Mike Nicolas (03:49):
They ended the most recent quarter with almost 10% of their market cap in excess capital above their regulatory requirements. And we would expect all of this to be returned to shareholders over time. 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.

Mike Nicolas (04:10):
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 low to mid-teens return on tangible common equity over a cycle.

Mike Nicolas (04:30):
And that implies the normal earnings power of the bank as well of $3 a share with many of the shorter term concerns that we discussed with you guys last year, having improved quite a bit. Bad debt expense, long-term interest rates have improved. The headwinds are beginning to abate. The outlook is much healthier than it was.

Mike Nicolas (04:46):
And that is well 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.

Bill Nygren (05:05):
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, but we would have argued that they should be creating more like 15 times earnings, if the S&P is at 20.

Bill Nygren (05:22):
Now, the S&P is at 22. If anything, relative to a year ago, big banks’ competitive positions have even improved because economies of scale keep growing. So they’re not at single-digit Ps 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 PE ratio.

Trey Lockerbie (05:48):
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 Buffet just held, he’s now consolidated all of his bank position into 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.

Bill Nygren (06:09):
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’s 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.

Bill Nygren (06:36):
They’re cheaper than Bank of America that we think make just as good an investment. So we’re always glad to be invested side by side with him. And we’re glad that he’s there at Bank of America.

Trey Lockerbie (06:48):
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 that there’s this whole movement of defy entering the space.

Trey Lockerbie (07:10):
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.

Trey Lockerbie (07:27):
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?

Mike Nicolas (07:40):
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 and a low rate environment.

Mike Nicolas (07:57):
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 for VSL.

Mike Nicolas (08:16):
And on the other side of the house, the commercial bank, 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.

Mike Nicolas (08:36):
They supported small businesses to 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 Square or PayPal.

Mike Nicolas (08:52):
And given the balance sheet intensity and evaluation 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 market.

Bill Nygren (09:05):
Just to throw in a more high-level comment rather than Bank of 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. There aren’t necessarily businesses that other people would want to purchase.

Bill Nygren (09:23):
But 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 pretty good downside protection, we think, with most of the banking industry.

Trey Lockerbie (09:49):
That’s a really great point. And another kind of macro thought I had about Bank of America was the fact that interest 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 generate loans and then they generate revenue by collecting interest on the loans.

Trey Lockerbie (10:08):
The interest is essentially the top line revenue in this way. And so last time you were on the show, you enlightened us, 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.

Trey Lockerbie (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 costs 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.

Mike Nicolas (10:41):
Yeah, I wouldn’t say that Bank of America has necessarily pricing power on fees, but 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.

Mike Nicolas (10:56):
Historically, we would expect this to be the case going forward. It’s just not that evident in today’s zero-rate environment. But if short rates do rise, we would expect the rate date on their deposits to go up much less than interest rates would, which of course would benefit margin.

Mike Nicolas (11:09):
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 turn very much.

Mike Nicolas (11:22):
So 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.

Bill Nygren (11:32):
The 50% that they get on fees, what are the biggest sources?

Mike Nicolas (11:36):
Yeah, it’s more 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 neobanks or some of the fintechs.

Bill Nygren (11:47):
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.

Trey Lockerbie (11:59):
There’s no free lunch as they say.

Bill Nygren (12:01):
Right?

Trey Lockerbie (12:02):
So I’m curious, last question on Bank of America is just 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?

Bill Nygren (12:18):
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 has never a big number for us, usually mid-single digit. So if you think about that, it means the average position is just shy of 2% of the portfolio.

Bill Nygren (12:37):
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 four, believing that nothing should really be more than twice a typical position in the portfolio.

Bill Nygren (12:53):
Bank of America’s done well enough that we have had to trim 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.

Trey Lockerbie (13:04):
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 cashflow, for example, has been growing 27% over the last five years.

Trey Lockerbie (13:24):
The top-line revenue is growing at 37%. I mean, these are just incredible numbers. So let’s start with a highlight or 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, but I’m curious to see how you look at it from a value perspective.

Mike Nicolas (13:42):
Yeah, I was thinking back to our last conversation with Steve and he reminded us on that call that Bank of America’s NPS score was nearly as bad as Facebook. So naturally, you guys requested we discussed Facebook this time, but I can assure you we don’t intentionally screen for businesses that score poorly on this metric.

Mike Nicolas (13:59):
But it was one of the most heavily scrutinized companies on the planet. The figure really doesn’t surprise us. Seemingly everybody hates Facebook. They just can’t necessarily agree to why. But 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.

Mike Nicolas (14:17):
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. And the company benefits from powerful network effects, and from those granular targeting capabilities for advertisers.

Mike Nicolas (14:36):
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.

Mike Nicolas (14:53):
People use it services because they provide value. The ability to stay connected 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 per incremental user.

Mike Nicolas (15:13):
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 revenue by north of 40%, which given the size of the existing revenue base is much stronger than I think either Bill or I would have told you a couple of years ago in terms of what was capable.

Mike Nicolas (15:36):
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.

Bill Nygren (15:48):
And I would say, when we look at Facebook, we see multiple businesses and assets like their cash, what to have, Oculus the augmented reality business that they have. In 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.

Bill Nygren (16:11):
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 of Facebook and Instagram businesses.

Bill Nygren (16:26):
And you hear a lot of arguments about how long will it take for Facebook’s growth to slow down to an S&P growth number, but nobody really wants to argue that Facebook is going to be a worse company than the S&P. That you can buy it at a discount multiple. It just doesn’t make sense to us if you have that opportunity.

Trey Lockerbie (16:46):
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”. 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?

Mike Nicolas (17:10):
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. Mack Zuckerberg has talked about and believes that virtual and augmented reality could really become the next major computing platform.

Mike Nicolas (17:31):
And some of the recent successes 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&D budget into this. What’s interesting just kind of getting back to Bill’s points is that the Reality Labs team at Facebook now accounts for, by some estimates, nearly 20% of their total employee base.

Mike Nicolas (17:51):
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 modality labs, which helps to explain a lot of the margin leakage that we’ve seen in this business over time.

Mike Nicolas (18:07):
Just for some context, Facebook had a 50% operating margin in 2017 on a $40 billion revenue base. Looking forward to next year, they’re projected to grow to 140 billion of sales, but the margins are expected to be down with 10 percentage points. So what’s going on here?

Mike Nicolas (18:21):
On the surface, the margin degradation would almost seem to conflict with what we were talking about earlier about the low incremental cost for a new user, but this drag is at least in part due to higher capital intensity and certainly increased content moderation costs.

Mike Nicolas (18:36):
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 technologies like this.

Mike Nicolas (18:59):
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. Margins would go up significantly and the reported metrics would look even more compelling than the headline numbers.

Mike Nicolas (19:15):
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.

Bill Nygren (19:26):
Now, 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. We’ve seen that with YouTube inside of Alphabet, even Amazon with their basic retail business.

Bill Nygren (19:44):
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, I mean, that’s been a successful formula for a lot of venture cap businesses.

Bill Nygren (20:05):
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 cashflow generator. We’ve seen it with cash at company. 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.

Bill Nygren (20:27):
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.

Trey Lockerbie (20:43):
Well, 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 by trying to continue to grow through acquisition. So instead they might need to continuously fund internal development like this.

Trey Lockerbie (21:03):
Sometimes stereotypes exist for a reason. And the stereotype at 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?

Mike Nicolas (21:25):
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.

Mike Nicolas (21:43):
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.

Mike Nicolas (22:01):
People sometimes forget that Instagram had no revenue when 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 kinds of other bets need to pay off in spades in order for the business to grow at attractive rates.

Mike Nicolas (22:24):
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, even prior to the kind of implicit restriction on M&A.

Bill Nygren (22:36):
If Facebook or Alphabet made the decision to not do this internally, 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 asset. They’re doing it internally because it benefits the whole company.

Bill Nygren (22:56):
As basic search for 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 externally.

Bill Nygren (23:20):
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.

Mike Nicolas (23:32):
And Trey, most street analysts don’t make the adjustment that 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.

Trey Lockerbie (23:52):
A lot of people forget that when Amazon, for example, went public AWS didn’t exist, right? So a lot of these spawning efforts on companies in this way are very fruitful over time. I’m curious maybe 10 years from now, what do you think the spawning looks like for something like Facebook?

Bill Nygren (24:10):
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.

Bill Nygren (24:25):
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 worth. I could envision this scenario with Facebook that’s the same, where something that they do with augmented reality, building it into basic computing, takes off.

Bill Nygren (24:49):
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, we sold it off too soon, but at a number that’s much higher than today’s price.

Trey Lockerbie (25:14):
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?

Bill Nygren (25:35):
What a high-class problem to have. Facebook can be turning out the kind of growth that it’s reported over the past year and its business model is so capital-light that its big problem becomes its 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.

Bill Nygren (25:56):
But 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.

Trey Lockerbie (26:12):
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 to wipe out all the liabilities on the balance sheet, which is also a good place to be.

Bill Nygren (26:23):
Well, and those liabilities are just operating liabilities. Effectively, the company doesn’t have debts. 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. Generating more cash than they can rapidly deploy is a great problem to have.

Trey Lockerbie (26:43):
At the last Berkshire Hathaway shareholder meeting, Charlie Munger said something I’m paraphrasing, but something like paying $1 over intrinsic value and share buybacks is highly immoral. In buying $1 under intrinsic value is maybe the most moral thing you can do. So there’s a very fine line with share buybacks.

Trey Lockerbie (27:02):
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?

Bill Nygren (27:20):
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. When a company is demonstrably beneath intrinsic value, share repurchase becomes a better alternative than anything other than reinvesting where you’re competitively advanced.

Bill Nygren (27:44):
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 misjudged what it was worth.

Trey Lockerbie (28:03):
Well, speaking of the ethics around Facebook and the culture there, you mentioned that the net promoter score being very low. And I mean, I would say that Facebook does not have sort of a brand halo, right? Obviously, it’s recognized for being just a behemoth and a great business model, but there are some gray areas around the ethics. So how can investors get comfortable around that aspect of the business?

Bill Nygren (28:25):
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 things that they cost them the 2020 election.

Mike Nicolas (28:40):
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.

Mike Nicolas (28:57):
But they certainly are investing a lot to 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.

Mike Nicolas (29:16):
It’s not something that necessarily is good for engagement and advertisers certainly don’t like to advertise against or near 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.

Bill Nygren (29:34):
I think the privacy issues are really interesting one. 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.

Trey Lockerbie (29:59):
I think that’s a great point. Let’s talk about their users a little bit. 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 may be slowing down?

Mike Nicolas (30:22):
We don’t have a specific target for MAUs, but you’re correct, eventually, 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. I think that growth rate will continue to accelerate as we’ve seen over time.

Mike Nicolas (30:38):
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 many people define that as the traditional advertising pie, maybe something defined by eMarketer.

Mike Nicolas (30:56):
But the true size of the revenue pool given their user base is likely much larger than we think this narrow definition really understates the opportunity. Bigger picture digital advertising really has the potential to extract dollars from non-advertising budgets too.

Mike Nicolas (31:10):
And this is often referred to as below-the-line advertising and includes things like promotional spending or product placements and sliding 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.

Mike Nicolas (31:31):
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.

Mike Nicolas (31:46):
With three and a half billion people using at least one of their services every month, I’m not sure how many more users they need to grow at this point. I think that 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.

Bill Nygren (32:04):
And don’t forget, even more, Facebook stock is priced. If it’s growth close to that of an average S&P company, it’s a cheap stock.

Trey Lockerbie (32:13):
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 MAU start to slow, they still have the ability to make more money off of the users they currently have.

Mike Nicolas (32:31):
The price per ad unit did show considerable growth last year, but it’s important to remember that advertisers bid for ad units on Facebook at 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.

Mike Nicolas (32:50):
So impression growth is inversely correlated with pricing growth, and you can see these dynamics over various points of Facebook history if you map it to. Of course, pricing is ultimately driven by the return on ad spend that’s being generated by advertisers.

Mike Nicolas (33:04):
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, or certainly apply 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.

Mike Nicolas (33:18):
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.

Trey Lockerbie (33:28):
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 Z, if that growth is there, or if it’s more just growth on the millennials and baby boomer generations.

Mike Nicolas (33:44):
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 you read the news, Facebook is not as popular with millennials and Gen Z so much as it tends to be with some of the older demographic.

Bill Nygren (34:00):
And don’t forget when you’re buying Facebook, the company, you’re getting Facebook and Instagram. Instagram skews younger, I don’t know what it is, maybe a third of revenues and probably more 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.

Trey Lockerbie (34:26):
Speaking of another tech company, Apple recently made the decision to no longer track personal data in a certain way. So does that affect Facebook’s effectiveness for targeting ads in any way? Does it have any effect on Facebook?

Mike Nicolas (34:41):
I think for advertisers to shift their budgets to other platforms, they’d certainly have to see better relative targeting capabilities or better reach for better engagement. And we think that’ll be difficult to do for most competitors.

Mike Nicolas (34:53):
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, we still expect their return on ad spend to be superior to most digital and certainly offline mediums.

Mike Nicolas (35:10):
There’s seemingly a new ad targeting headwinds or at least a new competitive concern to be aware of every year. I mean, I can think back to the transition to 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.

Mike Nicolas (35:29):
As people opt out, it certainly will present some challenges for advertisers and therefore Facebook. But historically, I think that there’s one thing that the company has proven is that 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.

Mike Nicolas (35:46):
And we think they’ll continue to do that and they still have as good of targeting capabilities as anybody. And I think they 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.

Mike Nicolas (36:04):
And Facebook has it mass, and we continue to expect them to remain a force in digital advertising, even if some of their offsite targeting and attribution capabilities proved to be a little weaker than they once were. But somewhat ironically, increased privacy regulation has at least thus far seem to actually further entrenched the walled gardens with deep first-party data like Facebook.

Bill Nygren (36:26):
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.

Trey Lockerbie (36:40):
So one thing I’m incredibly fascinated by with Oakmark is your ability to look at these big tech companies 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, how do you just fight this?

Trey Lockerbie (36:56):
Is it just that if I look at Buffet taking on his Apple position, is it just that the companies are getting to this point where they are now the incumbents that are hard to disrupt, 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?

Bill Nygren (37:18):
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. 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 at a premium to the S&P multiple during that time.

Bill Nygren (37:44):
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 PE is low. We think it’ll continue growing. Maybe not as fast as it has historically, but growing at a number that justifies a higher price.

Bill Nygren (38:05):
With Alphabet, with Facebook, with Apple, the question always was, if you cut it down to the core business, the market price is at below-market multiple. You really think this is a worst business than average. And that has made all of them very simple for us.

Bill Nygren (38:21):
Netflix was probably the more complex one, but it was so similar to our history in cable stocks where cable companies were losing money, had negative book values as back in the 80s. But we saw an active private market that was paying a thousand to $1,500 a subscriber.

Bill Nygren (38:39):
Why were they doing that? Because customer acquisition costs were really, really high in the early days of the cable industry. 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 $1000 subscriber.

Bill Nygren (38:59):
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. 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.

Bill Nygren (39:24):
And you’d look at the prices of the others were all 15 to $20 a month, but Netflix was like 11 bucks. But then you ask people to rank order which one is the most important service to them, and Netflix always won.

Bill Nygren (39:36):
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. We haven’t needed to do a lot of mental gymnastics to get to a point of saying these are really cheap businesses.

Trey Lockerbie (39:58):
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.

Mike Nicolas (40:14):
The investment thesis is pretty straight forward as Bill had mentioned. I mean the stock trades around 300 bucks today, a share. And we expect this business to have about north of $40 a share of net cash and investments on its balance sheet by next year. That cash, as we spoke about is next to nothing today.

Mike Nicolas (40:30):
So even using consensus forward EPS estimates for Facebook is trading for less than 17 times next year’s earnings likes 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 are billions of dollars of losses that are further inflating what’s already a below-market PE multiple for a business like this.

Mike Nicolas (40:56):
And we believe they’ll either be monetized or eventually at least in the case of ARVR, could be turned off. They’re investing well ahead of business growth. And many of these investments are going to take some time to pay off. But adjusting for the spend between Facebook’s PE multiple would grind down much, much further.

Mike Nicolas (41:11):
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, and extremely strong existing competitive position. There is a tremendous amount of fear and skepticism built into this valuation, which we think is the source of our opportunity.

Mike Nicolas (41:28):
What could it be worth? Hard to say. I mean, 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.

Bill Nygren (41:37):
If you parked Facebook down to just Facebook and Instagram and you ran with a balance sheet that had no net cash and no data on it, it seems crazy to think that consult could be for market multiple. And like Mike said, I think it’s such an advantage economic model that it’s pretty easy to see that it could be 30 to 50% higher than the market PE.

Bill Nygren (42:00):
And after you account for the other businesses in the cash today, we believe you’re getting Facebook and Instagram at a significant discount to the market.

Trey Lockerbie (42:09):
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 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?

Bill Nygren (42:27):
We do discounted cash flows. 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 a business value.

Bill Nygren (42:45):
One of the ways we look at Facebook has nothing to do with what the market multiple is. It’s to say, how much of a premium would an 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, where we think, because we don’t think investors will forever accept the negative real return to invest in the bond market.

Bill Nygren (43:12):
But so you say if inflation’s going to be 2% at a seven 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.

Trey Lockerbie (43:32):
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?

Bill Nygren (43:48):
We don’t think of it quite that way. I think the biggest difference between us and fundamentally based growth investors is when we 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.

Trey Lockerbie (44:11):
Interesting. Where did the seven years come from?

Bill Nygren (44:14):
Asking our analysts to forecast out in detail two years and then kind of 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.

Bill Nygren (44:37):
The moats are so great. It’s obvious that they can last, they can grow super normal rates a lot more than seven years. But I’m old enough to remember when that argument was last used for newspaper, for pharmaceutical companies that seven years down the road, their patents had expired and earnings were less than half of what expectations had been.

Bill Nygren (44:58):
There’s some value investors that will only look backward. They won’t look forward at all. There are growth investors that will look out 15 to 20 years. We’re kind of in the middle of that. I’m pretty comfortable in that range.

Trey Lockerbie (45:10):
I like it. It reminds me of Buffet’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, of all the companies you’ve looked at, does it have the staying power that you think it might?

Bill Nygren (45:34):
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 for a long time.

Bill Nygren (45:55):
Put them in that category, or maybe I’d want to bet on them for more than seven years or a MasterCard or [inaudible 00:46:02]. But our track record is not good on that. Market’s track record is not good on that.

Bill Nygren (46:09):
The businesses that earn really good returns today that you see no possibility of being disrupted are 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.

Trey Lockerbie (46:27):
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 QQQ fun, just because a lot of these tech companies, I’ve kind of subscribed to the idea that I don’t understand them.

Trey Lockerbie (46:44):
But you are kind of helping me look at this in a different way, by saying it’s time to retire at the tech company title. These are just companies now. They’re not internet companies as they were back in the early 2000s. I think that’s the right approach.

Trey Lockerbie (46:57):
Before I let you go, I want to make sure I give you an opportunity to hand off to Oakmark Funds to any of your platforms or any other resources you want to share with the audience.

Bill Nygren (47:06):
I’d point people first to our website, oakmark.com. All of our quarterly reports are there. I’ve written a quarterly commentary every year for, getting to be too long now, 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 processes we are on social media.

Bill Nygren (47:32):
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 have forgotten you’d follow us. But we usually do try to highlight new information that’s up on our website through our Twitter account.

Trey Lockerbie (47:49):
Fantastic. Well, Bill, Mike, I really enjoyed having you back on the show and I hope we can do it again soon.

Mike Nicolas (47:56):
Thanks, Trey. I appreciate it.

Bill Nygren (47:57):
Thanks, Trey. It was great to be with you today.

Trey Lockerbie (48:00):
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 @TreyLockerbie, 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, Google TIP finance to check out our TIP Finance tool.

Trey Lockerbie (48:20):
Had you use the TIP 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. So go ahead and check that out at theinvestorspodcast.com. And with that, we’ll see you again next time. Cheers.

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Outro (49:02):
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