This time last year, I published an article on Livewire called ‘What Peter Lynch taught me about Facebook’. Here, I made a warning call on the data privacy issues Facebook is facing today. Livewire has since got in touch with us to discuss: what the next 12 months looks like for Facebook, a tech stock which could face similar issues, and 6 tech stocks we like today.
Are events unfolding as you feared they might? How have things differed?
“Facebook’s valuation is now starting to look attractive with it now trading on a cheaper multiple than Google.”
Unfortunately, events at Facebook are unfolding exactly as anticipated. Following a whistle-blower complaint about use of data, the issue has been highlighted very publicly and the stock has substantially underperformed other technology stocks. Facebook’s valuation is now starting to look attractive with it now trading on a cheaper multiple than Google. However, I still have reservations as there is an existential issue here given that Facebook depends on continued user engagement to exist - the breach of trust calls this into question. We have seen sites like Myspace and Orkut go into oblivion pretty quickly once users found alternative platforms. There is currently no competitor to Facebook, but we do need to see management getting ahead of the problem.
What could the next 12 months look like for Facebook, and what should investors be thinking about?
“We do find it interesting that the CEO has not been using his product”
The next 12 months are likely to be choppy and investors should monitor management response and their ability to get ahead of the problem. For now, the authenticity of the response has been lacking and it has been couched in legalese - users don’t like hearing their data has been misused. While the management have embarked on a marketing blitz, to us their initial response has been reminiscent of a deer caught in headlights. Anecdotally, Mark Zuckerberg (who usually posts publicly every week) had no posts between Feb 16th and March 2nd and then again between March 2nd and March 21st. This is just an observation, but we do find it interesting that the CEO has not been using his product! (Personal anecdote - my family shut our Facebook account post writing the note last year!)
This said, we should bear in mind that Facebook also has the Instagram and WhatsApp platforms that have been embroiled in the issues on privacy to a much lesser extent. These platforms, together with Facebook itself still have strong potential to generate advertising revenues as long as user trust is restored/maintained. These are the major social networks currently used with no obvious competitor alternatives. For these reasons, we keep an open mind about investing in the stock in the future, particularly as the valuation becomes more compelling.
Is there another big tech stock that could face similar issues?
Our expectation was, and continues to be, that regulation is going to be an issue for the big tech names going forward. As we have also written and talked about with Amazon, and taxation and government regulation will only increase as these companies grow bigger and more influential. These are issues which investors need to think about both in terms of calibrating revenue and earnings growth and the multiples at which they expect these stocks will trade.
How are you now thinking about the tech sector more widely?
“We find that compared to 2016 there is a lot less difference between our valuation of the businesses versus the prices they are available at on the stock market.”
As investors, the returns we make are a function of the difference between the value of a business versus the price we pay to buy it on the stock market. In general, there is significant bifurcation between the high-priced high-growth names in technology versus the old-tech names like IBM, Oracle, etc. We remain bottom-up stock pickers and Google, IBM, Microsoft, Oracle are the names we prefer amongst the big names. We also find attractive names through careful research of smaller names in the sector such as the likes of AKAMAI and OCADO.
We find that compared to 2016 there is a lot less difference between our valuation of the businesses versus the prices they are available at on the stock market. This is changing as we speak given the 9.5% correction in the NASDAQ between 12 March and 2 April (see chart), but in general the margin of safety on a sector-wide basis does not seem sufficient. To take Amazon as an example, we love the business model, but worry about taxation and government regulation risk. To put things simplistically, at Amazon’s current market valuation of US$700bn, the stock market is saying that sometime between now and eternity the company will generate free cash flow of US$700bn to be returned to shareholders in the form of dividends and buybacks (actually this number needs to be substantially more as there is a time value of money). At the company’s current pace of capital generation, we are talking about 50 years in terms of return of cash. As a comparative Apple, Exxon Mobile and Johnson & Johnson will all take, on average, about 12 years to generate their market cap in undiscounted free cash flow.
In summary, our focus remains the same: we still want to own great quality businesses run by strong management teams, but we are conscious of the price we pay.
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