a disconnection similar to 1999 for tech investors? Amazon (NASDAQ:AMZN) has revenues and revenue growth with little profit and little free cash flow in relation to its capitalization. Facebook (NASDAQ:FB) has eyeballs (including mine), Twitter (NYSE:TWTR) has tweeters (including Smead Capital), and LinkedIn (NYSE:LNKD) has users (including me). The question we ask is do they have profits now and in the future which will justify the current stock prices. In other words, is there any chance of finding LaFawnduh via the technology? Can they make us "salivate" over existing and future profits and free cash flow?
Charlie Munger explained to Berkshire Hathaway Annual Meeting attendees that "Competition is the enemy of competence." When asked how to determine where you have competence, Munger said, "If you are 5'3" tall, don't try out for the NBA." It seems to us that everybody wants to try out for tech among today's 15-30 year olds worldwide. We see the primary problem with investing in cutting edge tech companies is the fact that there are possibly millions of bright, young software engineers who get up every day and seek to create new technology that will cause Kip to fall less in love with the existing technology. In our view, these young brilliant software and computer science experts are coming after the profitable tech companies and even coming after technology companies whose profits could possibly be a fantasy. The competition is challenging competence in both cases.
The latest fears about eBay (NASDAQ:EBAY) and our long-duration ownership of the company reminds us of this dichotomy. EBAY loves to use technology, which is mostly created by somebody else, to facilitate e-commerce. This online commerce facilitator has massive revenue in their Marketplace and PayPal secure online payments business. They generated enough revenue and profit in the last year to have $4 billion dollars of free cash flow. In effect, it seems they are the envy of the incredibly popular companies like Amazon, Facebook, Twitter and LinkedIn, because they love technology and the way it helps meet an economic need, but they love LaFawnduh (profits and free cash flow) "more, you see."
Experience has taught us that the best way to measure a moat is to see how well it stands up to a real test. A few years back (centuries in tech land) Google took a run at creating an online payments competitor to PayPal. It was reported that Google spent over $300 million and had all the muscle that a monopoly in search could provide. Can anybody even remember what they called it originally? PayPal has grown much larger and is more dominant today despite the run at payments Google made. It has 148 million registered users and gushes free cash flow. Is it any wonder that one of the companies which loves technology and needs to figure out ways to make profit and free cash flow would hire the guy who ran PayPal? My guess is someone at Facebook recognizes that you should love LaFawnduh (profits and free cash flow) more.