Zuck warned you, and you wouldn’t listen

Good morning. Amazon’s guidance for the Christmas quarter was below expectations, and the stock got whacked in late trading. At the risk of becoming repetitive, this makes sense to us. As much as we like the risk/reward mix of the big tech companies, we think that recession is probably coming, earnings expectations must fall, and the market has only partly priced this in. Big tech is the first to this party, but the rest of the corporate world is invited too. Think we’ve already hit bottom? Email us your argument: robert.armstrong@ft.com and ethan.wu@ft.com.

This is exactly what Mark Zuckerberg promised all along

Would Mark Zuckerberg still be chief executive of Meta if he didn’t have voting control of the company? Probably, because things only really started to go off the rails this year. But his job would not be safe. Remember what the bond market thought of Liz Truss’s plans for the UK? The stock market takes a similar view of Zuckerberg’s plans for Meta — only much, much less enthusiastic. The shares are where they were seven years ago, have lost two-thirds of their value in a year, and lost a quarter of their value yesterday.

Happily for Zuckerberg, he can’t be fired. The right metaphor for him is not Liz Truss; it’s Xi Jinping.

Financially, the Meta story is simple. Revenue has slowed dramatically over the past three quarters, and spending has not. The result? In 2021’s third quarter, the company generated almost $10bn in free cash flow. In 2022, it produced almost none.

Meta is making a huge expensive bet on innovation at the same time as the primary business is softening (maybe it is making the bet precisely because the core business is no longer growing). On Wednesday’s conference call, one analyst spoke up for the masses:

Summing up how investors are feeling right now . . . there are just too many experimental bets versus proven bets on the core. And I’m curious if you can just add more colour on why you don’t feel these are experimental . . . everyone would love to hear why you think this pays off.

Zuckerberg’s reply:

Obviously, the metaverse work is a longer-term set of efforts that we’re working on. But I don’t know. I think that [it] is going to end up working . . . I appreciate the patience. And I think that those who are patient and invest with us will end up being rewarded.

Zuckerberg simply doesn’t know if metaverse investment will provide an acceptable return. How could he? How could anyone? What is striking is not the uncertainty of the bet — tech companies try uncertain new stuff all the time — but its size.

This shouldn’t be a big surprise, though. Zuckerberg has promised all along that he would make huge uncertain investments. Here he is in 2016, talking about his total control:

This structure has served our shareholders well. Early on, we received some generous offers for companies trying to buy Facebook, and our structure helped us resist that pressure. More recently, we navigated a challenging transition to mobile, but because we were a controlled company, we were able to focus on improving the user and product experience of our apps first, and then build a strong mobile business over time rather than being forced to do something shortsighted.

And over the years, our structure has helped us make big bets on acquisitions like Instagram that were very controversial initially but were good decisions for our community and our business.

And here he is this year:

I want to live in a world where big companies use their resources to take big shots . . . [I] feel a responsibility to go for it. Use the position that we’re in to make some bets, and try to push forward in a way that other people might not. We’re also not a typical company. It’s a controlled company, so I can make more of these decisions than most companies would.

This is a legitimate argument. But the whole point of it is that when Zuckerberg does something investors think is disastrously stupid, he tells them to buzz off and keeps on doing what he was doing. Otherwise, Meta would be a “typical” company, as he puts it. The fact that Zuckerberg is now doing something apparently foolhardy on a previously unimaginable scale doesn’t change the rules. It’s his call.

Dual-class shareholder structures are a bad idea. We forget this when things are going well, but we’re remembering now.

Cover your tail

Markets are a sea of red this year, but here’s something that’s been going up lately:

The blue line above is an index tracking tail risk hedgers, funds that profit when stocks crash and everyone panics. Notice the pattern: amazing in the coronavirus pandemic crash, lousy through the 2020-21 bull run, and solid during this year’s painful but gradual bear market.

In isolation, it’s an awkward return profile. Bull markets are long and glorious; panics are infrequent. So tail-risk funds are often bought to supplement larger portfolios. It’s a bit similar to buying the S&P alongside short-dated, out-of-the-money put options. Pay some premium while times are good, shield your capital when times are bad.

But the details matter. Many publicly traded tail-risk funds look disappointing, such as Cambria’s TAIL ETF, which has lost 12 per cent this year. A hypothetical portfolio compiled by Cboe, which buys the S&P 500 alongside 10 per cent out-of-the-money puts expiring quarterly, is hard to tell apart from the S&P:

These publicly traded tail risk investments amount to cost-ineffective “sucker’s puts”, says Mark Spitznagel, who founded the tail-risk specialist hedge fund Universa with Nassim Taleb as a top adviser. Unhedged caught up with him recently.*

Where bad tail-risk investments err is in misunderstanding what risk mitigation is meant to do, Spitznagel says. Severe down markets are what ruin long-run returns. This is because losses compound just as gains do. Recovering a 25 per cent loss requires a 33 per cent return, but a 50 per cent decline requires a 100 per cent gain. The result is that merely avoiding big losses can juice returns, as this chart of long-term S&P returns shows:

You are seeing a snapshot of an interactive graphic. This is most likely due to being offline or JavaScript being disabled in your browser.

Avoiding big losses is, of course, hard. But Spitznagel argues it’s the entire point of having a tail-risk hedge: to outperform so outrageously that you offset losses in the declining equity portion of your portfolio. How outrageous? Universa reportedly returned 4,144 per cent in the first quarter of 2020 as the S&P fell 30 per cent, leaving a hypothetical 97/3 portfolio (that is, mostly stocks plus a sliver of Universa) about flat. Here, from an investor letter circulated in April 2020, is what overall performance looked like two years ago:

Options wizardry is needed to get results like this, and Spitznagel provides no details about implementation, noting only that Universa’s relationships with options dealers plus the market’s illiquidity help contain costs.

This performance has been flatteringly covered in the press. Unhedged is impressed too, but we wonder about scalability. For every tail hedge bought, there must be someone willing to assume tail risk on the other side. Who are these people? Are they simply bad at math? Are there any derivatives traders out there who haven’t read Taleb’s Black Swan?

In any case, Universa has some $15bn assets under management, and we’d be curious whether its approach would work at $150bn. We’re also curious why, given the reported returns, even more investors have not flocked in. Perhaps the strategy is too hard to understand and most institutional investors simply can’t get comfortable with it. Universa did not say how much of a performance drag a 3 per cent allocation to their strategy is in a year when markets are up. But suppose it is only 1 per cent. In a long bull market, even that could be hard to endure — even if better long-term returns are promised.

For his part, Spitznagel is confident markets’ memories will remain short, and mass inflows will not be forthcoming. “Most people only want [tail risk protection] when there’s a crash”, he told the FT previously.

Spitznagel is more open about what he thinks does not work to mitigate risk: Treasuries. He argues they offer the worst of all worlds, with no equity-like upside in bull markets, no asymmetric upside in bear markets and, as a bonus, exposure to duration risk. In his words:

People are in bonds as a risk-mitigation strategy. With the [sharp increase in interest rates this year], you might’ve lost more in bonds than you did in stocks. Truly the cure worse than the disease! This year is an extreme example of that. In other years it’s more subtle, when you diversify into strategies like fixed income or hedge funds. Their underperformance costs you tremendous wealth over the years.

We tend to disagree. Investors have made great risk-adjusted returns in Treasuries over the last 40 years, and yields are starting to make sense again. But enough investors have been hurt in this year’s bond carnage that Spitznagel’s case might fall on sympathetic ears. (Wu & Armstrong)

One good read

On Tuesday, we wondered why crypto prices have been so stable lately. Louis Ashworth at FT Alphaville writes that the HODLers are simply holding on.

*This article has been amended to reflect Universa’s ownership structure