Snapchat and the Substitution Heuristic

We have a cognitive quirk.

We have a bunch but let’s focus on one.

When faced with a hard or complex problem instead of answering it we swap it for an easier question to answer. We believe we have answered the hard question when in fact we answered a totally different question.

Substitution Heuristic

This is the Substitution Heuristic.

These are few examples from Daniel Kahneman’s book Thinking, Fast and Slow.

Target question: How much would you contribute to save an endangered species?

Heuristic Questions: How much emotion do I feel when I think of dying dolphins?

Target Question: This woman is running for the primary. How far will she go in politics?

Heuristic Question: Does this woman look like a political winner?


A more timely and real world example.

Is Snap Inc. (SNAP), aka Snapchat, a good investment?

A simple but complex question.

Snapchat recently IPO’d and like a lot of new publically traded companies it is not profitable yet. In lieu of earnings and cash flow, you need to figure out Snapchat’s path to profitability and how likely Snap is to achieve this goal.

Snapchat is a social network. You’ll need to track its daily and/or monthly active users. Is it growing or slowing? What is the demographics of its users? Is it popular with the young and tech-savvy or is this group moving on to something else?

Then there is competition. How does Snapchat fit in a world with Facebook, twitter, and other emerging companies?

Finally, you have to figure out an appropriate price to pay for Snapchat’s potential versus the risk.

I told you it’s a hard question.

The Easier Question

It is far far easier to swap these questions with do I use Snapchat? Do my friends use it? Do we like it?

That’s what a lot of millennials did when thinking about investing in Snapchat on the day of its IPO.

Trading activity on Robinhood, an online brokerage platform, jumped by half on Thursday as Snap began trading, with 43% of users active that day buying shares, according to the company.

Robinhood’s demographic already skews to the younger side, with a median user age of 29, the company said. But the median age among Snap buyers on Thursday was even younger, at 26. (That happens to be the same age as Snap co-founder–and newly minted billionaire–Evan Spiegel.)

Rebecca Shoenthal, a 22-year-old journalism student at the University of North Carolina at Chapel Hill, was among them. She said she bought four shares of Snap for about $24 each. She put in an order for them on Wednesday night, stipulating that she would pay as much as $40 per share.

Heuristics Help But Can Cause Trouble

Heuristics are not bad. They help us get through the day.

We face a lot of decision throughout the day and we don’t have time to contemplate everyone. Heuristics help us make quick decisions freeing up time for more important things.

Also, the answers heuristics give us are good enough but they can lead us into trouble. Especially with investing.

Snap Inc.’s Earnings

Snap Inc. reported its first earnings as a public company yesterday and it wasn’t good.

  • Slowing user growth
  • Stock compensation expense greater than annual revenues
  • Large increases in operating expenses

Snap was down over 20% after the announcement and the stock is now down 26% since its IPO.
SNAP Chart

SNAP data by YCharts

Heuristics, Investing, & Trouble

Because they didn’t answer the hard questions before buying Snapchat these young investors are unsure what to do now. And instead of asking the hard questions now, they are selling their shares.

On Robinhood, an online brokerage platform with a younger clientele, sellers of Snap shares outnumber buyers among users under 30. Ahead of the earnings report, the ratio of those Snap buyers to sellers was 0.80, meaning 80 hypothetical buyers of the stock for every 100 sellers. In the week after the IPO, there had been 280 buyers for every 100 sellers. For those over 30, Snap’s buy-to-sell ratio is currently 1.2 times, down from 3.1 times the week of the IPO.

Rebecca the UNC student who was excited about Snpachat’s IPO is starting to realize the questions that need to be answered.

Rebecca Shoenthal, who is due to graduate from the University of North Carolina at Chapel Hill this weekend, told the Journal in March that she bought Snap shares after their public debut because she was excited about the company.

In a follow-up e-mail Wednesday, she said that, “Facebook is certainly making things hard for Snap, especially since they have essentially the same product with a much larger user base already established.”[emphasis added]


Does the sell off present a buying opportunity in Snapchat?

You’ll have to ask and answer the hard questions to determine that.

Splitting AbbVie to Unlock Value

AbbVie (ABBV) is a rare stock.

AbbVie’s yields almost 4%. Its current dividend yield is 3.87%. And unlike the other 4% yielders, it is not a slow growing utility, telecom, or cyclical car manufacturing business.

High dividend yield
Chart from Goldman Sachs. Click image to enlarge.

AbbVie is a growing biotech company with a promising drug pipeline with even more potential growth.

Why is a growth company trading with the yield of a utility company?

Because of Humira.

Humira starts losing patent exclusivity in a couple years.

Biologic vs Small Molecule Losing Its Patent

We’ve argued before that the loss of the Humira and other large biologics will be different than a small molecule drug losing its patent.

With a small molecule drug, like Claritin or Viagra, a generic version only has to prove that it is the same chemical formula and structure as the name brand drug. The generic drug does not have to undergo efficacy and safety tests. The name brand drug already underwent these trials and the two drugs are exactly the same.

Biologics are different.The entire process to produce the biologic is the drug. Small changes in the process can have large effects on the outcome. It is because of this that a generic biologic, a biosimilar, has to undergo efficacy and safety tests. This drives the cost of the biosimilar up. The cost savings of switching from a name brand biologic to a biosimilar is much less.

The entire process to produce the biologic is the drug. Small changes in the process can have large effects on the outcome. It is because of this that a generic biologic, a biosimilar, has to undergo efficacy and safety tests. This drives the cost of the biosimilar up. The cost savings of switching from a name brand biologic to a biosimilar are much less.

The real issue is potential Humira users using a biosimilar to start their treatment and finding it works. The likelihood of these patients switching to the higher costing Humira when their lower cost biosimilar works are minuscule.

Growth will slow but Humira will remain a cash cow from AbbVie.

And yet AbbVie is trading as if Humira will follow the same pattern as a small molecule going off patent and very little value is being given to AbbVie’s pipeline.

Goldman Sachs has a potential solution.

Splitting AbbVie into Two

Splitting the company into two. A Humira company and a pipeline company.

While investors wait for Growth-co to mature, we believe the company could unlock trapped value by separating business segments for reporting purposes (“Humira-co” and “Growth-Co”) and returning cash to shareholders. While Humira-co is a cash cow that is funding the pipeline, we believe its value (i.e., sustainable cash flows) is underappreciated, with heightened fear of Humira’s inevitable decline, the rate and magnitude of which are unclear. ABBV could unlock value by monetizing the asset and reward shareholders for owning the shares in the face of this uncertainty. We believe ABBV could return cash to shareholders through either a perpetual Humira dividend or share buyback, although we believe the former would be more attractive. We expect ABBV to have a strong balance sheet generating ~$60bn in cumulative cash flow (64% of current market cap) over the next 5 years that can more than support an additional dividend payout. With most of its cash overseas, tax repatriation makes this scenario even more possible. We think fears around Humira have overshadowed the new product story. For this reason, we think separating Growth co. for reporting purposes would reveal the segment’s potential for biotech top-line growth and margins. Driven by oncology, immunology, women’s health and other, Growth-co should see top line growth of 16% over the next 5 years from $9.8 bn (including legacy) to $20.5 bn.

AbbVie would remain whole. The company would create two new reporting structures.

I like the idea of a special dividend.

Chart courtesy of Goldman Sachs. Click image to enlarge.

The goal of the split is to act as aa catalyst to unlock and/or reveal AbbVie’s true worth. I’m all for that but when I’m ready to sell. I like AbbVie’s current low prices. I get to buy more at a cheap price.

Investing in Hilton, Did We Make a Mistake?

We own Hilton (HLT). We bought it for clients after it underwent its three-way spin-off into Hilton Grand Vacation (HGV), Park Hotels & Resorts (PK), and Hilton (HLT).

Did we make a mistake? Maybe, according to this video.

The video was uploaded on March 29, 2017, and uses financial data as of year end 2016. This is crucial.

First, I’ll give the guy credit. He is practicing his valuation skills and he is putting himself out there. I’m curious to see how he arrives at his data points: real earnings, the amount of capital the company earned, the percentage the company needs to earn, and the amount of capital needed to maintain the business. These would be helpful to know.

The important issue that the video doesn’t cover and what affects the valuation is on January 4, 2017, Hilton Worldwide completed its corporate restructuring.

New Hilton

The new Hilton is an asset-light business. It no longer owns hotels or builds them. Hilton solely focuses on management contracts and its franchise business. The new Hilton needs very little capital to maintain and grow its business. Returns on invested capital should increase. High returns on invested capital with very little need to reinvest that excess capital will lead to more capital returns to shareholders via buybacks and dividend increases.

High returns on invested capital with very little need to reinvest that excess capital leads to increased capital returns to shareholders via buybacks and dividend increases.

The perfect example is Marriott after it spun-off it’s timeshare business in 2011. After that spin-off, Marriott focused solely on hotel management contracts and its franchise business like Hilton now.

Below is Marriott’s return on invested capital, total shares outstanding, and dividend per share from right before the spin-off of its timeshare business until its buyout of Starwood.

MAR Return on Invested Capital (Annual) Chart

MAR Return on Invested Capital (Annual) data by YCharts

Hilton could and should follow the same pattern.

Hilton is the subject of our next dividend letter. Sign up now to get it.

Interview with Warren Buffett and the two Ts, Ted & Todd

Yahoo! Finance conducted an interview with Warren Buffett, Ted Weschler, and Todd Combs.

If you like to read all day and manage money, then Berkshire is the place to be. This is how Todd Comb’s describes his daily routine.

“I get in around 7 or 8, and I read until about 7 or 8 at night,” he says with a laugh. “And I go home, and see my family, and then I’ll read for another hour or two in bed at night. And you know, there might only be three to four phone calls the entire week. So there are very, very few interruptions. I have a great assistant who knows everything that I read, and she kinda provides everything, and there’s a back and forth between us where I’ll mark it up, and give it back to her. And we have a system for filing and so forth. But it’s literally just reading about 12 hours a day of everything I just mentioned.”

What I Wish I Wrote ~ April 28, 2017

A collection of mostly finance related links that I wish I had the talent to create.

An article went up on Value Investor’s Club recommending a short position in Apple (AAPL). These are all the counterpoints to that short thesis. (Bireme Capital)

Inside the Hotel Industry’s Plan to Combat Airbnb (New York Times)

“And famous New York short seller Jim Chanos’ Kynikos short fund has reportedly turned $1 into a dime since its inception.” (Confessions of a Contrarian Investor)

David Einhorn thinks the markets are repeating the late 90s and 2000. Josh Brown says hold up on that comparison. (The Reformed Broker)

Aluminum was a boon to the aerospace industry and graphene could have an even bigger impact. (Virgin)

Star Wars moisture farmers are becoming a thing. Some scientists at MIT and Cal created a deice that can pull moisture out of the air using solar power. (The Telegraph)

AbbVie (ABBV) has tremendous value in the both the amount of cash flow humira generates and the potential in it’s drug pipelinnnnnn. (Sure Dividend)

ESPN can’t afford to go on like this (Bloomberg View)

The invention of Air conditioning did some great things for the modern economy. It helped create the Summer blockbuster movie season and probably even helped Ronald Reagan get elected. (50 Things That Made the Modern Economy – BBC)

Marginal gains versus the long shot. (Tim Harford)