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Thursday, 24 July 2014

Greater fools in Facebook circular firing squad

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The Facebook IPO, which started as a global search for a greater fool, has developed into a circular firing squad.

James Saft, Reuters Columnist

Facebook’s newly minted stock tumbled well below its issue price on Monday, falling as much as 12%, as it struggled in its first day trading without the full support of its investment banking syndicate.

The problem, of course, is that too many buyers were playing the same game, looking to lay off their exposure quickly to some other patsy. As they say in Silicon Valley, this isn’t a bug, it’s a feature.

We are now 15 years into what may some day be thought of as the great speculative era of financial history, during which a series of bubbles was caused to come into existence and then duly explode. The easy lesson has been to get in early and then get out. As such the Facebook IPO isn’t just the third-biggest such offering in US history, it is one of the largest ever exercises in collective cynicism.

After all, what “long-term investor” buys into a public offering and then changes her mind, bailing out simply because that satisfying initial pop we’ve been conditioned to expect fails to materialise? On the evidence, there were precious few Facebook buyers who really did want a long-term option on the company’s vertiginous growth. They were instead game-players, some of whom always planned on getting out immediately and some of whom probably wanted to wait a short while but, having little actual conviction about the company’s valuation and prospects, panicked when trading went sideways on Friday.

What the players failed to recognise is perhaps the central feature of the bubble series which started in Southeast Asia in the 1990s and spread in turn to dotcom shares, real estate and now social media: growing frequency and severity. The bubbles are inflating faster each time, growing more disproportionate to underlying value and bursting faster. There is no arguing that the social media bubble is bigger or more damaging than housing, but you can make a case that it has, at its worst, gotten more out of proportion. It also took less time to inflate, and is showing every sign of bursting more quickly.

Human beings are good at pattern recognition, but not perhaps quite so good at working out that so are their fellow men. Everyone saw clearly what the game was, but failed to account for what would happen when everyone plays.

Fine line between best and worst

As such, it is hard to judge if the Morgan Stanley-led deal is one of the best or the worst navigated major IPOs in recent history. If you believe that social media is a bubble and one with severe risks of rapid deflation, then this was a work of genius. This does, on the other hand, make future social media IPOs much more difficult. No one likes being played for a fool, at least not on the first date.

It is worth noting that existing holders provided an unusually high percentage of the shares sold, never a good indication in a business with a long road to justifying current valuations.

None of this is to say that Facebook isn’t a great franchise and won’t continue to be very successful. Facebook is profitable and a great success story. It is just horribly over-priced. Even at its current price 10% or so below the offering, it is trading at about 70 times prospective 2012 earnings, making it almost five times as expensive as Google shares. Sure, Facebook is only in the early days of extracting revenue from its massive user base, but even if you credit it with the ability to generate 50% earnings growth over an extended period – five years or so – it still ends up as a terrifically expensive stock.

That leaves very little margin of safety. Sure, Facebook has changed the world but it would be silly to expect those changes to remain fixed. Based on the evidence of the past decade the world, especially that province inhabited by Facebook, is changing extremely rapidly. It is all too easy to imagine Facebook’s network being undermined by new technologies.

Facebook looks great right now, but so did Ohio farmland in 1825 when the Erie Canal opened a cheap route to European markets. The problem, of course, was that railroads and other canals would shortly open up supply from the two-thirds of a continent to Ohio’s west.

Facebook investors are banking on its undoubted ability to innovate and create revenue while being unwilling, and probably unable, to account for that ability among literally millions of potential competitors, using technologies which may not have even been invented yet.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)

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