Facebook (FB) has been a public company for just over a month now, and already it has become one of the most controversial companies in the market. Questions about valuation, growth, and its business model have all been raised, and the company's stock price has so far followed sentiments regarding those issues.
Facebook's critics have also levied another charge against the company: that it is a poor investment because of the majority voting power held by founder and CEO Mark Zuckerberg. They argue that because Mark Zuckerberg has control over the company, Facebook should not be invested in. We, however, believe otherwise. To us, having Facebook controlled by Mark Zuckerberg is cause to be bullish on Facebook, not bearish, because it helps protect shareholders from one of their worst enemies in investing: themselves. We explain our reasoning below.
The Modern Markets: A Distortion of Time and Expectations
Today's markets have become distorted from their original intent. The rise of hedge funds and high frequency trading has caused many investors to lose sight of what the markets are actually meant: long-term capital appreciation.
Companies go public for three main reasons: to provide early investors and employees with an "exit"; to allow new investors a chance to invest; and to raise capital. The intent of an IPO, at least in the 20th century (excluding the dot-com bubble), was for retail and non-insider investors to have a chance to grow their wealth alongside the company in the long-term.
Today's markets, however, have changed investor expectations, and how many companies respond to those expectations. We will use the financial industry as an example, because we feel it is the industry that best captures this problem. Many investors today have become obsessed with quarterly results, causing them to lose sight of the bigger picture. They buy and sell based on a single quarter's worth of performance, or demand that companies change their entire models or ways of doing business because something was not to their liking in the last quarter.
The financial industry offers the best example of why companies should not respond to such short-sighted thinking. Almost everything that financial companies do is cloaked in the notion of "creating shareholder value," even when the industry's track record of creating shareholder value is quite poor. Financial companies bend over backwards to make each quarters results, often damaging their own business in the process, all in the name of creating value. JPMorgan's (JPM) reaction to its London trading losses epitomizes the flaws of such an approach.
Ideally, on its next earnings call, JPMorgan will quantify the loss, say that it is making progress on containing it, that internal controls have been strengthened to ensure that this mistake is not repeated, and that the people responsible have been held accountable. And after that, the company will move on with its normal course of operations, because from a financial standpoint, this trading loss is not that big of a deal for JPMorgan. But of course, JPMorgan will not do that. After all, doing the right thing would be far too easy. Instead, sources close to the company say that JPMorgan is selling of billions in securities to book profits on them to mitigate the impact of its London losses on this quarter's income. We believe that this is a mistake on the company's part, and a reflection of the attitude that the only thing that matters is each quarter's results. JPMorgan has sold $25 billion of bonds and other securities to book profits of $1 billion to offset its trading losses. What JPMorgan did not add income to this quarter. What it did was siphon off income from future quarters. Lynn Turner, the former chief accountant for the SEC, summed it up best. He said that, "They really made two stupid decisions. The first was taking risks with derivatives that they did not understand. The second is selling assets with high income that they can't replace. In a low interest-rate environment, the bank will struggle to generate as much income with the cash it received from selling the securities." JPMorgan, in an effort to "create shareholder value," has actually robbed shareholders of value by selling good, high-yielding securities. JPMorgan now has $25 billion in extra cash, which will do little for it in today's low-rate world.
Companies should remember that it is best to think for the long-term, not obsess over each quarters. And shareholders who believe only in beating "this quarter's numbers" are not shareholders that a company wants to have. That is why some of the companies that have generated the most value for shareholders in their public lives are those where shareholders have essentially no control.
Founder Control and Influence: A Winning Recipe
Marc Zuckerberg controls well over 50% of the voting power at Facebook, giving him control to continue creating and innovating. And for Facebook's investors, that is the best model. One of the primary reasons to invest in Facebook is the presence of Mark Zuckerberg, and it is important for him to be insulated from short-sightedness.
The IPO of Google (GOOG) and its subsequent fate serves to highlight the importance of founder control. From the beginning, Google made it clear that Larry Page, Sergey Brin, and Eric Schmidt would control the company. And right up until the IPO, Google was met with skepticism. Questions abounded over its business model and its profit potential. And Google's valuation was also greeted with skepticism. Many people, in their rush to criticize Facebook as "expensive," forget that Google went public at 218 times earnings, a much higher valuation than that of Facebook. But Google has done quite well, creating a great deal of value for shareholders, due in large part to the fact that its founders and CEO had free rein to run the company in the style they thought was best.
Google was successful because of its three leaders, not in spite of them. While corporate governance experts may not like this approach, because it does not give regular shareholders enough say, we think that is how it should be. Often, shareholders are their own worst enemies, demanding a company change its ways because of a poor quarter or two, when in fact nothing needs to change. Amazon (AMZN) serves as a good example of this.
Amazon went public in 1997, well before the dot-com bubble burst, and is one of the few internet companies to survive it. But after the bubble burst, Amazon was maligned for not focusing on quarterly results. Shareholders wanted to see profit now, unaware of the long-term plans Jeff Bezos had (and still has for Amazon). Those shareholders sold their Amazon stock, and Amazon plunged to new lows constantly in 2001. But shareholders who kept their faith in Jeff Bezos and focused on the long-term were amply rewarded, because of Jeff Bezos' influence over Amazon.
Mark Zuckerberg at Facebook: A Reason to be Bullish
We see the presence of Mark Zuckerberg, and his voting control of Facebook as a reason to be bullish, not bearish. It frees Zuckerberg to continue innovating and extending Facebook's reach across the internet. And it makes monetizing the business easier, not harder. If Facebook is where internet users always want to go, selling advertising, both on the desktop and mobile, will be easier. If Facebook simply stopped investing in research & development and started to monetize every aspect of its business, we are certain that profits would soar this year, and possibly the next. But what about all the years after that? If Facebook were to begin focusing on short-term profits, it would imperil the company's ability to generate profits and create value for shareholders. And standing in the way of that danger is Mark Zuckerberg's control over Facebook. It frees the company from having to deal with short-sightedness amongst its investor base. And, it protects long-term shareholders from any pressure short-term investors might bring to bear on the company to change its ways. In effect, founder control at Facebook protects the company's investors from one of the chief threats to their wealth: their own emotions.
Is Facebook for You?: It Depends
Aside from judgments about Facebook's valuation, growth, and financials, investors need to come to terms with a simple truth. As an investor in Facebook, your vote means essentially nothing. Mark Zuckerberg will run the company according to his vision, with his trusted lieutenants ensuring that the company is able to profit from that vision. If you are an investor who is not comfortable with that reality, then you should not invest in Facebook. Every investor is different, and a company that is a good fit for one investor's portfolio may not be for that of another investor.
Within the technology industry, there is a ample evidence that companies with visionary founders can create value for shareholders over the long-term. We believe that over the long-term, Facebook can create value for shareholders. That is why we bought shares of the company, for we believe in Mark Zuckerberg's vision, and the company's ability to profit from that vision.
Additional disclosure: We are long shares of GOOG and AMZN via a mutual fund that assigns the companies a weighting of 2.1% and 0.94%, respectively.