This chart is fascinating:
This is the last month’s pricing trends for Pandora (P), an internet start-up that is big on mobile and is also bleeding cash—and will actually lose more cash as its business grows. This is because its operating costs are higher than its current revenue. This is due to two factors: the smaller issue is that there is a limit to how much the company can charge for advertising on its service, and how many ads they can run. The much bigger issue is how much in royalties the company must pay the musicians whose music it broadcasts.
Pandora has been fighting for legislation that would lower its royalty costs, and has met opposition from musicians. Rihanna has been a high profile opponent in recent weeks, but she is joined by many other pop stars. This high royalty cost makes Pandora’s current business model unsustainable, and the company is hoping that it can convince Congress to change the way it pays royalties so that it matches the costs that traditional radio stations pay.
This has been a long-term issue and some could argue that it’s been priced into the company’s stock for a long time. Another more short-term issue, which rears its ugly head every few weeks or so for Pandora, is the rumor that Apple (AAPL) is going to eat Pandora’s lunch by launching a rival streaming service. At the beginning of September 2012, Pandora’s shares tumbled from the ~$12 range to single digits after the Wall Street Journal reported that Apple was going to launch a rival service.
Nearly two months later, no such service has shown up, but that doesn’t stop bloggers from waving the AAPL flag every once in a while.
While I think it is very important to respect fellow investors and acknowledge that a variety of opinions can co-exist in the investing world, this is one moment where I have to point out that the emperor has no clothes. There is no evidence on the marketplace that Apple is going to release a streaming service, whereas Microsoft (MSFT) has already announced its Xbox Music service and an aggressive Surface/Windows 8 campaign (where Xbox Music is automatically bundled) could seriously threaten Pandora. Yet these bloggers ignore Microsoft and focus on a non-existent Apple product.
This is partly due to the echo chamber that the marketplace often becomes, but is also partly due to the fact that AAPL has been a powerful and disruptive force in the mobile media space for a long time. Nonetheless, these are rumors, and rumors have limited value. They haven’t stopped Pandora’s stock from tumbling, and worries of an AAPL threat as well as the viability of re-legislation benefitting Pandora have resulted in high volatility for this stock.
I am not saying they are wrong or that Pandora is a good buy. I am saying, however, that this is a great instance of market inefficiency and a savvy investor who measures the intrinsic value of Pandora’s business model and the threats that other players can post to it could possibly make a lot of money by betting on or against Pandora. The fact that savvy investors can take advantage of the volatility this chatter has inflicted on Pandora leads to a rather controversial conclusion: the market is inefficient.
Market inefficiency is what makes portfolio managers their livelihood. By identifying market inefficiencies and betting against them, managers can make a lot of money and make the market marginally more efficient at the same time.
This goes against the “efficient market hypothesis” (EMH), which argues that a market has already priced in all publicly available information into a stock and therefore researching publicly available information cannot possibly give an investor a market edge. Thus investors should simply dollar-cost average their investments and bet on a rising tide in a particular marketplace. Hedge fund managers and portfolio managers would by nature disagree with the hypothesis; since the premise of their career is that a savvy investor can synthesize publicly available information and create superior returns by understanding the marketplace better than most.
I’d suggest that the pontificating on Pandora’s market value and the threat of AAPL—and the subsequent tumbling of the stock price—points to one fact: markets are inefficient, and individual investors react quite emotionally to speculation, rumor, fear, hope, greed, and a bunch of other emotions that make the market very inefficient.ood portfolio manager’s job, then, is to suppress these emotions and synthesize publicly available information better than anyone else. I’d like to suggest this is possible—and Pandora’s volatile stock price is another proof of that. It’s just very, very hard.