Friday, November 23, 2007

Positive Black Swans

As I received my copy of The Black Swan back last night, I began flipping through some of the pages just as a refresher. I luckily came across one of my favorite paragraphs, and a concept which I had almost forgotten:
Learn to distinguish between those human undertakings in which the lack of predictability can be (or has been) extremely beneficial and those where the failure to understand the future caused harm. There are both positive and negative Black Swans. William Goldman was involved in the movies, a positive-Black Swan business. Uncertainty occasionally pay off there.
A negative-Black Swan business is one where the unexpected can hit hard and hurt severely. If you are in the military, in catastrophe insurance, or in homeland security, you face only downside. Likewise, if you are in banking and lending, surprise outcomes are likely to be negative for you. You lend, and in the best of circumstances you get your loan back- but you may lose all of your money if the borrower defaults. In the event that the borrower enjoys great financial success, he is not likely to offer you an additional dividend.
Aside from the movies, examples of positive-Black Swan businesses are: some segments of publishing, scientific research, and venture capital. In these businesses, you lose small to make big. You have little to lose per book and, for completely unexpected reasons, any given book might take off. The downside is small and easily controlled. The problem with publishers, of course, is that they regularly pay up for books, thus making their upside rather limited and their downside monstrous. (If you pay $10 million for a book, your Black Swan is it not being a bestseller.) Likewise, while technology can carry a great payoff, paying for the hyped-up story, as people did with the dot-com bubble, can make any upside limited and any downside huge. It is the venture capitalist who invested in a speculative company and sold his stake to unimaginative investors who is the beneficiary of the Black Swan, not the "me too" investors.
I had forgotten this idea of positive Black swan type businesses, and I came up with a little exercise: Could you recognize the potential in Google, a real positive-Black Swan business, and invest in it at its IPO?

In 2002, Google had revenues of 439 million and 185 million in income before taxes.
In 2003, Google had revenues of 1,465 million and 346 million in income before taxes.
In the first half of 2004, Google had revenues of 1,351 million and 325 million in income before taxes.

If you annualized the first half of 2004 numbers, you get about 430 million in net income. Now, taking into account its growth prospects, what value would you pay for the company at that time?

Well, the market capitalization of Google at its IPO was 27 billion. So you were paying 62 times earnings, a multiple which would make many value investors cringe. And there was only 1 billion in shareholder's equity, leaving no safety in the traditional Ben Graham sense. But Google was also doubling its revenues and earnings each year, and it offered great value to both consumers and businesses. Today, the company is earning 4 billion a year, so the initial valuation seems actually very cheap.

How has Google defied logic and built a such a profitable internet company? Where is the moat? Well I guess (and I'm no expert) what makes it different from other internet companies is the fact that nearly everyone sets a search engine as their home page. And although other search engines now have similar performance, the fact that Google had the best engine first has made it "sticky"- every time a consumer opens his web browser it pops up, and they really have no reason to switch. In contrast, there is exogenous factor compelling me to go to Expedia every time I want to book air travel. I believe this is what has allowed them to keep their market share and hence make it the most valuable company to advertisers.

I looked at Google at its IPO and I knew it was a positive-Black swan type business. But I also knew that "paying for the hyped-up story, as people did with the dot-com bubble, can make any upside limited and any downside huge." So I passed because I thought it was too expensive and couldn't see the moat. But if you saw the competitive advantage, then the valuation of Google really depended on the potential for the online search and advertisement market, and that was much more obviously enormous. In the end, there are two important points to remember. One, the most important factors are the value a business provides and the moat around it. Two, keep your mind open.

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