Markets

Facebook shares offer a salutary lesson on being priced for perfection

Facebooks high-profile woes over its collection, storage and use of personal data are a vivid illustration of the extra risk investors take on with any stock that is priced for perfection.

With the former stock market darling losing as much as a fifth of its value in a recent rout, owners of the F of the so-called FAANG stocks – an acronym that also includes Amazon, Apple, Netflix and Google – have been well and truly bitten.

Before that Facebook represented an unquestionably appealing story for growth-oriented investors.

For businesses looking to advertise their products and services to particular demographics, the company offers all sorts of tools to target specific elements of an almost two billion-strong database that of course, if it were a country, would easily be the most populous one on the planet.

Growth, however, is a slippery and unpredictable beast and when expected growth fails to materialise, the market can be unforgiving.

Why a 'margin of safety' is crucial

As hedge fund manager Seth Klarman wrote in his classic Margin of Safety: “For fast-growing businesses, even small differences in ones estimate of annual growth rates can have a tremendous impact on valuation.”

So while 10% is objectively a very good growth rate, if the market was expecting 15% from a business, its share price will have to adjust for that.

Add in peoples misguided yet abiding confidence in their ability to forecast an unforecastable future and, as Klarman notes: “With so many investors attempting to buy stock in growth companies, the prices of the consensus choices may reach levels unsupported by fundamentals.”

To be fair, for a business with plenty of cash and no debt whatsoever on its balance sheet, Facebooks valuation – even prior to the recent drop in its share price – has never been as punchy as that of, say, Twitter or Amazon.

Nevertheless, it was still viewed as one of those “consensus choices” among growth investors and that can leave a share price with nowhere to hide should a business hit a bad patch.

Another issue Klarman highlights is investors tend to oversimplify growth into a single figure when in fact it is more a blended number with many different sources.

For example this could stem from “increased unit sales related to predictable increases in the general population, to increased usage of a product by consumers, to increased market share, to greater penetration of a product into the population, or to price increases”.

What is more, notes Klarman some of these sources of growth are more predictable than others – general population increases, say, being easier to call than changes in consumer behaviour or how people might react to a price increase.

“On the whole,” he adds, “it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialise and how it will affect profits.”

In the case of Facebook, then, you had a very good narrative based on the power of its database, how that could be used to target specific markets and the advertising revenues it could generate – and all of that was embedded in the companys valuation.

What the valuation – and most investors – did not add into the mix, however, was that life is unpredictable and certainly does not always run smoothly.

In short, there was no margin of safety in the share price and so, when these data-shaped clouds suddenly appeared in what the wider market had taken to be a clear blue sky, it was only going to head in one direction.

No doubt Facebook will adapt and work to protect itself and its database going forward but the episode seems very likely to have wider regulatory implications that few will have expected to happen quite so soon.

As we wrote in Be prudent, it was actually Benjamin Graham, the father of value investing, who coined the term “margin of safety”, explaining the price paid for any investment should allow for a range of unexpected adverse outcomes – in effect, because many things can go wrong at once, it is prudent to be cautious.

That is one piece of data of which we never lose sight.

  • Juan Torres Rodriguez is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

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