There was an interesting article in The Economist this past week about the numbers behind voting to draw the 2012 U.S. presidential election to a close. Economists (and as we known, academics in the finance department at institutions worldwide) love to lean on a simple premise that materially influences what they ultimately conclude about the world around us: Human beings are rational and keenly focused on utility-maximization. With that as a given, the obvious question is asked – why do people bother voting when the probability that their single vote will actually have any impact is zero? As they note, you are more likely to get struck by lightning on the way to the polling station than to be the deciding vote in the U.S. presidential election.
They quickly address and dismiss a few common responses as to why one could still justify voting, including “what if everyone else didn’t vote either” (the smart money for the last 57 elections in the U.S. has been that some people will go to the polls), the importance of “preserving democracy” (one skipped vote is unlikely to result in the country’s demise), and the good feeling that comes from performing a “civic duty” – an often cited argument and hardly a surprising one: people tend to do what’s in their self-interest (to make them feel good about themselves), and the investment of one’s time is a small price to avoid any personal shame. While these responses (particularly the third) each have their place in the discussion, there’s one argument from the piece that I personally agree with: “some academics reckon that voters are simply bad at calculating probabilities.”
In connection with equity investments, that statement alone doesn’t do justice - absurd valuations aren’t solely built upon the fact that people are poor at calculating probabilities; instead, it appears that people have a way of always convincing themselves that this time truly is different (much like our voter who has convinced themselves their voice counts, even though they don’t need a calculator to figure out that 1 divided by 123 million – the number of votes in the 2008 general election – is a percentage of microscopic proportions). They end up believing that by a miracle of sorts, the company will justify this valuation – and a much higher one – over time.
A great example of this is from the tech boom at the turn of the century; in a Business Week article written in April of 2002, Scott McNealy, CEO of Microsystems, was quoted as saying the following about his company’s stock, which had previously traded at 10x revenues:
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no tax on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock for $64? Do you realize how ridiculous those basic assumptions are? You don’t need transparency. You don’t need footnotes. What were you thinking?”
We don’t need to search very far to find a comparable example in today’s market: Salesforce.com (CRM) has traded at more than 10x revenue a couple of times over the past twenty-four months; according to Marketwatch, the analyst community (calculating probabilities must surely be in their job description) currently has a Buy-to-Sell ratio of fifteen-to-one, essentially saying that they uniformly agree that CRM is a strong buy.
As I noted in an article a few months ago, CRM would need to attain annualized revenue of growth of 25% over the next decade (ahead of Microsoft’s 20.8% annualized growth rate in the decade after the release of Windows 95), as well as reach a mid-twenties net margin in line with the current average for computer software firms – likely the company’s closest comparable industry (remember, they compete with giants like Microsoft, Oracle, etc, and have struggled to report positive earnings for some time now). If all this were to happen, and the company was given an earnings multiple in the mid-teens (in-line with the current large cap tech companies), the annualized return to shareholders would be in the high single digits (assuming a starting price in the low-mid $150’s per share).
Again, that’s in the scenario where things work (by any reasonable measure) perfectly. What is the probability that CRM is able to attain a revenue CAGR of 25% over the next ten years, and will be able to handily dominant its peers in the space despite their considerable share of mind among CIO’s at the largest companies in the world? More importantly, assuming that this scenario is considered to be a 100% certainty, what are these analysts modeling in the bear case scenario? At this valuation, and to continue to pushing CRM as a buy, one has to wonder – is there even a bear case scenario in these analyst projections?
Whether or not Salesforce ends up justifying this valuation over time is to be seen (CEO Mark Benioff certainly seems convinced that this company will change the world); personally, I would try my luck at voting before I considered going anywhere near CRM common stock.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with a handful of positions accounting for the majority of the total. From the perspective of a businessman, I believe this is sufficient diversification.