Mark S.F. Mahaney - Nothing But Net
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Bill: Ladies and gentlemen, welcome to The Business Brew. I'm your host, Bill Brewster. This episode features Mark Mahaney, author of Nothing But Net. Mark's book Jacket describes him as the oldest and longest lasting internet analyst on the Wall Street. In this conversation, we talk about his early days leading up to the internet bubble, his experiences the internet bubble burst, and what he's learned along the way. I really enjoyed his book. I enjoyed this conversation very much. I believe you all will as well. He's a really fun guy to talk to and I'm glad that he joined the pod. His outlook on things is very different from mine and I really appreciate him expanding my knowledge and joining the show.
As always, none of this is financial advice. All of the information contained in this program is for entertainment purposes only. Please consult your financial advisor before making investment decisions and do your own due diligence.
So, thrilled to be joined today by Mark Mahaney, author of Nothing But Net, a book that really pushed me to think and I appreciate you writing it. Thank you very much.
Mark: Oh, thanks, Bill.
Bill: Do you want to start off giving your background? Obviously, the audience, not everybody's going to know you. So, if we can start at when you became a tech analyst and some of your career, and then, we'll pick the conversation up from there.
Mark: The very beginning of my book, there's a preface that's entitled, The oldest and longest-lasting Internet analyst on the street, so there, that's everything you need to know about me.
Bill: [laughs]
Mark: I'm just kidding. I think that would make me one of the longest-lasting oldest tech analyst on the street, too. I started in spring of 98 at Morgan Stanley working with a legendary analyst Mary Meeker, who invented the internet sector category. At the time, there weren't that many public stocks in the space and it was Excite, Yahoo, Amazon, AOL, EarthLink, and MindSpring. I don't know if anybody listening will remember EarthLink and MindSpring. But over time, you got more and more market cap came into this space, Google wasn't even an idea back then. I guess, Zuckerberg had been born then, I think he would have been early teenager then. There weren't any smartphones. There was certainly no Uber. And Netflix was launched just around that time, but it wasn't streaming then. It was DVD by mail. Anyway, I wasn't there at the beginning not like Al Gore. But I was there pretty early on and I've been covering Internet stocks flat out for 25 years now at different places, but that's been all nets, Nothing But Net, the title of the book. Always online. Those have been my signature email taglines for a quarter of a century. Hopefully, I've learned a lot over that time period.
It's been one of the most dynamic parts and at times controversial. No doubt about it. It's been controversial at times, especially 1999, 2000, 2001, and that the level of skepticism, quite rightly the sector phase lasted for a decade and a half after that. Even when companies like Chewy went public a few years ago. There was harkening back to the Pets.com dat. They were the poster child, a sock puppet, if you will of irrational exuberance. Anyway, that's what I've been doing. I've been covering this sector, whether it's ad names like Facebook and Google, whether it's subscription names like Spotify and Netflix, whether it's retail names like Etsy, eBay, Amazon, and then, there's just a slew of other business models that have come up over time, and I've done my best to try to stay on top of them, and published a lot of research on them, and had some great calls, and had some terrible calls. The book that I published tried to draw lessons from those 25 years of good and bad calls.
Bill: Yeah, I really liked the format of the book. For those that don't know, there're roughly 10 lessons in there. Two of which I think were titled, "There will be blood, right? When you pick wrong stocks and when you pick right stocks." So, you've got to be willing to live through the ups and the downs. What a time to start, huh, in 1998 and then watch the bubble really have a blow off top and then implode. What was that like from a career perspective? You were young at the time. Were you worried at all?
Mark: Yeah, and I think I may have phrased it in the book, but I certainly thought about it. For the 1998, 1999, I thought I was pure genius. In 2000 and 2001, I thought I was pure idiot and the truth is always somewhere in the middle. It was extremely volatile time. I talk about it in the book, I got laid off as the internet sector didn't need multiple analysts. It just needed one. It was a great experience. I worked at Morgan Stanley for five years. I think I said I got hired into the internet boom and I got fired out of the internet bus. But then, the sector came back and there was this thing called eBay that at the time was bulletproof phenomenal company. Yeah, there are some caveats here to trying to draw investing lessons from what's been one of the biggest secular trends of the last several decades. Question is just, how heavily do you want to lean into lessons from that? I think there are reasons to lean in and there're also reasons to look for the next rounds of secular trends. But it was a fascinating experience and a great learning experience trial by fire.
Bill: Yeah. It's interesting that you bring up eBay. In my mind, I have this rule where, when value investors get interested in technology, stocks be very, very wary of what's coming next. The most recent example is Facebook. But eBay has gone from a growth story to now, I hear it pitched as a basically, you're relying on habit and free cashflow yield, plus some buybacks to get you to where you need to go. In your experience, how do you ride the growth curve of these companies is, I think the question that I'm coming up with and how do you maintain a long view while also watching like acceleration and deceleration? I think that's a lot of the choppiness that we're seeing right now seems to be lapping tough comps.
Mark: Yeah. I'll at least start off this way, Bill. I think if you'd looked at the internet sector back then, they were three major unknowns. Is there really going to be a large internet market, are there really some good management teams in here, and are these other viable business models in here? Those are all three good questions for brand new sector, brand new companies. Some of them just got silly. I'd forgotten this but Pets.com went public and I think they had six months of experience as a company. I just don't think that would fly today, but it did back then. Probably, the single best example of irrational exuberance that I can think of, but I'm sure there were others.
Those are the three main questions. There was some phenomenal wealth creation that came out of the internet space. Some of the best performing stocks of the last two, five, 10 years have come from Google, Facebook, even with the recent correction, Amazon that put it in a book, it was up 160,000% if you had bought and held it since its IPO. Now, I think you would have been completely irrational to do that, but anyway, there was a point when it was a very rational buy and the question is, when was that. We can go into that. Then, even Netflix. This sector because of the secular growth, it allowed these companies to sustain premium growth for years and years, and they generally scaled into profitability. I was stopped in the hallway, I relayed this story in a book, by the senior strategist at Morgan Stanley at the time, and very, very experienced senior strategist, well known, regular contributor to Barron's, stopped me in the elevator, and knew that I was the junior person working on Amazon, put his finger on my chest and said, "You know Amazon's never going to make any money." My reaction was, "Well, I guess, they won't because you're a lot more senior than I am and I'm just trying to earn my way."
But yet, Amazon did generate lots of cashflow over time and became by retail standards, highly profitable. One of the lessons I picked up is through scale, scale can solve most things. I've seen the toughest business models in much more recent history, Uber names like Spotify, where you've got very low gross margins. I've seen examples of companies being able to scale into profitability.
Bill: Yeah. One thing you talked about is, if you had ridden Amazon all the way, what your returns would be? The book, the everything store, made me realize there was no way that I could possibly ever do that. There was just too much hair, executives leaving the stocks down 90%, I definitely would have gotten shaken out. How do you think about inflections, for lack of a better term a story, even though it's a company, it's not a story, but how do you think about the inflection point when you want to reenter or when you're watching something and you want to get in? I know that that's broad.
Mark: Yeah, I got you. Let me do this, Bill. I think one of the most important lessons I talk about in the book is the importance of revenue growth. For growth investors, tech investors, revenue trumps everything. Of course, earnings matter and of course, free cash flow matters, too, but the reason that people look at growth stocks is that, if you can find a company that can sustain premium growth rates for quite some time, they can become wonderful compounders. I don't want to over harp on the rule of 20, but companies that were able to sustain 20% revenue growth for years and years, they're rare. The percentage of the S&P 500, which are supposedly the best companies, best stocks out there. The percentage of those that can sustain 20% that have sustained, that are sustaining 20% revenue growth for multiple years is low single digit percent. It's a very hard thing to do.
When you see that to me, that's a tale of a company that you should invest in, even though, it could have been the last two or three years and you could argue, well, that's all there is. You can't sustain that growth going forward. I got a couple of names even to think about. Here's the history of Google. Google generated 20% revenue growth for a full decade after reaching the $25 billion revenue run rate. That's phenomenal. Only three companies in history have done that. Amazon, Apple, and Google. Then, when you see companies do that, it could be pure accident. But oftentimes, it speaks to something either something special about the-- I look for those kinds of financial tells. The ability of companies to sustain premium revenue growth, because it's rare and because it's usually a tell of something else, like, "What?" Well, large total addressable market, very good management teams, outstanding customer value propositions, and very good product innovation.
In order to do new premium revenue growth, and I mean, from scale, not from $50 million in revenue. I mean, from a couple of $100 million in revenue or billion in revenue, something like that, something chunky. In order to do that, you've got to have that combination of those four things. That was to me was the lessons and I'm sorry. I did this not just based on the successes. I looked back at what went wrong with eBay. And now, eBay has been a great stock the last two years, but if you'd bought eBay in 2005, you would have been at the same share price in 2015. There were clear examples of companies that failed. I also looked at some of the smaller ones that saw the light of day, but just barely, Blue Apron, Zulily, Groupon. Yeah, so, I looked for those financial tells. The ability of a company to consistently sustain premium growth, not just for a quarter or two, but for a couple of years. And then, I'd like to peel back that onion and say, "Well, why are they doing that?" At the end of it, I boiled it down to these four things that I'm looking for that give me confidence and the ability of a company to sustain premium growth.
Again, the bigger the market opportunity, the better the opportunity to develop really large, really consistent premium revenue growth. I look for these total addressable market. The book goes through a couple of examples, where I was trying to figure out what the TAM really was for a name like Spotify. It wasn't obvious. And then, secondly, you look for companies that have really got compelling consumer value propositions. For one reason, Netflix really demonstrated this. You have a compelling value proposition, that means you have pricing power and that means that one of the unusual things about Netflix is that, they started increasing pricing in 2014, and pretty much did it every other year, and they still had accelerating number of sub ads. When you increase prices and your number of new customers accelerates, you've got pricing power. And it's based on the fact that you've got an overwhelming customer value [audio cut]. Any of us can make a decision as to whether Netflix is a great value for consumers or not, decide it for yourself. You can also do this with other businesses, too.
Third is that, I really look for companies that can innovate really well. I mentioned earlier that if you had bought Amazon at the IPO and held it today, you would have had phenomenal returns, you would have been retired many times over. But you would have been highly irrational, because Amazon was so unproven early on. But somewhere along the way, Amazon became, should have become a core holding for tech investors. To me, that happened around 2006, 2007, 2008, somewhere in there, because the company showed this ability to really innovate. They develop this cloud business that nobody ever really thought about. Except for maybe Google and Microsoft, a little bit. There's something called AWS. I remember writing one of the first reports on that, I was skeptical about the real value proposition of AWS. But, man, the ability of an online retailer to also generate a really successful enterprise offering, that says something about how skilled that management team and how good the product innovation is at Amazon. They also had this phenomenal success with Kindles. Apple did this, too, but that succeed and innovate in very different verticals, retail, cloud computing, electronic devices. That says something about how heightened the level of product innovation is at the company.
Then, the last tell before things I'm really looking for TAM, value prop, product level of product innovation, the last thing I look forward and what's hidden under a lot of that is the quality of the management team. And that's a very hard thing to really assess. I love to see founder-led companies. I'm going to work backwards. If you look at the largest market cap companies in the world, the tech companies, they are pretty much all are founder-led or were heavily run by founders for a substantial period of time. I don't know why they have to be more-- There are some examples of companies that aren't founder-led that I think can be very good investments. Uber's one, Priceline or Booking.com is another one, too. Of course, if you had bad founders, well, that doesn't help you. But if you had good founder, there's just something about their ability to think beyond the quarter, to think long term, to be willing to make long-term investment bets. Bezos is my quick example.
Here's when he launched Amazon Prime back in 2000 and shoot, 2012, 2013, something like that and I remember, I wrote a note on it that night, they were going to do earnings. Earlier in the day, they announced the launch of Amazon Prime for the first time for $79. That's what it was back then. You would get essentially free shipping. In that press release, Bezos also acknowledged that, "This is going to cause a financial knock to our results." Sure enough, later that day, Amazon actually printed its quarterly results. I think it was the March quarter results. And they took down their Forward Operating Income guidance and the stock got whacked over the next couple of months, fell as much as 30%, 40% or something like that. But Bezos absolutely made the right bet. He must have known that the street was going to punish him for near-term operating income losses. But he created one of the greatest customer satisfaction, customer retention tools, customer clubs of all time. There're two over 200 million Prime customers now that are really locked in sounds antitrust-ish, but that are really-- [crosstalk]
Bill: [crosstalk] locked in from a habit perspective, right?
Mark: Yeah. I do think that founders are able to willing to take the hits, the near-term hits, probably more than professional managers are. So, that's the last thing I look for.
Bill: Yeah, that makes sense to me. I think the thing that's tough, I've got two different forks. We'll go one of them first. It's tougher for me to look at some of these revenue growth companies, and then look at the current expense structure, and then try to figure out what the actual underlying margin structure of the business looks like x growth spent. How do you think about deciphering? How much is this company spending because they're looking to innovate the next product versus what maintenance for lack of a better term? Because sometimes, when it appears to me that the need to innovate is a constant cycle that the free cash flow is always on the come, but never comes. But the stocks work like crazy and it's forcing me to ask myself, "What am I actually missing here?"
Mark: Let me try this. Sometimes, it's very hard to peel apart maintenance versus growth investments. The mistakes I've seen, I referred to eBay and Yahoo, those are the should've, could've stories. Maybe, this is going to answer your question. eBay and Yahoo were phenomenal stocks. Yahoo was a phenomenal stock for about two or three years, eBay was a phenomenal stock for about five or six years, which is great. Hats off to them up until about 2005. Both of those companies took up their margins pretty aggressively. They reported rising, rising, operating margins and we're really proud of it, too and yet, there's this Apple and then, Google was almost on its own. It had such a high margin business to begin with, but Google's market cap, that could have been Yahoo's. Amazon's market cap, that could have been eBays. But those companies missed some major opportunities. They probably didn't invest aggressively enough. They probably over earned. It's easy to say in hindsight, but I think that's exactly what happened with those companies. The e-commerce market ended up being a lot bigger than we all thought, but eBay could have tapped into that. By not investing aggressively and maybe they should have vertically integrated. They never wanted to get into that messy distribution centers, never wanted to manage fulfillment. They wanted to be a virtual marketplace.
At the end of the day, what that meant was a less customer friendly experience. With eBay, higher margins, great. You got the margins, but you cutoff your future growth or you limited your future growth. I don't know. Hopefully, that's a little bit of answer to your question. Let me try something else, which is one of the problems and I certainly understand a lot of these tech stocks, look at the NASDAQ offerings. So many of them come public with no profits. Why should you step in and buy them? The correct approach may well be, I'm just going to wait until they can prove that they can consistently generate profits before I buy them. I mean, miss out on some of that early speculative move, but I'm going to sleep better at night and I'll better manage my risk and my reward.
I have a section in the book, where I just talk about how do you value unprofitable companies. To me, this may not be that helpful to value investors, but I leave the math behind and I really focus on logic, which is, the reason that Twitter, Pinterest, and Snapchat had a pretty robust, welcoming sound to the public markets, even though, they weren't profitable, is that there was a company just like them called Facebook that had been on the market for multiple years and was highly profitable. We knew what social media companies could do. They're wonderful business models, by the way, because you get your users to generate all the content. You don't have to pay them for it. So, great. We should all have thought of that business.
But anyway, of the four logic questions, when I see these unprofitable companies come out is, well, is there a public market comp that's already profitable? Has the business model been proven profitable? Second question I ask is, can you look within the company and find a portion of the business that's already profitable like the lead market? Is there a segment it's already profitable? Okay, well, if that's the case, then my guess is that the rest of the business, assuming it's relatively similar can also move its way to profitability. I'm looking for a profitability proof point within the company. Third is, I asked myself the question, "Is there any reason why scale can't drive the business to profitability?" That was my lesson from Amazon, which is always very thin margin business means with incremental operating margin business, I mean, fixed costs is going to lose money. But with enough scale, they'll be able to generate profits to cover the fixed costs. That's in fact, exactly what happened with Amazon and it happened with other businesses. I thought it could happen with which is Uber. You really push yourself, "Is there a particular reason why scale won't drive the business to profitability?" Then, you have to ask yourself, "Do they have a good scale strategy, do they have a good growth strategy?"
Then, the final thing is, are there specific steps that they can take to reduce losses. Uber is a wonderful example of this. They've gone public, they have assets all around the world in terms of Uber Eats in Korea and ride-sharing in Russia, places where they probably shouldn't have been in the first place. Under new management, they started cutting out all these loss generating areas. If you can find business that are just too spread out, but you think that the right manager could start cutting off some of those loss-generating areas, yeah, there're specific steps that companies can take to drive themselves towards profitability. I know, it's profitless now, but there's good reasons to think it will be profitable and I love these inflection points as stocks they can be great. When companies sustain premium growth and then turn the corner from losing money to generating money, then, you just wide open that earnings growth aperture. That may sound a little momentumy to you. It's not really value oriented.
You can wait for these companies to generate profits and you don't have to swing in any of these. I'm more struck by the ability, companies that people were really skeptical about could generate profits, ended up doing so through a scale and selective actions by the management teams, and so I'm less turned off by companies that don't generate profits. If I get a chance to invest in an early stage, great. There's just more upside for me.
Bill: Yeah. Well, to be clear, I think that the value bent or whatever that I have and certainly had more of has made me miss a lot of these things. It didn't help that I let the person that I look up to the most say that tech was unpredictable rather than think for myself, I outsource my thinking, which is the violation of rule number one, I think he would not be proud that I did that. So, I'm trying to get better, and talking to you, and people like you is helping. One of the things that I've been thinking about since you wrote your book, you dedicate a lot of time to Facebook. I don't want to go too long on it, because it's such a well-covered name. But you've got management that clearly has sacrificed short-term profitability in the past, has had a long-term vision. I would argue he has under monetized some assets and then, Mr. Zuckerberg comes out with this Metaverse concept. How do you frame what's going on with their Metaverse ambitions and what--? Certainly, I think that decision has muddied the story and the stock has somewhat reacted to that and somewhat reacted to deceleration in the growth. But how do you think through what's going on over there with $10 billion to spend a year?
Mark: Facebook, I like Facebook here. It is one of those DHQ stocks, dislocated high quality. Yeah, did they takedown margins and investment cycles? Yeah. But they're still doing north of 30% GAAP operating margins during an investment cycle. That just tells you how robust the business model is during an investment cycle. They're doing 30% to 35% GAAP operating margins. Wow, what a great business that is. They do generate a lot of cash, they've got large balance now at $50, $60 billion, and they're using it to start stepping up materially buying back stocks. They are doing kind of the right thing with it in terms of capital allocation strategies, this is a company that's clearly founder-led. In fact, of all the major tech, the largest tech companies, this is the only one that's still founder-led. That's Facebook and Zuckerberg. That's not the case with Amazon, not the case with Microsoft, not the case with Apple, and not the case with Google. Say good or bad, I don't know. But Zuckerberg, I think it's generally good. Zuckerberg, in my mind, he doesn't get the credit for it. Maybe he shouldn't. But he obviously did a pretty darn good job with Facebook and then acquiring Instagram. We'll see about his success in his acquisition of WhatsApp. But he does own the two largest social media assets in the world, the two largest messaging platforms in the world with a very robust business model.
This investing in the Metaverse, okay, I think about this with Google and Waymo, I think Google Alphabet is worth more because of its investment in Waymo. It's like option value. It may come out and be worth zero by the way, I think that's what the markets giving it. But they could become the operating system for Jetson era, the operating system for driverless cars, that's got to be worth something. I don't know whether driverless cars will exist or not. If you give me a long enough time horizon, I'd probably take the over on that. I probably would be long the idea that and there'll be a lot of societal advantages to that, I think including fewer car deaths, which is the most important. I like these companies that do these long-term bets. Google has been spending about $5 billion a year on Waymo, losing about $5 million a year, which is a lot, but maybe not so much versus its P&L. Facebook is doing the same thing with Metaverse. There's a vision here and I don't know whether this can be true or not, but there's no question that Mark Zuckerberg has been absolutely visionary when it comes to social media. I'm going to give him a little bit of credit that he may be right in terms of for gaming, maybe for social interactions, and I don't know, maybe for productivity, office productivity, work interactions that we will be using more virtual reality. We will be looking for more immersive experiences.
Just step back for a second, Bill. Just in the last two years, our internet interactions have become a lot more immersive. What do I mean? Well, what we're doing right now, podcasting has become a lot bigger in the last two years. Virtual communication, I'm sorry, visual communications have become a lot more prevalent. They're almost the norm now. Yeah, we've already leaned into becoming into more immersive connectivity. Zuckerberg is saying, "We're going to lean even further" and in virtual realities really feel we're experiencing something with other people, not just in this, what are we doing here? Two dimensional interactions but in a virtual three-dimensional context. Maybe. I'm just intrigued by what we-- This guy has been successful at predicting one trend, to me dramatically successful. We've lived through a very brief period of time, where our interactions have become more immersive absolutely with-- We've zoomed, we've become zoomed and then, so, could we take it a step further go to virtual reality? I think there's a distinct possibility that will happen.
Yeah, I think it's probably a good bet by Zuckerberg. What I prefer, if it was $5 billion, Google asked Waymo $5 billion of losses a year, yes. I wonder how they got the $10 billion. We had estimated it was more $6 billion and they've rounded up a little bit. But nonetheless, I think these kinds of long-term option bets of the right things for companies to do. I think in hindsight, I bet eBay wishes that they had done some options investing. And eventually, Yahoo wishes that they had some options investing. And AOL, too. So, generally the companies that do that long-term options investing, if they get it right, they can be worth a heck of a lot more.
Bill: Do you worry at all about the signal that it sends Instagram and Facebook Blue employees to change the name of the company and dedicate so many resources? I'd imagine Mark is heavily focused on this new area. The only concern that I have for that company and him doing this is that, he signals to the rest of the company that maybe they're not as important and that becomes an employee retention problem, which in a business that is people driven could be an issue. But I don't know that that's a real risk. I'm just curious to hear you think about it.
Mark: It could be. I hadn't really thought about it that way. I'm just thinking another way to think about the risk is, what are we doing here? Google's investment in Waymo is an orthogonal option value. Whether they succeed or not in Waymo will mean Jack Diddley nothing to the core search business, or to YouTube, or to Google Cloud. It's just out there. It's a data play. Google's a data company, but there's no-- The success or failure here with this option doesn't have any impact on the core business. That may not be the case with Metaverse. If Zuckerberg could be right that we're going to move part of our experiences to virtual reality, in which case, there's a defensive element to this. If he accurately predicted the future, Facebook better generate a very robust, intuitive, virtual reality experience or else they're going to lose the throne of the kings and queens of social media. That's a different way than you were thinking about it. But both ways make you less-- It may not be all upside in terms of Metaverse and maybe a defensive element to it. I could see how it could-- It was an odd thing. That sounds like a founder call to me. I'm just going to change the name of the company, because it's my company. But this sounds like founder mentality, which can rub people the wrong way.
It's a question is whether you want to make a bet on Zuckerberg. He's done pretty well by so far and I like the fact that he's willing to takedown margins in a way that Bezos did way back when with Amazon Prime saying, "This is going to gut my margins near term, but stick with me on this, because I think it could be a great customer loyalty program." Check, he got there right. Zuckerberg in 2019 did the same thing in the wake of that Cambridge Analytica scandal and warning he was going to take down margins, he is going to really beef up security of the platform. If you invested off that and if you'd bought the stock off that investment cycle in a major correction, you would have had a phenomenal return over the next one and two years. My guess is the same setup now. That's my guess.
Bill: Yeah. I think I largely agree with that. For anyone that's not familiar with what's going on, I do think that the shift to short form video and replicating TikTok basically within Instagram, which is now reels, I do think that that impacts ad load and potential ad efficiency. I think somebody's got to have a view on that. But over the long term, I think that they'll probably figure it out. I've listened to him speak about his views on safety and what AI and ML can do in the Metaverse. It's going to be an interesting thing to watch. I'm confident that people that dismiss the investment are too confident in their dismissal. I am not confident in what it leads to, if that makes any sense.
Mark: It does.
Bill: Yeah. Do you mind going through a little bit on your views on share-based compensation? Because this is a pushback that I often hear with tech companies. You look at the operating cashflow and all of a sudden, it's all stock-based comp. So, what's the true cash generation in these companies? I'm curious to hear you riff on that.
Mark: No, I think I might answer. I don't know if it's going to surprise you or not, but I think I 100% agree with what the thrust of your question is. Stock-based compensation is a form of expenses. If you didn't pay your employees the stock, you'd have to pay them with cash. It's compensation to them. They're rational economic beings. They can put a price on the shares that you've given them and the price on the cash you've given them. That's easy. I treat it as a real expense. I don't look at non-GAAP earnings. Now, in all fairness, that wasn't the case early on. I learned along the way. I refer to it, I don't know, seven years ago is the GAAPification of the internet like the GAAP, GAAPification of the internet. I thought that was a healthy thing. It seemed to me like there were too many companies giving out stock like candy. To their credit, Netflix, I don't think they ever reported the non-GAAP earnings number. Amazon hasn't in a decade. Facebook and Google both did for a short period of time and then, they cut that out.
Shockingly, [chuckles] there's probably one major internet company. That's not quite right, but the one that really strikes me as odd is eBay, which always refers to non-GAAP earnings. It's like, "Really, why are we doing this?" When I look at P/E multiples, I look at GAAP P/E multiples versus the growth rate to determine what I think fair value is, that's my shortcut inside of the DCF. The DCF doesn't that treats-- I look at the cash required that's used to buy back stock to offset, the share-based compensation. Absolutely, it's an economic expense and it's a financial expense. It may not be a cash expense right now, but now, there's depreciation. I still consider that an expense. So, yeah, hopefully, I think that would be copacetic with your view.
Bill: Yeah. I heard somebody they go by @postmarket on Twitter. But they said something super smart, where they said, "Basically, they refer to it in the office as phantom OpEx." Whenever I look at the buyback to offset the shares that are issued, it's like this is-- Come on, this is just OpEx, right? Or its dilution.
Mark: Yes. Completely agreed.
Bill: But I have morphed a little bit in my opinion, because I do understand the idea of having your employees motivated and I also understand the idea of investing in growth if you truly believe that you're going after a market that is going to be long-term profitable. I do understand spending. I used to favor profitable growth way too much and I think that's probably where people like myself have missed on some pretty big trends. I don't know.
Mark: Yeah, you may have missed some winners, I know you've missed some losers, too. I'm not a portfolio strategist, but I'm perfectly respectful of the fact that the growth equities I look at should only be a portion of your overall investment outlook. I love finding these compounders companies that-- The ideal situation for me as a stock picker is to find a company, where I can get a double-barreled win, where I think I can get a rerating in a multiple and I think earnings about three barrels, if such a thing exists, where I think I can get upwards estimates revisions. When the earnings growth by itself, it can be 20%. I look at the drivers of earnings growth, the highest quality driver of earnings growth and I look at his revenue growth. Then, margin expansion, then, share buybacks and the stuff you do below the operating income line. I think tech investors are willing to pay a lot more for revenue growth, because that's the toughest trick to pull off. If you can pull it off, that probably says something interesting about your TAM management team value prop and your level of product innovation. So, I like to find those companies that if you could trade it in the market multiple--
One of my favorite stocks and I spent a fair amount of time to book on this Priceline.com, now, known as Booking. Priceline for a decade was the single best performing S&P 500 stock. It's just a phenomenal performer. They had this funny thing, where for about a decade, eight years, they grew their top line about 40% and yet, they traded between 17 times earnings close to a market multiple on GAAP, 17 and 25 times earnings. A huge discount to their growth rate. What was happening throughout this entire period is that, investors were just skeptical. They thought there was too much commodity risk. They're just reselling hotel rooms. Who can't do that? How are they going to be able to sustain this growth? And yet, they kept sustaining that growth. It led to this phenomenal stock, because the multiple didn't change, but the revenue growth and earnings growth, the margins were rising during that time, so, you had a company that was doing 50% earnings growth for five years. All you have to do is keep the multiple and that stock is going to dramatically outperform any market.
I love to find those situations. They rarely occur. If I'm looking for stocks, I can find stocks that are trading at a discount to the earnings growth rate. That was the lesson from Priceline for me. Man, I love those. If they traded these really high multiples and it's almost like growth investors are playing a little bit of a game. The earnings going to grow fast enough to offset what's going to be eventual derailing in the multiple and you're toggling back and forth. You're always nervous about that. How quick is that multiple going to come down? And then, you get these terrible double whammies the other way, I mean, it's double-barreled up and double-barreled down, because when these high multiple stocks, they miss, well, shoot, estimates go down and then, the stock derails. That's a double whammy and it can happen awfully quickly. That's the risk of holding high multiple stocks. You better have a darn lot of confidence in that growth rate.
Yeah, I don't mind sticking my neck out on some of these high multiple stocks, but I'm going to be right up front about that. But that's the risk you're taking on. This is why I think the growth can be truly exceptional, but it better be truly exceptional or else you know-- So, I'm fine with speculative longs, I prefer core longs.
Bill: Something that I thought was interesting is, you had said at the very end of your book, what was it? It was extra credit is what you said. You said, "Material revenue growth acceleration is great. But it's more impressive if it's faster than the rate at which comps eased in the prior year likewise, material revenue."
Mark: Oh, yeah.
Bill: You issued a warning on the COVID beneficiary work-from-home stocks. And boy, was that pression? If you look at what has gone on in that sector in general, we're now trading below 2019 multiples in a lot of cases it's as if COVID never even happened. I think it's a very interesting observation or set of facts here, where I think some of these companies that are objectively stronger have now had some of those growth rates put in question, even though, I think that their businesses have been somewhat proven. I don't know. It's one of those scenarios, where they got all the benefit in 2020 of the revenue growth, it couldn't quite scale up the OpEx to go along with it. Now, some of them are catching up on the OpEx, but the revenues decelerating, and you just see this compression, and I think of it a lot is the fog of war in the sector right now. There must be opportunity is all that I can think.
Mark: I liked the way you set it up, Bhil. I'll make two points, which is, you had a good number of stocks that traded up like they were COVID winners as crude as that term is in the back half of 2020 and if you could have correctly identified the companies that, "Ah, no, they probably weren't COVID winners. There's a couple-- Netflix's COVID winner." Yes, of course it is. A huge jump up in subs in the first half of 2020, but other companies are trading like COVID winners, but there aren't. A few had identified those. Pinterest is actually a good example of one that traded like it was a COVID winner, stock gapped up, rerated, but in the end of the day, they had the slew of new users that came on about $9, $10 million in the US. They gave them all back in the following quarters.
Bill: Yeah.
Mark: That's the past. Let's go to the present. I see five stocks and, Bill, I'll even be tighter on what you just started off as the analysis. I was just thinking about this recently. I just ran this yesterday. There are five stocks that I think are clear COVID winners. Their businesses benefited from the COVID crisis. They got a bunch of new customers and at very low customer acquisition costs. People went looking for Netflix. They went looking for Peloton, Netflix and Peloton didn't have to advertise. So very little customer acquisition costs, slew of new customers, and yet, these five stocks are all trading below where they were, pre-COVID. We go back to the middle of February 2020, their stock price is not their multiples, their multiples are probably below. I just meant their freaking stock prices. Here's the list. Shopify, Netflix, Roku, Peloton, and maybe Wix. Those five names are all trading below where they were pre-COVID. Yet, I think all of them were bigger businesses because of COVID. Chances are in that list of five stocks, there should be some good long ideas in there. The one challenge for Shopify, that was a high multiple stock. We had this other trend that's going on now that I talked about in the book, too. I was prescient on and maybe unfortunately, prescient on, which is what happens to this sector in a rising rate environment and an aggressively uncertain rising rate environment. Well, we know we're in a bear market for NASDAQ stocks, for tech stocks, for growth equities.
Anyway, I, my team are looking at these five names saying, "Which of these should we be aggressively recommending now?" Because they're fundamentally stronger than they were pre-COVID, but their market value is actually lower than it was unless their market value was really artificially trumped high prior to COVID, which could arguably be the case in the example of Shopify. I don't think it is the case with Netflix, Roku, Peloton, or Wix. So, I'm intrigued by those four.
Bill: Yeah, I spend a lot of my time thinking about media, and I go back and forth on whether or not I think Netflix wins, because they are completely dedicated to SVOD, and no one else is going to be. And then, recently, I've shifted to-- Well, wait a second, could Netflix and Roku, both win and Roku is the arms dealer to the companies that have to straddle the AVOD, SVOD decisions. I don't know. But I agree with you. I've heard people tell me that Roku is too cheap, but you can't buy it. I understand that statement and I also don't understand that statement at all. So, it's an interesting time.
Mark: Well, you step in on these-- We saw this at the end of 2018. Bill, you'll remember this. We had a dramatic sell off in NASDAQ. That's the last time we had a major correction. I had to dig back into this, because I was looking at Amazon trying to draw lessons from Amazon. When you look back at the chart on Amazon, you see this outlier event, where the stock corrected 30% in the back half of 2018. When I was writing the book, I forgotten why it corrected like that. I went back, I looked at the earnings. Nope, no problem in the earnings. I literally went back and read the transcripts in the earnings reports. Street numbers actually went up. There wasn't something's company specific and then, I looked at it, and you had a trade war back then between the US and China. You had a new Fed. Powell had just come in and was talking about raising rates, and then, you had slowing global GDP growth. That was your cocktail that caused that NASDAQ correction and NASDAQ corrected 20%, Amazon record 30%, although, nothing had changed in Amazon's fundamentals. And that created this great DHQ, dislocated high-quality opportunity to buy Amazon, and you would have had a really good return if you had done that.
I think that's what we got now. I get it. I understand why and I think growth equities are in the strike zone is the wrong word. The markets not looking to buy growth equities and I don't think will for a while probably not until the summer. We need some interest rate leaving aside the Russian war on the Ukraine, you need some confidence in what's going to happen to interest rates. Growth equities can outperform in a rising rate environment. It's harder than in a falling rate environment, but they can. But you least need some confidence that we're going 25, 25, 25 into how many increases rather than in the last six months, we've gone from one great increase in 22 to 24 to 25 to 26 to 27 that we do in 25 bits, 50 bits, and that uncertainty growth equities get crushed and that's exactly what's happened. But throughout all this, let's take a look-- That means the high-quality names actually outperformed, but they're still off. They've outperformed the more speculative names. Here's your chance to wait in, you can buy Google on sale, you can buy Amazon on sale, you can buy Apple and Microsoft, the four highest quality tech growth equities out there. They're all off 10% to 15%. So, it's not a gimme, but when growth equities come back and my guess is that they will at some point later this year, the market will pay more, will want to buy companies that can grow at premium levels at reasonable prices. Well, we're not reasonable prices. Anyway, I'm very intrigued by this DHQ opportunity.
You mentioned this earlier on, the first two chapters of the book are, there will be blood. You can pick the absolute best management team, best product innovation company, great TAM company, total addressable market company, you can pick a great stock, but you will lose money, because the market rolls over on stuff you can't forecast COVID, Russia invasion of Ukraine, dramatically rising interest rate, uncertain interest rate environment. That's your opportunity to step in on the highest quality names. That's when you should have the confidence of your convictions and that's why I do not, question is whether this is-- I can't call bottom on this. I just know that I went through this example in the book of, "If I bought these stocks, identify the highest quality assets and then, wait for them to be dislocated." I either trade at a discount to their growth rates or they're just simple rule of thumb, they're off 20%. If you'd bought the stocks when they were off 20%, some cases, they ended up being off 30% and 40%. But you still would have made money buying that 20% correction.
That's what I'm doing on the highest quality names. My top picks here are names like Amazon, and Google, and then, I also like some of these recovery names, because we will be coming out of COVID, we are coming out of COVID. So, these recovery names like Booking, and Uber, and Expedia, and Lift, you get improving fundamentals and then, as the appetite recovers for growth equities, there's a lot of jet fuel behind those stocks, especially with names. I call them Venn diagram names, because they're high-quality in terms of business model and valuation. Bookings and Expedia always have had high margins that 30% plus EBITDA margins, generate cash, buyback stock, just high-quality business models been tested for over a decade, and our valuations are reasonably close to market multiples. And yet, they've got this real-- There'll be certainly a dramatic recovery and leisure travel this year and into next year, and these companies should really be nicely levered to that. I call them Venn diagram means recovery and high quality. I want to be along that basket. I'll buy them here. I doubt I will call the bottom and I wouldn't be surprised to see them lag for another three months or something like that. But I just like the entry points and I'll let the market figure out exactly when we're going to regain our appetite and growth equities.
Bill: How do you think about something like Etsy, which is a marketplace business model, which is a fantastic business model? Not quite in that second Venn diagram, because they're arguably a loser as people lean more into physical retail. But I think it's hard to argue that they haven't drawn more people onto the marketplace and marketplaces over time tend to get stronger unless they pull an eBay and stop investing. But I would think that going forward, if I were to think about it, I would say, "Okay, I want to know that they're investing and being innovative." Even if maybe, I am not benefiting from the reopening, that's a heck of a business. It's probably going to be here for a while. But maybe I'm wrong on that. To any listener, I haven't done deep work. So, don't hold me to that comment.
Mark: Yeah. We clearly had an inflection towards online retail sales, a little bit of a shuffle back towards offline retail sales as people were thrilled, halfway through last year to be able to get out and go to the mall again. But the growth rates for online retail still remain elevated. I still haven't figured out the right way to phrase this. I pull forward. It sounds like you've just taken from the future and pulled it forward. I use this expression, "permanent pull forward," I'm not sure that really got it across. It's like, we were like 15% of retail sales were online. During COVID, it gapped up to 20%. It's not going back to 15%. It is going to keep growing from there. We're going like 11%, 12%, 13%, 14%, 15%, 20% and then, I think we go 20%, 21%, 22%, 23. So, it still keeps rising. We do have this little shuffle back to offline, but I think that's for a short period of time.
Bill: It's almost like a step change, right?
Mark: Yes, yes, thank you. That's the way to phrase it. Yes.
Bill: Yeah, and then, if you really want to get complicated, maybe you're living in a split level and you got to walk down a little bit, but then, it'll keep going up. I don't know. But I think objectively, we're going to be higher than we were coming into COVID on the backend of all this. What precisely that works looks like is tough. Something I really liked about that what you-- I liked the whole book, man. I really do appreciate your writings [crosstalk], but I really liked when you said, "Don't get hung up on false precision" and then, you went through a DCF that's 10 years long, you've got, what, 70 inputs, at least right? How many of those could go wrong? So, I thought that that was a nice way to frame. Just embracing the imprecision of all this.
Mark: Yeah. Estimates are about the future and you can predict the future as well as I can, which is as well as anybody else, which is you can't. I do think it. That's why they always say what is past performance is no indicator of future performance, something like that. That's the tagline and that the SEC requires all-financial prospectuses. Now, I think when it comes to management teams, past performance can be an indicator of future performance. It's possible the management team just gets lucky and lucky year in and year out. But usually, you get a company like Apple, Microsoft, Google, they can sustain premium fundamentals for a sustained period of time. They've got something going for them. It's rather management structure, the market opportunity. And this stuff can be squandered over time. Yahoo squandered it, eBay squandered it, and the companies I looked at much more recently Grubhub squandered it. They were also, though, tapping into a market that was very early stage and that's a company like eBay, they ramped up margins too quickly.
Anyway, yeah, I do try to be careful with-- I tried to come up with a range, when I think about where stock can go to. I tried to come up with a range of where I think shares can go, what could happen to the multiple, what could happen to the earnings. That's my shortcut on these names. I do have DCF on all the names I look at, but I don't lead with a DCF. I like to see what DCF inputs do you have to believe in order to justify a higher price target. That's my little bit of my sanity check. But it's a check, it's not the driver of valuation for the reason you mentioned, which is "Perfection can be the enemy of the good."
Bill: Yeah. It's almost embracing-- It's the marriage of qualitative plus expectations investing. I think that's where I'm going and where I've morphed as an investor. I can tell you every time that I have figured, I'm uncomfortable with parts of the story, but boy, the valuation supports some of this discomfort, it has never worked. [chuckles] I am no longer evaluation first thinker. But we'll see whether or not that's a good thing to more fun. Something, I don't know why I'm thinking of this, but I lived in Chicago for a long time, and a business that was interesting to watch stumble was Groupon.
Mark: Yes.
Bill: It goes to being accurate on TAM. When they started to expand outside of restaurants and they got into this yelpy type, we're going to start selling canoe trips and stuff like that. It really felt like the brand took a hit. Maybe that's wrong to me, but that's when it felt like Chicago is a city kind of-- I don't know. My friends stopped using Groupon nearly as much when it became ubiquitous, which I think is interesting.
Mark: Yeah, Groupon was a fascinating example. That company went public. Enormous initial public market enthusiasm for them. Highly innovative business model. CEO that just looked like he was one of those geniuses. A business that was so popular. There were 700 Groupon copycats and a TAM that seemed really large, they were the fastest company to reach a billion in revenue ever, and Google had tried to buy them. Well, that sounds there's strategic interest. The company with a big market cap thought there was something interesting in this business model and then, it all kind of fell apart. That's a tough one. Growth investors jumped in and I was generally pretty cautious on it from the beginning. I got lucky on that one, perhaps and I don't know what the issue was. This is going back a couple of years. I wrote about this a little bit in the book, but one of them was the fact that there were 700 copycats. What's going to cause this name to-- Why are people going to use this versus other services? And man, that company also just extended itself into so many different verticals, so many different countries. It was just imperial overreach on their part. And then, they had a fair amount of management turnover in short order. I quoted it in the book, the resignation letter by Andrew Mason. I just thought it was humorous, self-deprecating. I appreciate it a little bit of levity on Wall Street. You don't get it too often.
Yeah, that may have been a case of they just didn't have the right managers running the business and the value prop may have been more limited than people realized. Not so much for consumers, but for merchants, because you were bringing into coupons pitch to merchants as we're going to bring you in new merchants. But then, the subtitle of that pitch was we're bringing you merchants that are really looking for a deal.
Bill: Yes.
Mark: They're going to go to your flower shop, they're going to take out your pizza, because we're giving them 20% off. That strikes me as a, cheap customer is the wrong word, but a deal-seeking customer.
Bill: No, that's right.
Mark: [crosstalk] the deal rather than in your brand and so, how good of an acquisition channel really is that. That may have been at the end of the day that the Achilles heel of Groupon that they generated new incremental customer demand, but it was for deals rather than for brands or for particular services, which meant that they were lower quality to customers.
Bill: Yeah, 100%. Because the customers relationship was with Groupon to get a coupon and then, they would go spend that. It was not with Roy's Italian. Well, Roy is not an Italian restaurant owner. But anyway, we agree. Mark Mahaney, thank you so much for your time and thank you for writing the book. I think everyone should go out and buy it. I think it's great and I appreciate you being a guest.
Mark: Thank you, Bill. It's great talking with you.
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