My first entry is a perfect example of
the point I made in my manifesto. Facebook completed its long awaited
initial public offering last month amid an absolute media frenzy.
The initial frenzy is understandable.
The Facebook IPO was the third largest ever and the largest ever for
a technology company. That is a big deal. The stock market has been
languishing in a certain price range ever since the Great Recession
began. Big stories have been few and far between. All of the economic
news has been negative so Facebook was supposed to be a ray of
sunshine against a gloomy horizon.
Except it wasn't. Shares of Facebook
rose approximately 10% on their first day of trading but finished
that same day just barely above the opening price of $38. Since then
the price of a share has slid almost 30%, setting off a second media
frenzy trying to figure out what went wrong.
So what went wrong? A couple of
things. First, IPO prices are historically volatile. Facebook traded
over 500 million shares in its first day of trading and according to
Yahoo Finance it has averaged 114 million shares each day since. In
my experience as a retail stockbroker in the late 1990's I watched
many IPOs experience huge price swings. Now, the late 1990's was a
dramatically different time in the stock market and the country as a
whole.
However, a story in Journalist's
Resource which was published on May 23rd of this year,
confirms my previous experience. This article examined a study
published in 2010 in The Journal of Finance entitled “The
Variability of IPO Initial Returns.” The study examined the price
performance of over 8000 IPO's from 1965 to 2005.
Two of the findings in the study are
particularly relevant to the price performance of Facebook. First,
“IPOs that feature an intense marketing period are associated with
more volatility and thus a less accurate initial share price.”
Coverage by the media of the impending Facebook IPO could easily be
described as intense. Second, “The problems are particularly acute
for technology firms.” Facebook is clearly classified as a
technology firm. The study concludes by saying, “Our results raise
serious questions about the efficacy of the firm-commitment IPO
underwriting process.”
The second thing Facebook did wrong
was pricing the shares at the top of the range recommended by its
underwriters. Doing this certainly contributed to the probability of
both errors in its pricing and the volatility of its trading. At an
initial price of $38, the price earnings ratio of the stock based on
the last 12 months of earnings was almost 100. Compare that to the
long run historical P/E ratio of the S&P 500, which is right
around 16, and it becomes clear that buying Facebook at the IPO price
is more a gamble than an investment. Imagine if the underwriters had
decided to price Facebook at 20 times earning instead of 100. The IPO
price would have been in the range of $7.50 to $8. I don't think we
would be experiencing the same post-IPO wave of negativity under
those circumstances. Of course, Mark Zuckerberg and the other
principals would have made billions less, but those investors who had
the stomach to buy Facebook and figured they had a sure thing would
have lost billions less.
So that begs the question, is Facebook
a good investment now? In my opinion, the answer is a definite maybe.
Facebook is the unquestioned leader in the social media industry. As
of the end of March 2012, Facebook had over 900 million registered
users. The number is expected to surpass 1 billion by the end of the
year. That sounds like an incredible treasure trove of opportunities
to be mined for data and profits, but it also has a downside. Even in
a new industry like social media, Facebook is the most mature member.
The growth rate of its membership is bound to slow down as time goes
on. I would like to have seen it go public when it had 50 million
members. The expected growth rate of membership would have been much
higher, which might have made it easier to justify its currently
bloated P/E ratio.
Still, Mark Zuckerberg has proven
himself to be a smart businessman and philanthropist and I get the
feeling that Facebook will figure out a way to make its advertising
more effective and will venture outside of the social media arena to
fuel its future growth. So in the long run I think the stock will do
well.
Personally, I wouldn't touch the stock
until the average volume dies down a little and the 90 day waiting
period is over, so I can see what the insiders, including Mark
Zuckerberg, do with their shares. In the meantime, if you are one of
those unfortunate millions who got caught up in the hype and bought
shares at $38, I would recommend holding on. Remember, it isn't
really a loss until you sell and as I just stated, I think your
patience will be rewarded over the long term. If you've got any
investment capital left, you might also consider picking up some
shares at today's closing price around $26 which will automatically
drop your cost basis to around $32. That might help you sleep a
little better.
Don't listen to what the media says
about Facebook and the aftermath of the IPO. They get paid to make
you feel as if you made a mistake and it lets them know they are
succeeding if you get really upset about it. Let it be a learning
experience and let the patience you learn as a result help you to
make better investment decisions in the future.
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