What I Was Saying About Facebook BEFORE The Mega-Meltdown
In April of this year I wrote two articles about concerns that I had about Facebook and giving the reasons why the two stock indices which I helped design and help run (FLAGLSX and VCUSX) had no Facebook in the portfolio at all, which is really saying quite something given how Facebook is a major holding in almost all major funds in which it is eligible to be held.
Those zero weightings hurt our portfolio performance significantly during the first half of the year because Facebook was a strong performer. As I write this, the first trading day after Facebook’s quarterly conference call, Facebook’s losses are now officially the largest single day destruction of shareholder value ever recorded. Now, I don’t want to fall too much into hype. It’s the largest sell-off in point terms ever, but that’s because Facebook is such a huge market cap company. And of course, over the past century, as the prices of almost everything go up, then point moves tend to be larger. What matters is percentage losses. So by that standard, Facebook’s loss is not the absolute largest drop in history, but it is still a major loss.
So do I write about our zero weighting to take a victory lap, or for pride? No, not at all. We don’t have anything which is not a gift. Soli Deo Gloria! I write instead to help investors rewire the investment mind. Investors tend to look at high performers, which go up in price even when there is significant evidence that they are overvalued; even when there are problems with the financial statements and problems with management; even when there are structural problems with the board of directors. But despite these many problems, investors are drawn to these companies. They tend to pile onto what has already gone up, thinking of the stocks as ‘winners’.
And let me add (as someone who works a lot with financial advisors) that investors tend to punish advisors who don’t have them into the bubble stocks when those stocks trace (what turns out to be) that last vector upwards to the top of the parabola before coming back to earth. And ditto for people like me who work on designing portfolios with a maximum probability of getting clients good long-term results. No one knows when the bubble will pop, so the most reliable way to avoid being left standing on a bubble when it pops is to step off of it as it inflates. That means looking like a fool for a while. I’m quoting the reasons I gave for our decision to hold Facebook at zero, because it’s weeks like this which are the real reasons we prefer to exit a bubble stock early than to exit it late.
This first two are about the ‘encore problem’, which over-hyped growth stocks tend to fall prey to. One of the reasons that Facebook collapsed is that even though both members and revenues and earnings increased, they did not increase quickly enough to keep up with that growth expectation:
“That’s why the financial statement analysis showed some flags in sales and revenue growth – they’re too high. But high growth is good, right? Yes, real high growth is a blessing, but it comes with problems – for example, the encore problem. You get known as a growth company and woe-betide-you if you have a quarter without growth. Growth companies ride the tiger of expectations. This creates very strong incentives to tweak things here and there to keep the appearance of momentum going.
Facebook was always going to have real trouble growing into the hyped expectations built into its high valuations, which made it probably not worth the risk, which is why we didn’t own it.”
Next, we look at problems with possible earnings distortions. Facebook had a ‘miss’ in both revenue expectations and earnings expectations. This tends to happen when accounting practices have distorted the picture in some way which creates an unusually high baseline expectation of financial performance. Revenues are booked early, expenses are treated as investments. This raises the probability that when the tricks run out, a company will end up with sudden and unexpected declines in earnings. That is exactly what happened last week. Here’s why we thought something like this was likely enough to avoid the risk:
“First, there is a lot of room for shenanigans when it comes to accruing revenues early and deferring expenses into the future. Technology companies like Facebook, by their nature, have a lot of intellectual capital and a lot of good will and other assets which are not hard assets. Valuing things like property, plant and equipment is relatively easy compared to valuing the types of abstract assets that media/tech companies tend to have on the books. So, these warning signs could indicate a problem or they could just be par for course when it comes to valuation in the strange new world of social media. It’s hard to tell, and when you’re assessing risk, ‘hard to tell’ means be wary, not complacent.”
We also suggested that Facebook’s bubble valuation left it fragile in the face of bad news. It was priced for hyper-growth. That’s okay (not great, but at least somewhat defensible) when there is actual hyper-growth, but trees don’t grow to the sky and eventually hyper-growth turns into just ‘growth’, and high valuations tend to shatter at times like that. Here’s the case as of four months ago:
“Second, things would be different if Facebook were ‘on sale’, but this is a company which at the end of January, when we last looked at this, was anything but ‘on sale’. It was at very high valuations; so high in fact, that many analysts stopped talking about old school metrics like PE ratios and switched over to items like sales growth. Sales growth is a nice thing, but it’s not a valuation metric. By normal valuation metrics, Facebook was priced for growth AND safety. Whatever measure of prices of investment in comparison with whatever various components of income one looked at, this was a company which was not offering income at a bargain price.”
There are companies that I’ve argued against and hold at zero weighting which are still doing well, at least for the moment. They’re overpriced, over-hyped, over-accrued, under-expensed and with shareholders who are underrepresented. The time to recognize those problems is now, not at some indefinite time in the future when they have the kind of week that Facebook is currently having.
Originally published on Townhall Finance.
Jerry Bowyer is a Forbes contributor, contributing editor of AffluentInvestor.com, and Senior Fellow in Business Economics at The Center for Cultural Leadership.
Jerry has compiled an impressive record as a leading thinker in finance and economics. He worked as an auditor and a tax consultant with Arthur Anderson, as Vice President of the Beechwood Company which is the family office associated with Federated Investors, and has consulted in various privatization efforts for Allegheny County, Pennsylvania. He founded the influential economic think tank, the Allegheny Institute, and has lectured extensively at universities, businesses and civic groups.
Jerry has been a member of three investment committees, among which is Benchmark Financial, Pittsburgh’s largest financial services firm. Jerry had been a regular commentator on Fox Business News and Fox News. He was formerly a CNBC Contributor, has guest-hosted “The Kudlow Report”, and has written for CNBC.com, National Review Online, and The Wall Street Journal, as well as many other publications. He is the author of The Bush Boom and more recently The Free Market Capitalist’s Survival Guide, published by HarperCollins. Jerry is the President of Bowyer Research.
Jerry consulted extensively with the Bush White House on matters pertaining to the recent economic crisis. He has been quoted in the New York Times, The Wall Street Journal, Forbes Magazine, The International Herald Tribune and various local newspapers. He has been a contributing editor of National Review Online, The New York Sun and Townhall Magazine. Jerry has hosted daily radio and TV programs and was one of the founding members of WQED’s On-Q Friday Roundtable. He has guest-hosted the Bill Bennett radio program as well as radio programs in Chicago, Dallas and Los Angeles.
Jerry is the former host of WorldView, a nationally syndicated Sunday-morning political talk show created on the model of Meet The Press. On WorldView, Jerry interviewed distinguished guests including the Vice President, Treasury Secretary, HUD Secretary, former Secretary of Sate Condoleezza Rice, former Presidential Advisor Carl Rove, former Attorney General Edwin Meese and publisher Steve Forbes.
Jerry has taught social ethics at Ottawa Theological Hall, public policy at Saint Vincent’s College, and guest lectured at Carnegie Mellon’s graduate Heinz School of Public Policy. In 1997 Jerry gave the commencement address at his alma mater, Robert Morris University. He was the youngest speaker in the history of the school, and the school received more requests for transcripts of Jerry’s speech than at any other time in its 120-year history.
Jerry lives in Pennsylvania with his wife, Susan, and the youngest three of their seven children.