I hate to say I told you so—although the truth is, I love it! Investing is a hard game, so when you’re right about something it feels good to stretch the legs and take a victory lap. Soon enough, experience has shown me, I’ll be back in the scullery eating humble pie.
In my year-end letter to clients several months ago, I said that I have never liked and would likely never invest their money in Facebook
—oh, I’m sorry, “Meta.” With three billion users, it’s true that the owner of core “blue” Facebook, WhatsApp, and Instagram spans the globe, but it’s also facing rising competition from TikTok and other, younger networks.
Here’s the longer-term and more substantive point: Nobody uses Facebook because it’s awesome. People use it because everyone else is using it; unlike Google’s search network or Amazon’s delivery infrastructure, Facebook is not clearly the best in class. For this reason, core Facebook, where analysts estimate the company makes 80% of its money, is much more vulnerable to competition than Google
If users begin to abandon Facebook for another site, the value Mark Zuckerberg has created over the last 18 years will unwind very, very quickly.
Now comes news that apparently Facebook’s—I mean Meta’s—second-in-command apparently agrees with me. At the very least, Sheryl Sandberg, the company’s chief operating officer, is voting with her feet, announcing on Facebook Wednesday that she is quitting—to “spend more time with her family,” of course, and to spend time on philanthropy.
I don’t know about you, but Sandberg has never struck me as the kind of person driven by anything but her work. Her departure is clearly signal rather than noise.
Facebook—I mean Meta—closed down 2.5% on Wednesday before more than recovering on Thursday. It has lost about 45% of its value in only five months.
As I wrote here and in my recent book, “Where the Money Is,” I’m a huge fan of technology companies—but only certain ones. Software-driven and asset-light business models are changing the economic landscape in ways not seen since Henry Ford and John D. Rockefeller, but the laws of competitive advantage have not been repealed. What Peter Lynch said a generation ago remains as true as ever: “In the end,” he wrote in “One Up on Wall Street,” “superior companies will succeed and mediocre companies will fail, and investors in each will be rewarded accordingly.”
What constitutes a superior business in the digital age? The answer can be involved, but it always boils down to a single marker: a company must have an edge — a moat, to use Warren Buffett’s metaphor — which keeps rivals away. Only such businesses can grow sales and earnings for years to come.
Meta has never struck me as a company with the kind of durable competitive advantage that makes it a good long-term investment. Over the years there have been plenty of warning signs about this, and Sandberg’s announcement marks a good time to tally them up.
I do this partly to take that victory lap, but more importantly to serve a forward-looking purpose. If we study Meta’s warning signs in hindsight, we can use the lessons to identify potential problems lurking in our portfolio right now.
Lesson No. 1: Own companies that invest $1 today for $3 tomorrow, even if it means lower current profits
When I started studying digital enterprises in 2016, it was interesting to compare the income statements of Facebook and Alphabet, Google’s parent. Powered by its search business, Alphabet reported revenues that were more than triple Facebook’s that year—but Alphabet’s operating profit margins were only 25%. Facebook’s, on the other hand, were 45%.
These disparate percentages make no sense to any student of business. Both Google and Facebook use almost no assets and, once they have built the essential infrastructure of their sites, they incur almost no incremental costs. If anyone should have higher margins, it would be Alphabet. It has triple the revenues and therefore much more opportunity to bring these incremental dollars to the bottom line. Alphabet should be benefiting from digital economies of scale, but the opposite has been true. Although Alphabet has recently closed the gap some, Meta’s margins remain materially higher.
It’s easy to understand why. Ambitious and creative almost to the point of naiveté, Alphabet’s managers historically have gone for “moonshots.” Confident in their ability to generate lots of money through search, they’ve spent billions knowing that some but not all these bets would work.
By contrast, Zuckerberg and Sandberg have been much more interested in milking their business rather than fattening it up for later. That’s why for every $10 of revenue, Alphabet makes only $3 in profit, while Facebook historically has made nearly $5.
This kind of profit-maximization behavior is very dangerous in the digital age. Online markets are just now being conquered, and there is so much growth ahead. Why milk the business now when you can reinvest in it and milk triple the profits down the road?
The best companies are long-term greedy, but Meta has been short-term greedy, and it’s starting to pay for it. Recall how, several years ago, the company announced that it was reducing some of the “ad load” in customers’ news feeds. That’s because Facebook had oversaturated consumers with promotion and publicity; adding any more risked alienating them. By front-loading the ads, the company not only prevented itself from layering in more ads gradually as time went on, it also increased the perception that Facebook was a commercial, quotidian product.
Lesson No. 2: If you feel threatened by competition, outcompete it
Facebook, qua Facebook as a social media site, has never won awards for being excellent, riveting or transformative to people’s lives. It’s always just been a way to post, gossip, exchange information and, increasingly, misinformation. Any product that’s undistinguished in such a way is vulnerable to becoming a commodity, and commodities in turn are vulnerable to competition.
Zuckerberg realized this early on. Watching WhatsApp’s user base explode, he emailed colleagues in 2008 that “it’s better to buy than compete.” Not surprisingly, Facebook bought WhatsApp several years later. “I just need to decide if we’re going to buy Instagram,” he wrote to company employees in 2012 as it was clear that “the Gram” was catching on. “Instagram can hurt us.” Later that year, Zuck pulled the trigger and bought Instagram, again choosing the easy, short-term route vs. the harder, long-term one.
Instead of trying to co-opt the competition, he should have tried to innovate his way past the competition. To keep its search engine the fastest and most relevant, Google tweaks its algorithm at least twice a day. It doesn’t need to buy Bing; it buried it in the marketplace. Likewise, Amazon doesn’t need to buy eBay or Walmart.com; it spends billions every year to ensure that Amazon.com is your preferred e-commerce destination.
We see no such innovation at Facebook. It remains a tawdry product that people use because everyone else uses it.
Lesson No. 3: It’s a bad, bad sign any time a company changes its name
This was the latest and, in many ways, the biggest and most obvious warning sign. A person who changes his or her name often is running from their past. Companies are the same—see below.
Lesson No. 4: It’s also a bad sign when a company makes a big bet outside its core business
Alphabet makes lots of little “other bets,” and these are often foolish. My favorite was the aptly named Project Loon, an Internet balloon company that new CEO Sundar Pichai thankfully closed last year. But these other bets lose Alphabet only a few billion dollars annually; search, by contrast, makes $25 billion every year.
Amazon is also hugely ambitious, spending $10 billion on Project Kuiper, a satellite-based rather than balloon-based attempt to bring the internet to all human beings. But Amazon is disciplined enough that if it doesn’t work, the company will shut it down. Meanwhile, with Amazon generating a half a trillion dollars in annual revenue, Project Kuiper is not going to sink it.
Zuckerberg’s bet on the metaverse is different in two important respects. First, to build out the metaverse he has committed to losing at least $10 billion every year for several years. These numbers dwarf both Alphabet’s and Amazon’s bets.
Second, he is making these commitments on a much smaller revenue base. Amazon’s annual sales run rate is $500 billion. Alphabet’s is $250 billion to $300 billion. Meta’s is only $150 billion, which means that Zuckerberg is not only making a bigger bet, but he’s also doing it with fewer resources.
Why? The answer ties back to my point about competitive advantage. Vulnerable to competition in social media, Meta must do something desperate. It bought WhatsApp; it bought Instagram; but given the current regulatory climate, it can’t buy TikTok, which is gaining traction with teens. With the network effects of its core website at risk of unraveling, Meta must “pivot,” although “throw a Hail Mary” is a more appropriate term.
Meta’s actions remind me of Comcast
another complacent monopolist which, when faced with a deterioration in its core cable business a few years ago, decided to buy U.K.-based Sky. CEO Brian Roberts said the purchase didn’t indicate he was less bullish on his core cable business, but Sky isn’t a cable company—it’s a TV network and a content provider.
Why would Comcast pay $31 billion in cash for Sky if Comcast believed so deeply in its core business? If it really believed in cable, Comcast could’ve taken that cash and repurchased 20% of Comcast’s stock instead.
In the three years since the deal was announced, I’m not surprised that Comcast has materially trailed the S&P. For similar reasons, I’m not surprised that Meta’s stock has recently suffered so badly. Zuckerberg milked the business instead of reinvesting in it; he bought competitors rather than trying to outdo them; and when those tactics didn’t work, he made an audacious and likely fallacious bet on a tech frontier that barely exists today.
Now, after Sheryl Sandberg’s departure, he must pull it off without his favorite Metamate.
Adam Seessel is the founder and chief investment officer of Gravity Capital Management in New York and the author of “Where the Money Is: Value Investing in the Digital Age.”