Is the SaaS market a voting machine or weighing machine?

February 8, 2016

Benjamin Graham, father of value investing, famously described the stock market as a "voting machine."  His star protege, Warren Buffett, would later expand that to "a voting machine over the short term, and a weighing machine over the long term."  What the heck was Graham talking about, and why did Mr. Buffett feel the need to expand?  Do these assertions provide any help when looking at the state of the SaaS market for the stocks of SaaS companies?

Let's first unpack the machines.  Graham's voting machine illustrates the markets as popularity contests.  The SaaS market participants are using the share prices to vote which companies they like the best.  Just as important, the market is not seriously using the assets, income, dividends, or any other financial metrics to value a company's stock.  Graham is making the point that the markets are not rational, but subject to the messy emotional ebbs and flows of its human participants.  (Economist John Maynard Keynes was making similar comments at the time, about the markets being "beauty contests.")

Warren Buffett, Graham's most famous pupil, would expand his teacher's metaphor and add that over longer terms, the market becomes a weighing machine.  This is where Buffett breaks from Graham, who seems to have believed that the market was always a fickle popularity contest.  Buffet believes that over time, the market begins to weigh a company's revenue, earning power, strategic position, and other key attributes when determining value.  Buffett explains to his shareholders how he exploits this potential inefficiency when buying stock;  a company loosing the short term popularity contest but accumulating lots of "weight" is a good potential target for purchase.  Buy a "weighty" company when the market is a voting machine and watch the stock price rise as the company's tangible business values count more and more in the marketplace.

I started thinking about this whole voting weighing machine thing while reading a recent article in Venture Beat about Box a year after their IPO.  Sure, Box has lost $1.7 billion of SaaS market cap since its peak, which was also their opening day.  But Mike Trigg does a good job digging into Box's numbers, and he finds a lot to like.  Mr. Trigg finds a company with a $1.2 billion market cap (still a unicorn) that is backed by good, solid financials.  "Box has successfully transitioned from an arguably over-valued unicorn to a publicly-traded company that has grown into its own fact-based valuation."  Bingo.  Voting to weighing.

Now I see this shift from voting to weighing all over the place.  This weighing machine SaaS market coming into effect is skeptical of Jack Dorsey's ability to get Square settled into a nice profitable business model.  This new market is also loving Atlassian, because they have a powerful and organically growing business with good profits and loyal customers.  The public market is unsure how much weight Square can gain, but they can clearly see that Atlassian came to the public market already bulked-up and growing strong.

Private unicorns generated so much hype that they became ultra-popular and their valuations spiked high in the voting contest.  But the public SaaS market has already started to turn into a weighing machine, and those companies hoping to attract public capital had better focus on tangible weight, like efficiently growing revenue and strong profits or a clear and obvious trajectory to those profits.