More on Teladoc (TDOC) - Why I Am Not Holding

My previous write-up about Teladoc (TDOC) did not leave a clear conclusion as to what to do with the stock. The answer is I'm planning to exit the small starter position I have.

While Teladoc's revenues will continue to grow at a healthy rate, I'm doubtful that it can ever achieve the margin necessary to justify stock valuation.

Here's some simple math on where margins needs to be in 10 years to call this a buy. Right now TDOC trades at $58/share, or about about $7.9bn enterprise value. Let's say I want 2029 EV/EBIT to be 10x to call it a buy, so by 2029 I need them to have EBIT of $790mm. Annualized revenue are getting close to $500mm. If revenue grow at 30% CAGR for the next 10 years, by 2029 revenue could be $7 billion. This implies an EBIT margin of 790/7000 = ~11%.

Can Teladoc get to this 11% margin? I doubt it. As I illustrated in my previous article, TDOC is less a tech company than a "sub-insurer" that its payer clients outsource to. Insurers like UNH and ANTM operate at 6-8% EBIT margin, and it doesn't make sense that TDOC can capture higher margin than its clients since it has a weak bargaining position relative to them.

Weak Strategic Position Limits Margin Upside

The problem is telehealth itself is not a thing, not if it's just doctors using video chat. What IS a thing, is the creation of a business model that 1) adds value to the overall system, and 2) captures part of that value. 

Teladoc creates value for the overall system - many patients would simply not visit a doctor without TDOC. So they're creating value by competing against non-consumption.

To capture value though, disruptive entrants should have a separate value chain to avoid being co-opted by incumbents. TDOC does the opposite, it contorts itself to fit into the incumbent value chain. 

In order to grow revenue quickly, Teladoc uses health insurers as distribution, so insurers ended up owning the end-customer (patients) relationship and TDOC's leverage is weakened. As I argued in the previous article, TDOC's true value proposition for payers (as opposed to for the overall system) is to control cost by turning a visits based variable cost into a per member per month based fixed cost. This is a nice to have, not a must have for its payer clients. 

TDOC's margins already suffer from this weak position. It is forced to spend on marketing to drive utilization, even as that benefits clients (insurers) directly and hurts TDOC's margins (higher costs of service and marketing costs). 

Nor is Teladoc integrated enough with patients to own that relationship and impose high switching cost on its payer clients. Although Teladoc has a separate registration, it's the insurers that really own the patient relationship. Not only because patients still go first to insurer portals, but also because the current TDOC value proposition simply isn't able to stand alone. Consumer cannot just use TDOC and leave their regular insurance plan - because if conditions get any worse they'll need to physically visit a doctor, which would be outside of what TDOC can offer. The perils of fitting yourself into incumbent value proposition!

Not owning the patient relationship leaves TDOC replaceable. Payer clients can swap TDOC out for another telehealth provider the second TDOC tries to go direct to consumer. 

In this way, the center of gravity is with payer clients. They've managed to keep the most valuable part of the job and outsource what's NOT valuable to TDOC. Not only that they do it in a way with minimal tie-in, making TDOC replaceable.


Conclusion

An inherently flawed business model leaves TDOC at the mercy of its payer clients. This means low pricing power. This means the higher margins needed to justify stock valuation will be hard to achieve. It also means I should exit my position.

Going direct to consumer and owning that relationship would be a good fix, but that requires Teladoc to further differentiate itself in terms of value proposition and value chain. My own recommendation is to achieve that through 1) focus on chronic care, 2) use of nurse practioners, and 3) ideally hire them as employees.

Teladoc's Business Model and Implications

I’ll start with an short hypothesis of how Teladoc (TDOC) could play out to the upside (or else why bother right?) then analyze the business model, implications and options to change that model.

Summary Upside Case

• Continued organic revenue growth at 20-30% CAGR. Growth comes from both membership increases and price increases.
• Government expansion of telehealth coverage for Medicare Advantage plans beginning in 2020 should help membership increases
• Operating leverage kick in as TDOC drives utilization, proving its worth to clients, which in turn justifies price increases. Management expects EBITDA to inflect positive this year.

TDOC trades at 8x EV/revenue while still unprofitable, so buying it requires us to think 10 years+ forward and project sizeable revenue and margin increases. That calls for an understanding of Teladoc’s business model and its place in the healthcare value chain.

Business Model

For the most part, Teladoc gets revenue from payer clients (health insurance plans, self-insured employers), and not directly from patients/consumers. 

These clients pay TDOC recurring "subscription access fees", typically on a per-member-per-month basis.

Costs of revenue are essentially based on volume of visits:

Cost of revenue is driven primarily by the number of general medical visits, expert medical services and other specialty visits completed in each period. Many of the elements of the cost of revenue are relatively variable and semi-variable, and can be reduced in the near-term to offset any decline in our revenue

As far as value proposition and "jobs to be done", here's a line from TDOC's filings:

(Clients) purchase our solutions to reduce their healthcare spending, or to provide market differentiating services as either part of, or a complement to, their core set of consumer service offerings,

Cost savings is the most tangible benefit, and in my opinion the most important one, since telehealth itself will not be much of a differentiator for health plans given the proliferation of video technology. 

TDOC saves money for payers by "capitating" an otherwise fee-for-service cost. The typical health plan pays doctor each time patients visit. More visit means higher costs for the plan/insurer. But with TDOC, the insurer just pays TDOC a fixed fee regardless of how many times patients visits doctors in TDOC’s network.

Here's a very simplified diagram that illustrates how economics flow from payers to doctors through TDOC (right side of picture). Compare that to the world without Teladoc (left side of picture), note that TDOC basically injects another layer of physician network for the original insurer to outsource to, and turn a volume based variable cost into fixed cost.

Implications

TDOC’s business model has several implications:

1) This business model only makes sense in a non-integrated healthcare world where payers still pay doctors on fee-for-service basis. It makes no sense in a vertically integrated healthcare system like Kaiser, where doctors are salaried staff.

As mentioned earlier, in a typical non-integrated healthcare system (for example Blue Cross for example), the more you visit doctors, the higher the costs for Blue Cross. TDOC comes in and fixes that costs at some per-member-per-month, regardless of number of visits. But with Kaiser that cost is already fixed because doctors are employees, so TDOC can add little value there.

This implies an inherent limit to growth. But TDOC has a long way to go before it hits that limit since systems like Kaiser are relatively rare.

2) Ability to raise prices depends on how much payer clients are saving by using TDOC. That saving amount is based on telehealth utilization - and TDOC is incurring marketing costs to drive patient awareness and utilization.

That TDOC couldn’t pass that marketing cost along to payers, even as it directly benefit payers, shows the weak bargaining position that TDOC occupies in the value chain.

Unlike say, Uber, where both sides of the market place – drivers and riders – are both fragmented and politically weak, TDOC is a middleman between 2 powerful groups – payers and doctors.

This is why I would love to see TDOC go more of a direct-to-consumer route, like they’re already doing with behavioral health. Owning the customer relationship would give them more bargaining power vis-a-vis health plans.

3) Where will operating leverage come from in the future?

The problem with driving utilization higher to improve client ROI is that TDOC itself would have lower margins, since revenue is fixed based on number of members while costs goes up when visits are higher. 

TDOC can change its own costs structure though, by hiring doctors (which turns variable costs into fixed cost), or even use algorithms for simple prescriptions. They are in fact already exploring the former.

Having more of a fixed cost structure would further incentivize TDOC to continuously prove and improve ROI for payer clients. This would convince payers to offer Teladoc through more of their health plans (boosting membership), and allow TDOC to argue for higher access fees per member (boosting both revenue and margins)

4) Perhaps Teladoc can carve out a separate product for chronic care and using nurse practioners instead of doctors. This would be a more optimal use of resources from not just cost perspective, but also from coverage perspecdtive (more supply available to cover patients 24-7). It would also let Teladoc cleanly differentiate itself against your typical “health plan with video option”– important if TDOC wants to go direct-to-consumer and build that brand.

More on Video Games, from a Disruptive Innovation Perspective

I have been reading Christensen’s theories on disruption. Some key themes of disruption are: 1) making a technology cheaper and more accessible, and 2) solving a problem that’s previously under-treated, or addresses a slightly different audience. Competing against non-consumption is a key theme as well.

So disruption is about creating value and diffusing it throughout society. You want things to be both cheaper and available to more people.

This also echoes “Crossing the Chasm”, where a technology leaps across the exclusive purview of early adopters and visionaries, and into the mainstream.

Disruption typically requires three things that are internally consistent and reinforce each other:

• An enabling technology
• A new business model
• A new value network (value chain) of disruptive players. Creating this often requires one strong company to vertically integrate the value chain and force industry changes.

From an investment perspective, picking winners means spotting industry trend changes, understanding the technologies and new business models that enable these changes, and then investing in a company that is part of the new value network of disruptors.

For practice, I'm trying to think through the video game landscape and apply these concepts. 

Video games - changes I’m observing

Two changes come to mind immediately:

• First, the value proposition and target audience of video games is changing, from teenage and college dudes in the basement shooting strangers, to a more inclusive (both adults and children, male and female) social experience.
• Second, costs have gone down dramatically. The proliferation of simple, low cost mobile games means people are conditioned to only paying a few dollars for games, if at all.

These fit the themes of disruption – a broader audience, lower cost access, and address problems that were previously unsolved (social needs instead of pure adrenaline rush).

The next questions are "what's technologies and business models fit with these changes", and "who's part of the disrupting value chain?"

(Apologies - the next couple sections are a bit messy because it's a bit of brainstorming)

Enabling Technologies and New Business Models

1. Enabling technologies- 

Internet is an obvious enabler that allows players to go online and shoot at random strangers, or team up with friends and strategize. This increased the social component of video games.

Network technologies continue to evolve. First, with CDNs (Fortnite uses Akamai), and now with full streaming (Google Stadia).

Another one I can think of is Nvidia’s ray-tracing chips. This seems to me a complementary technology for CDNs, where the ray-tracing capability can be done not at huge data centers, not at consumer’s homes, but at more remote (“edge” if you will) locations within CDNs.

2. Business Models

Free to Play (F2P) a revenue model that’s here to stay. This could be F2P with advertising, or F2P with microtransactions (loot boxes, battle passes, skins…etc).

Distribution is another obvious one. We went from buying game at physical retail stores, to downloading games at home, to now full on streaming.

Fortnite is potentially pioneering a whole new business model. With unique in game events like concerts, Fortnite real value could be as a “gamified” online gathering place that monetizes by selling tickets to events.

Value Networks - who’s part of the disruptive chain?

Now it's time to find parts of the value chain that benefits from these enabling technologies and (relatively new) business models. 

Let’s go from upstream to downstream.

• Hardware.  As mentioned earlier NVDA’s ray tracing chips could be used to bring top quality to mass market.
• Consoles are being disrupted by F2P model as well as streaming, so makers like Nintendo, Sony, and Microsoft will have to rely on their game development skills.

• Game Developers and Publishers.  
• Developers that grew up with low cost mobile games will fit well with the F2P paradigm. Zynga and ATVI’s King are examples. 
• Publishers with strong experience in online multi-player games have advantage.

• Streaming networks like Twitch, communication apps like Discord, or even Reddit amplify the social value of playing video games.

How to invest – Tencent and ATVI

Unfortunately much of this is uninvestible. I'd love to invest in Epic Games, or Twitch, but they are owned by Tencent and Amazon, respectively. Both are so big that the impact of Fortnite/Twitch would be negligible. 

I do like Tencent itself though. The company is integrated along games, social, and payments. That’s three competencies that define the future video game world. No wonder they saw the potential of Fortnite before it happened! They also have a stake in Garena’s Free Fire.

Activision Blizzard (ATVI) is one that I have a small position in. Their games like Overwatch will be disrupted by F2P model, but they do have the resources to overcome disruption if management tread wisely.

Fending off disruption requires disrupting yourself, and separate the new business into an autonomous entity. ATVI (like EA) already does that. Activision is a different studio from Blizzard, which is separate from King. King is quite familiar with F2P model. So I do think ATVI has the skills to thrive in the new world. But we’ll see.

Video Games as Social Networks, and How EA Misses the Point

The market has been treating Electronic Arts (EA) and Activision Blizzard (ATVI) stocks rather harshly. A big part of it is the emergence of Fortnite, a free-to-play (F2P) battle royale game that’s taken the world by storm, and helped its creator generate $3bn in profit.

Investors who are long EA are counting on its new battle royale game, Apex Legends, to fend off this competitive threat.

Unfortunately, this type of thinking misses the point.

Fortnite is not about battle royale, nor is it about F2P. The disruptive part of Fortnite is turning traditional shoot-them-up games into a lively social experience, while broadening the audience beyond hardcore gamers.

All aspects of Fortnite’s designs, from graphics to game play to monetization model, fit together tightly to create that social experience.

Apex Legends on the other hand, merely copies Fortnite’s revenue model (free to play) and game mode (battle royale), without matching it to relevant product features.


Fortnite is more than a Battle Royale!

You don’t have to look very far to see that Fortnite is much more than a video game. It’s a social phenomenon:

• Athletes from basketball players to boxers have been celebrating with Fortnite dances
• Creatives like Carlton tried to sue Fortnite for its dances
• Carlos Santana had to smash a TV because his teammates were playing Fortnite during baseball games!

Why people play video games

Let’s take a step back and think about why people play video games. Common reasons include:

• Fill time
• For entertainment – this could be adrenaline rush or going through a story like in role playing games
• Get a sense of achievement - whether it’s solving puzzles or beating a stage boss
• Social needs – so they can interact with friends, or make friends through the game

The early generations of video games, say Super Mario, focuses more on the first three. There is a social component (kids talk about it in school or invite friends over to play), but in in general, game improvements are based on better graphics and fancier game play mechanics.

Then the internet came along, and we have multi-player online games such as Warcraft or Counterstrike, and all the sudden these games have more of a social component. Now you have to pick your teammates, strategize game plans, coordinate a time with your friends to storm some fortress. No one wants to let their team down, and the games are sticker because of that.

This is network effect in action. More players in the game means it’s more likely that my friends play, and the more my friends play, the more likely I’m going to play.

But a social network goes beyond simple interactions. In true social circles, people want ways to express their individualities, as well as build social status. Social circles also offer unique shared experiences that binds people together.


Fortnite as social network

This brings us to Fortnite. It has multiple elements of a social network - not just team play, but status signaling and shared experiences:

• Peer interactions 
• Play because your friends play - can’t let your teammates down!
• Or you can play with random strangers
• Shared experiences that people can talk about
• The Rocket launch in 2018
• Concert in Feb 2019
• But also ways to provide and signal social status 
• Game dominance = Bragging rights
• Your avatar can have its own unique attire (“skins”), including limited edition ones.
• Emotes/dances – these are great ways to express your individuality and sense of humour. Because earning these requires in-game achievements, they are bragging rights as well.

How Fortnite’s game features and monetization model both fit with this social function

Just saying “we want to build a social experience” won’t make it happen. Successful satisfaction of customer needs requires a suitable integration of product features and monetization schemes. And this is where Fortnite really shines. 

F2P totally makes sense given Fortnite’s “video game as social network” feel. To build a social network you want to minimize access barrier and maximize number of players. What’s more accessible than free?

To reinforce that accessibility, Fortnite’s cartoonish graphics broaden the audience to include kids and females. The game’s building mechanics also broaden the player base beyond just shooter fans. It drew in a class of gamers who likes solving puzzles.

In terms of monetization, Fortnite chose to monetize by selling skins/emotes/dances. These have no bearings on your competitiveness in the game itself, but are ways to express individuality and bragging rights.

Again, game features are fully consistent with monetization. The cartoonish graphics are aligned with silly dances, while 3rd person perspective (camera behind your character) means you can see the fancy clothes that you bought.


Now compare that to Apex Legends

Apex has copied two elements of Fortnite, the battle royale, and the F2P. But it fails to optimize game features to monetization while creating a social experience. As a result, this is just another game.

This article has a good comparison of Fortnite versus Apex Legend. Pay attention to various elements of the game (graphics, game play, perspective), and its implication.

• Perspective. Apex is also F2P and try to monetize by selling skins. But this is a first person shooter, so you only see the gun. This isn’t much incentive to dress up your avatars!
• Game play. Apex is more of a shooter, it doesn’t have the building mechanics, so gun skill is king. This limits access to a more niche group of players, and creates less of a diverse community.
• Graphics: Apex has more realistic renderings. While this is “better” graphics, it clearly caters to more of a mature audience, and will not work as well with humorous dances. This limits monetization through emotes.
• In-game events. So far I’m not aware of any.

Apex just put out its first Battle Pass (monetization). Not surprisingly, the feedbacks are disappointing across the board.


Conclusion

A disruptive business model has hit the video game industry, and it’s not about battle royale.

In Fortnite, Epic has found a way to do F2P to the tune of $3bn profit a year. That formula is to embrace the social network elements of a video game, complete with rare in-game events to encourage buzz, and with monetization tied to personal expressions.

Incumbents like ATVI and EA have to respond, but EA’s response via Apex Legends makes me wonder if they even “get it”. They seem stuck in the “let’s make the best shooter game we can and give it awesome graphics” mindset.

They better get it soon. Because Fortnite is here to stay.

What About Those Recessions? (From STOR's 4Q18 Call)

I bought STORE Capital back in mid-2017, right after news came out that Berkshire/Ted Weschler bought it. I remember reading the news at 10pm that night and got so excited that I jumped out of bed, stayed up all night researching, just in time to put in a buy order the next morning.

Since then STOR has provided good returns. More than that, I learned quite a bit about the real estate business by following a good management team.

The 4Q18 earning call was educational. You know one of these moments of mental clarity, when some one says something that (you thought) you knew all along, yet a light bulb just goes off in your head? It's one of those.

I had been thinking about cycles quite a bit, and STOR's CEO Chris Volk says this:

"So the first thing I would talk about is cycle, the notion of cycle, and this gets - a lot of analysts focus on the expansion cycle that this economy has been in for a long period of time and...somehow we must be getting near the end of the cycle..."

"...I think that this economy can grow at 2% to 3% at a margin, but inside of that 2%, 3% there's plenty of recession activity that's happening."

"...So if you were working for Sears Roebuck you might have thought you were in a recession, if you are working for Radio Shack you would have thought there was a recession.

Payless shoes I mean any one of the 9,000 retailers price closed toward and you would have felt pretty bad, right. A fewer in the oil industry, as oil prices plummeted in the Dakotas and elsewhere. And you are located in one of those states, you were thought there was a recession. 

So inside of that 2% to 3% growth there is a lot of kind of creative destruction that's happening that's buried in that."

Duh! Of course!

Instead of waiting/worrying about a big recession all the time, we're better off recognizing that mini "recessions" by sectors have always been with us. Its called creative destruction.

Sometimes real insight is simple and elegant, and right in front of you.

I'm not sure I can add much more without sounding banal. So I'll stop here.

Zillow's Endgame

Summary of my thoughts on Zillow ($Z, $ZG) and Redfin ($RDFN) as follows:

First, the real value of Zillow Offers is mostly about expanding target addressable market through adjacencies. Zillow is also positioning itself more at the center of transactions.

Second, I assess the threat that Redfin compresses the size of the commissions market, and there by hurting both companies.

Third, I think what's happening is Zillow is abiding its time. It's letting Redfin blaze the trail in disrupting the real estate market, but can eventually shift to Redfin’s model.


Quick Reminder of Business Model Differences 
• Zillow: Attracts buyer and seller to its website. Agents pay Zillow to advertise their services.
• Redfin: Home seller and buyers hire Redfin directly. Sellers pay Redfin 1-2% fee. Agents are employees of Redfin.


Zillow’s Upside – TAM expansion and Subtle Role Shift

Traditionally, Zillow’s Premier Agent serves as advertising for buyer’s agents.

With the Zillow Offers (their iBuyer offer), they now can expand to seller/listing agents. The idea is Zillow shows a low ball offer to the seller, and says “by the way, these listing agents here can help you get much higher prices, why don't we connect you?”

This doubles Zillow’s target addressable market. I think possibly more. Since listing agencies are more valuable jobs than buyer agencies, Zillow might be able to extract more value. (Listing agents are guaranteed to get his 3% commission, as long as the house gets sold. Buyer’s agents might pitch several houses to clients and end up getting nothing. Which job would you prefer?)

Zillow Offers also provides more opportunity to push the company’s mortgage offerings.

Not only did Zillow double its TAM, it’s also subtly shifting its role with consumers and agents.

On the sell side, the "Zillow Offers to seller leads" strategy let Zillow deal with home sellers before they get a listing agent, not after. On the buy side, Premier Agent 4.0+ includes lead qualification. Again, Zillow interacts more directly with consumers before handing off the job to agents.

By creating more touch points with consumers, Zillow is positioning itself to displace agents at the center of transactions.

Will Redfin Destroy Zillow and Itself?

Now let’s take a step back. At least for now, Zillow basically monetizes by taking a cut of agent’s commission pool via advertising and lead generation. So for seller listing, if seller agents make 3% commission, Zillow might be able to take 0.5-1% by providing leads.

The problem is Redfin compresses the size of the pie with their low fees. It's a big risk for Zillow. How can Zillow charge 1% for leads when seller agent only makes 1%?  They can’t.

Keep in mind Redfin is bleeding cash at these prices, yet they keep on doing it. In fact, they’re ready to ramp up advertising about the 1% fee service.

This looks like a lose/lose situation. Redfin can end up compressing industry commissions to the point where Zillow, Redfin, and traditional brokerages all get hurt, while home buyers and sellers benefits.

But How Far can Redfin Go? 

There's a limit to Redfin's creative destruction though.

First, Redfin’s price is not really 1%. That 1% is their basic listing service. They have a more complete Concierge service that charges 2%. And that’s just for seller agents. If buyers have their own buyer’s agent, they get paid commissions as well.

So at the end maybe Redfin gets the total commission down to say 3%-4%. It’s not going to be zero. That’s still a huge cut percentage wise (20-50%) from the current 5-6% commission, but there’s a floor some where.

Second, unlike Zillow, Redfin is bleeding cash. They’re pushing a low cost strategy, but don’t really have the balance sheet to do it. How much lower can Redfin go? How long can they keep this up? How much longer can they convince investors to fund this strategy?

Investors are willing to fund loss making, cash flow negative companies because of growth and operating leverage. But operating leverage here is limited, because unlike a pure software company, Redfin’s costs are not truly fixed.

Each agent can only handle so many customers before Redfin has to hire another agent. Redfin's limited ability to scale will eventually make it hard for Redfin to fund their low cost strategy.

I think Redfin is in land grab mode right now, but any pricing pressure they exert on the industry (and Zillow by extension) will take time, and that pressure will eventually let up.

Online Platform Gains Leverage Over Agents

So it would seem that Redfin’s low cost push has a limit, perhaps say cutting industry commission to 3-4% of sales price.

Price cuts are only part of Redfin’s disruptive strategy though.

Just as importantly, it’s shifting the way people buy and sell homes. Instead of going to individual agents, and let them hash out deals with other agents, people use an online platform like Redfin and Zillow to not just get a price estimate, but also directly sell their homes, or let the platform assign an agent to them.

The online platforms, Redfin and Zillow, then become the center of the transaction, instead of a collection of agents.

The subordination of individual agents to online platforms is already under way. Redfin obviously already does this by interfacing directly with home sellers, with agents being mere interchangeable employees. As I mentioned earlier, Zillow is making a similar move with their seller leads business and Premier Agent 4.0+.

The explosion of the iBuyer model, by quickly providing sellers a “quote”, should further position online Platforms as the center of home sales transactions, away from agents.


Alternative Ending - Both Redfin and Zillow Wins 

This increased leverage over agents increases the likelihood that Zillow can further shift their monetization model in the future.

If Zillow can take control of seller listings, lead qualification, and decide which listing agents to connect with sellers, the next logical step would be just to hire those agents as employees.

That puts them not very far from Redfin's model.

The exact route of Zillow's shift will vary, but it's happening.

Redfin is at the forefront of industry disruption, but they do it in an unsustainable way. At the same time, Redfin's success helps Zillow’s hidden agenda – which is increasing platform power over agents.

Redfin is blazing the trail by burning cash. Zillow is following behind, abiding their time with a revenue model that leads to positive cash flows.

When the time comes, Zillow’s monetization model can converge to that of Redfins, and they settle at a 3-4% total commission while taking a much larger market share.

Thoughts on Cycles

Update 2/12/2019
In my original post below, I talked about the concept that fraud is cyclical. It turns out there are words for it - the "bezzle" and "net psychic wealth" - coined by John Kenneth Galbraith. He explains it much more elegantly than I can:

“Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.” 

- John Kenneth Galbraith

So the "fraud is cyclical" thing is certainly not any unique insight of mine. In my post, I further distinguish between frauds perpetrated by management, frauds unknown to management, and unintentionally inflated results from murky data.



Original Post (1/19/2019)
I recently read Howard Mark’s “Mastering the Market Cycle”. It was particularly interesting to see how he reconciles common value investing believes like “can’t time the market”, “ignore the macro”, and so on with more acceptable topics like “where are we in the cycle”. I had always thought the differences are little more than semantics, but Howard Mark pointed out some subtle differences that I had not thought of.

Reading the book also had me thinking through cycles some more. Here are just some thoughts that I will elaborate in this post.

• Why credit cycles do die of old age, and how lack of new borrowings alone would lead to recession. 
• Instead of looking at asset prices and judge whether they are rich or cheap, look at capital provider’s behaviors. Are deals getting done at ridiculous terms? 
• Thoughts on inflated earnings. While most investors are well aware of natural cyclicality, what’s less well understood are various degrees of fraud and “pushing the envelope” behaviors. 

Why Cycles Do Die of Old Age

Bull markets die with the end of credit cycles, which die of old age.

Over the past 30 years debt to GDP ratio throughout the world has ballooned, meaning new borrowings drive an ever bigger share of spending.

Whenever someone take out a mortgage to build a new home - that stimulates the economy. You take out an auto loan to buy a new car, that stimulate the economy.

But how many mortgages and auto loans can I take on? How many houses and cars can you buy? TVs? If you just bought a new house this year, chances are you’re not about to buy another one next year. Not when you’re up to your neck in debt.

As time goes on we approach some natural limit on indebtedness, and new borrowing activity decreases. Instead of borrowing, we have to pay down debt. That means less spending in the economy, and less spending means less jobs are needed.

This may not be obvious to some – less borrowing and/or paying down debt may be prudent, but it causes the economy to contract.

So thus credit cycles do die of old age, and with that, spending and the associated bull markets die of old age.


Look at What Investors Do, Not What They Say. Oversupply of capital

Here’s maybe the most useful thing I learned from Mark’s book – in judging where we are in the cycle, it’s much better to judge investor behavior rather than asset valuation, or even investor sentiment as expressed through media.

Asset valuation is inevitably subjective (7x PE looks cheap but is that peak earning or not? Depends on if you think if a recession is coming soon right?).

Investor sentiment and news flow can also be misleading. News headlines and Twitter can be flooded with panicky takes, but if VC deals are still getting done at 20x revenue then it’s hard to say the market is in capitulation mode.

Much more reliable are investor actions, as expressed through lending terms, M&A terms, IPO terms.

What does this all mean for us now (December 2018)? The U.S. stock market has taken a beating; news flows are undoubtedly bearish (trade wars! Government shut downs!) And we have cyclicals like Goldman Sachs trading at 7x PE. Are we near bottom of the cycle? I would say hardly.

Masayoshi/Softbank’s Vision Fund is buying anything and everything with Saudi money. Companies are still doing large buybacks. Consumer staples are getting into marijuana space at high valuations. Amazon is still expanding into new industries everyday. These are not signs of capitulation.

Intuitively, ease of financing also implies lowers barriers to entry, excess capacity, and crowded competition in the underlying industries. This “creative destruction” is not good for investors.


Frauds (and false profits) are Also Cyclical

I think frauds are important triggers of financial crisis because the “you think you have money, but suddenly you don’t” effect triggers panics and sudden liquidity demands.

It’s no coincidence that scandals like Enron and Madoff get uncovered at end of the cycle. For one, eroding asset values force investors to take a cold hard look at their portfolio, and there frauds are uncovered. Second, the unveiling of fraud alert the market to huge losses, which leads to a more skeptical market and even more unveiling of frauds.

Frauds are cyclical. They may be discovered only after the fact, but some portion of an economy’s output will always be from questionable behaviors. More at top of cycle, less at bottom of cycle; less frequently discovered at the top, more uncovered near the bottom. 

Frauds may have nothing to do with management’s integrity. Frauds can take place while senior managers are blissfully unaware, or even explicitly forbids it. The Wells Fargo scandal from a few years back - where low level branch employees create fake client accounts to meet aggressive sales goals – is an example.

As the economy expands and firms fight for market share, the pressure to improve performance naturally incentivizes all sorts of fraudulent or “push the envelope” behavior that inflates revenues.

Nor does inflated revenue and data need to come from intentional fraud. Ellen Pao’s “it’s all fake” tweet has an interesting discussion here.

It's all true: Everything is fake. Also mobile user counts are fake. No one has figured out how to count logged-out mobile users, as I learned at reddit. Every time someone switches cell towers, it looks like another user and inflates company user metrics https://t.co/tk1PKuvLL6

— Ellen K. Pao (@ekp) December 27, 2018

Unlogged in devices can create confusion and inflate data. I personally have the experience of inflating advertising metrics recently. I played this videogame where I constantly have to play to level up my avatars. So I quickly learned the common practice of building a macro or bot to “auto-farm”. This game is free to play and depends on advertising revenue. So the company is likely selling overstated user metrics when pitching to advertisers (albeit unknowingly).

Nowadays entire business models are based on advertising revenue, which are based on unreliable user metrics. This inflated revenues and earnings will drop when the cycle ends - and not in a controlled, linear fashion that analysts tend to forecast in their models.