Why You Shouldn’t Hold Your Facebook Stock Forever

August 25, 2017

Why You Shouldn’t Hold Your Facebook Stock Forever

  • Good long-term investments can only come from companies that possess durable competitive advantages.
  • I’ll mention 6 things to watch for when looking for a durable competitive advantaged.
  • Today’s tech companies don’t have large moats, but this doesn’t mean you shouldn’t invest in them.

Introduction

As you probably remember, 1999 was a great year for stocks and a relatively bad year for Warren Buffett and Berkshire Hathaway (NYSE: BRK.A, BRK.B).

Warren couldn’t really compete with the hysteria surrounding dot-com stocks and his performance in 1999 was a mere 0.5% increase in book value while the S&P 500 was exploding. This was due to several of his investments lagging the market due to lower operating earnings. Nevertheless, Buffett mentioned in his 1999 letter to shareholders how he was still happy to hold onto those companies because over time, he believed his businesses would do better than the S&P 500.



In his 1999 letter, what’s also interesting is his statement about how he believed that S&P 500 returns in the next decade would be far lower than the returns since 1982. It’s incredible how right he was.


Figure 1: S&P 500 since 1982. Source: Yahoo Finance.

Today we have a similar situation to 1999, tech stocks have exploded in the last 8 years with the Nasdaq up almost 5 times. In 1999, Buffett said that he had: “no insights into which participants in the tech field possess a truly durable competitive advantage.” It’s interesting to look at the current market through the same lenses.

Apple, Google, Microsoft, Facebook, Amazon, Comcast, Intel, Cisco, and Netflix dominate the stock market. However, the question is: do any of these companies possess truly durable competitive advantages?

Durable Competitive Advantage

Buffett would describe a business with a durable competitive advantage, or moat, as having the following:

“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore, a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing powerful worldwide brands (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.

“Our criterion of ‘enduring’ causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s ‘creative destruction’ is highly beneficial for society; it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.”

The things to look for in order to determine whether a company has a moat are the following:

  1. Low Cost Provider – If a company can continually be the cheapest company offering a satisfying product to customers, there is no need for us to switch to something else. What I see happening is that we expect more and more things to be free, which makes it very hard for companies to make profits. Just think of Facebook’s messaging platform WhatsApp. As for Apple, remember the Nokia phones you were using not even 10 years ago? It’s impossible to predict what kind of new technology could disrupt the market in the next 10 years.
  2. High Switching Costs – This is Microsoft’s moat. As long as most people are using their operating system, it will be costly to switch to something else. However, more and more people are using Macs and who knows whether there will be a new player to disrupt Microsoft’s kingdom in the future.
  3. The Network Effect – Amazon is clearly dominating online retail as if you want to sell something online, you have to be on Amazon as customers first look to Amazon when searching for a product. However, as I live in the Netherlands where there is no Amazon because local players dominate the field (Ahold Delhaize’s Bol.com platform), it’s interesting to note that even without Amazon, the margins are much lower for Ahold’s online platform than for its normal retail grocery chain. This is connected to the previous thing to look for. We want things for free, which makes it difficult to operate at high margins. Low margins make it easier for others to take them away.
  4. Strong Brand Name – Perhaps 20 years ago, Coca Cola was the strongest brand out there, but today, with information instantly at the public’s fingertips, even a small mistake can quickly erode the value of a brand. And Coca Cola is definitely not what it used to be.
  5. Economies Of Scale – For example, high fixed costs would push back competitors because they would know immediately that it’s difficult to be profitable. When looking at the top 10 Nasdaq companies, economies of scale really aren’t present as anybody can start most of the above-mentioned Nasdaq businesses and compete, even with a low budget.
  6. Government Protection – None of the mentioned Nasdaq companies have a monopoly or any kind of protection from governments. Just think of the recent fine Google had to pay to the EU. Governments are doing their best to make it difficult for tech companies to become bigger, so there’s another potential risk for today’s tech companies.



Conclusion

It’s extremely difficult today to find an investment that has a moat like those of the companies Buffett has found throughout his investment career. Therefore, owning a stock forever might not be as good of an idea as it probably was in the previous century.

Given the low capital today’s companies operate with, it makes them vulnerable to attacks and especially to stock price declines. If, for example, people buy fewer new iPhones, Apple’s earnings would quickly turn into a loss and Apple’s stocks price would significantly decline as the book value per share is minimal.

Nevertheless, this doesn’t mean we shouldn’t invest in the top technology companies of today. It only means that we have to be very careful and watch what they are doing in order to cash our profits in before some other new and hot tech company eats up our returns.