Friday, May 18, 2012

If you like value, don't buy Facebook stock


Bargain-conscious Winnipeggers: don't do it.

I couldn't resist weighing in on Facebook today when I saw some of my friends openly talking about  buying some of the social network's pricey stock when it goes on sale tomorrow.

But worse is the psychology of the novice investor. The first mistake: equating a company you like with being "a good investment." Even a stable company doesn't necessarily make for an upward or stable stock price.

Remember: the key to buying stocks is to buy low and sell high. The only way to tell a good investment from a bad investment is through a thorough analysis of a company and its underlying fundamentals. A company's stock value tells you nothing.

There are some good reasons to be concerned with Facebook's fundamentals:
  • It was late to the mobile game and its apps are inconsistent and sluggish now that it's there.
  • Its users don't trust it to protect their privacy. 
  • Its unproven ad model and sole source of income.
  • Its value is that it has the most people using it. Even a small erosion of that base to other social networks represents a threat, which Facebook as much admitted when it bought Instagram for $1 billion.
  • Its terrible design, news algorithm, and apps that share when you don't want them to share. The Path app, which has had privacy issues of its own, is by far the better user experience. 
  • It will now have pressure from investors to roll out the new products faster - and they'd better be money-makers. One recent report: charging users to send a message or to have a higher-ranked status update. I believe this already exists as something called "email."
Facebook is a growth investment, which focuses on forecasted earning simply for the sake of growth. Growth investors tend to assume that "hot stocks" or those with strong historical growth will continue to perform strongly in the future, and equate good products with good stocks.

In this sense, growth investing is very much a groupthink mentality. Growth companies tend to trade at inflated valuation multiples, meaning you pay a premium for growth and bragging rights: "I own Facebook stock and you don't."

Growth strategies can work. However, the job of an investor is to look at probabilities and weigh the risk of loss of capital against the reward of capital gains.

Value investing

Contrast this with the Warren Buffett approach - "the most successful investor of the 20th Century." His approach is called "value investing," which should be of particular interest to my fellow Winnipeggers, who've never met a bargain they didn't like.

Buffett suggests staying away from stock in social media companies, because it's difficult to know future value. Initial Public Offerings in particular, he says, are almost always bad buys. 

You can understand the value investing philosophy in terms of a simple analogy:
You need stereo speakers.

To avoid price markups, you visit a distributor who offers scratched speakers at discount prices. You find the speakers you want and - after a thorough analysis - determine they are slightly scuffed.

Knowing you can easily fix or ignore the marks without any impact on sound quality, you buy them. In the end, the speakers might not be as exciting to purchase as the brand-new ones, but they are a better value. 
This, in essence is a value investment. Value investors search for stocks that are undervalued relative to their intrinsic value. They find them using a variety of measurements, including price-to-earnings, price-to-book-value, price-to-sales, price-to-cash-flow and price-to-dividend.

Stocks with low valuation multiples - trading at significant discount to their peers or historical norms - are often value investments. Of course, low valuations don't indicate value in and of themselves. The determining factor is why a company is trading at a low valuation.

Value investors, then, look for unwarranted discounts.

Then why doesn't everyone invest money through value investing? Of course, if everyone did, they would drive up prices and the value would disappear. Investors don't, though, due to a number of psychological reasons:
  • Equating the past with the future
Investors overreact. They have a tendency to place too much emphasis on stocks with better-than-expected valuations and recent earnings, while avoiding the opposite altogether.
  • Overvaluation of certainty
People are drawn to things that appear to be certain and will pay more for them than they must.
  • Overreaction to big, unlikely (but consequential) events
People are attracted to events that make the consequences of winning seem magnificent, even when they know the logical chances of winning are small. Think: lottery tickets.
  • Loss aversion
In people's minds, fear of loss looms larger than the expectation of gains. For most, the pain of a loss exceeds the pleasure of a gain. Consequently, a value strategy, which often entails the endurance of negative sentiment before realizing any gains, creates anxiety.

Mean reversion

Another principle of value investing is known as mean reversion. Simply put: good things get worse, bad things get better. This is what makes it possible to buy low and sell high.

Over time, companies will revert back to the mean of the market or the industry as a whole, because above- and below-average growth and returns can't continue indefinitely. In all likelihood, they will eventually "revert" in opposite directions: the beaten-down value stock prices should revert up, and the inflated-value stocks should revert down.

Value returns don't happen overnight. Often, investors will experience a series of disappointments beforehand, which is why patience is critical to value investing. Its very nature requires a long-term approach. To attempt to time the market most often results in buying high and selling low - the opposite of a successful investment.

The patient, long-term investor is well-rewarded for choosing quality over prestige.

***

Some of this stuff is from an article I wrote in 1999 as the then-communications manager for a big, rich financial firm. This article ran just before the first tech bubble burst on March 10, 2000 - now that's market timing. 

5 comments:

  1. Kudos Kenton, your best piece I've read I think.

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  2. nicely done Kenton. this is so true on so many levels.

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  3. It would be losing investment. Facebook has already seen its peak. Its got nowhere to go but down from here on.

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  4. I still don't think that GM pulling their ads will make any difference to Facebook. A big part of advertising is exposure over the long run, even if it is subtle, which is what many online advertisers are shooting for

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  5. Thanks for the comments, peeps.

    Aren't online advertisers seeking engagement?

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