The term ‘Lollapalooza Effect’ means a confluence of factors acting together that can lead to either large positive or negative results.
The key is that when forces combine, they don’t just add up; each force builds off and strengthens the other, creating an explosive effect with huge results, according to Charlie Munger, an American investor.
We should always learn as much as possible from a market or stock correction to build robust defence mechanisms. It will help in constructing a portfolio keeping in mind the various business possibilities. Currently, we are seeing a big carnage in one of the popular FAANG stock during this year — META.
Meta is a tech company which has a proven business model in digital advertising. It has brands like Facebook, Instagram and WhatsApp, which are used by about 3.7 billion people on a monthly basis.
Meta has built a reputation over the last decade as one of the safest investment choices by scaling revenues from $5 billion to more than $100 billion, and delivering 40% and above PAT growth. It also joined the $1-trillion club and the coveted FAANG club — a set of 5 dominant stocks, forming part of core holding for investors across the globe.
When such a well-discovered stock with stable core fundamentals falls 70-75% (close to $700-billion decline) in a matter of 15 months, it is worth understanding the forces behind it so that we can reduce the impact of such wealth destruction on our investments. Post this fall, the stock’s 10-year CAGR return was lower than the broader market return.
The factors which potentially led to a sharp fall in business and stock price are discussed below:
During the last decade, Meta grew its revenue in the range of 30-40% per annum on an average due to the high growth in digital advertising.
In 2021, digital advertisements hit 65-70% of the total advertising market. Value migration from existing segments to the new segment (digital) started hitting saturation levels. Now, online market growth is expected to resemble aggregate advertisement growth across the world, which is growing in low, single digit.
Since digital advertisement is a lucrative business given the high growth and high margins for established players, a lot of competition has come up in the last few years. The rise of TikTok was the first sign of a strong competitor for Meta which threatened its core business.
Meta’s clientele includes corporations that use Meta’s platform to make targeted advertisements. This was possible with the data Meta captured when its platform was used. Recently, Apple had changed the ecosystem policy in terms of sharing of data and it dented Meta in two ways — they were not able to measure the utility of their product and less data availability result in less productivity.
Due to the slowdown in the core business, Meta decided to incubate new businesses that would add value to the core. Meta has stepped up the capex for both Family of Apps and Reality Lab businesses. As a result, free cash flow slid from billions of dollars to millions in recent quarters.
Meta is expected to invest approximately $70-100 bn in the next 10 years in new areas such as Meta verse where the business model and profitability prospects are not clear. The capital allocation risk in the business had gone up significantly.
The pandemic turned out to be a boon for Meta in two ways. One, online commerce became mainstream, and everyone started using online advertisements to reach out to customers.
Two, the demand for products was significantly higher than demand for services due to lockdowns. Both these factors boosted sales and the profit margin for Meta.
Return to normalcy from the pandemic resulted in tailwinds turning headwinds.
Cost of capital
As we are coming to the end of a quantitative easing era, the cost of capital is going up across the world. So share firms that are still in the investing phase are priced lower. We have seen this impact even in stocks like Tesla and Amazon.
Advertisement is a discretionary expense. With a slowing economy, investors have realised that the digital advertisement market is also affected during an economic slowdown since a large section of the advertisement market has already moved online.
As investors, we need to understand what quantum of growth and profitability is priced into a stock. When stocks are priced for perfection with low margin of safety in terms of valuations, even the finest blue-chip is punished brutally when an adverse change occurs in fundamentals.
Avoiding a highly-valued, well-discovered stock is a better approach to protect us from a debacle such as Meta.
To achieve good investing outcomes in the long term, we need to ensure that we have an adequate margin of safety in terms of business quality and cheaper valuation, even as buying would help us avoid lengthy periods of underperformance or sharper drawdowns.
(The writer is Head of Research and Co-Fund Manager, ithought PMS)