Recent Sale: Facebook
If you would have asked me a month ago if I’d be selling my Facebook (FB) any time soon, the answer would have been an assured, “No.” Well, times change I suppose because on Monday afternoon I liquidated my position after digesting a weekend’s worth of data regarding the Cambridge Analytica suspension that is being called a data breach by some. While I’ve always viewed Facebook as a long-term buy and hold type position because of its massive profitability, strong balance sheet, wide moat within the social media space due to a user base consisting of billions of individuals, my stance has recently shifted a bit as I become more and more concerned with the potential for regulation and how this might effect future growth. Facebook appears cheap to me based upon current growth expectations; however, as this growth/profitability is put at risk by questionable management decisions and changing consumer sentiment in the social media space, my valuation models change as well. Without a dividend that contributes to my portfolio’s cash flows, I’m less patient with a holding like Facebook. Shareholder returns go a long way towards me offering the benefit of the doubt to a company/management team, but in Facebook’s case, I decided I’d rather be safe than sorry with regard to my unrealized gains, locking in ~16% profits at $171.90.
Regardless of the semantics surrounding the Cambridge Analytica situation (Was it a data breach? Was the data simply misused? Is Facebook at fault for trusting an elite University/highly regarded professor? If Facebook followed corporate best practices, will this issue be swept under the rug and forgotten about in the near future?) the risk profile for this company has changed. Facebook has underperformed its high growth peers for months now (FB peaked relative to the S&P 500 back in November) due to fears regarding its highly concentrated revenue stream (~98.2% of revenues came from advertising in 2017) and the impact that increased competition/potential regulation might have on these sales.
I don’t suspect to see the economics of digital advertising changing quickly in the near future. Facebook and Alphabet currently enjoy a near duopoly in the digital ad space, though other big tech names, including Amazon (AMZN) are taking strides to get into the game. As competition rises I suspect to see margins fall, which is another potential threat to profitability. With that said, I wouldn’t be surprised if ad volume growth more than made up for slimmer margins if competition does indeed increase as more and more ad dollars are directed to the digital space rather than more traditional media outlets. Facebook has proven to be a wonderful advertising resource for its customers and so long as it provides the best value then I don’t foresee volumes falling. With that said, I think so much of Facebooks value proposition comes from the use of its massive collection of user data and if this is disrupted or disallowed, then FB’s fundamental business model will be effected.
At this point in time, worrying about governmental regulation is pure speculation. However, I might also argue that returns from a stock that doesn’t pay a dividend are also highly speculative, which is why I sold my stake. It seems clear to me that Congressional/Parliamentary investigations are around the corner, though I can’t say for sure how these will work out for the company. It’s certainly possible that more scrutiny in the near-term will lead towards better trust/more sustainable business practices over the long-term, but all of the negative headlines could also lead towards a hit to trust as well that could hurt Facebook’s economy of scale.
I will say that the tide seems to be against the big tech names politically, especially in Europe, where technology is much less expansive in terms of the percentage of broader regional market indexes. Any penalties/taxes/regulations that Europeans companies put on digital advertising will effect American companies like FB and GOOGL much more so than any of their own and I can imagine the political will inspired by this relative inequity on the other side of the Atlantic will create further problems for American companies operating there. It’ll be interesting to see which side of the fence American legislators fall upon; will they favor privacy concerns of American citizens, will that take a protectionist stance regarding U.S. tech corporations (similar to the one that China has taken with its, allowing for its tech space to flourish), or will it be some sort of middle ground in between?
Another threat is decreased usage of the platform as negative headlines proliferate. For the most part, I think people tend to overlook digital privacy concerns when they pertain to mundane matters. I assume that most Facebook users understand that the information they make public on the site is likely data mined and used in its advertising biz. It doesn’t seem like individuals’ finances are at risk from this Cambridge Analytica situation (unlike major data breaches from retailers involving consumer credit cards/ the Equifax breach that contained much more sensitive information that already seems to be far in the rearview mirror of our incredibly fast and short sighted media cycle) and typically, issues like this don’t get a lot of major media run. However, because of the political nature of this event, I suspect that mainstream media will be all over it and this will result in a dark cloud over Facebook in the U.S. which is by far its most profitable region. I fear that FB is navigating a slippery slope at the moment with the trust of its user base. If this trust continues to erode it doesn’t bode well for Facebook and its properties. Switching costs are essentially nil when it comes to social networks and users will quickly migrate to whichever platform offers the most engagement/stability moving forward.
Something else that concerns me when taking a long-term view of this company is the company’s ability to compete in the talent wars in Silicon Valley. In a day and age where young workers are very concerned with the positive impact that they’re making on the world, I worry that any negative sentiment shift will make Facebook seem like a less attractive destination for the most highly sought after talent.
At the end of the day, when things like democracy and society in general are viewed as being potentially disrupted in a negative fashion by social media, I get concerned about the status quo. The status quo for Facebook is a very good thing (it represents ~30% growth for the foreseeable future). If FB is able to produce such growth, the $170 seems like a wonderful price to pay. Though, if the status quo is disrupted it will surely effect this growth trajectory which will lead to even more multiple compression.
Right now, I still own two of the four F.A.N.G. names: Amazon and Alphabet (formerly know as Google). I feel more comfortable with these non-dividend paying growth names because of the diversification that they offer with their business models. Like Facebook, a very high majority of Alphabet’s sales/earnings come from digital ads, but GOOGL’s corporate umbrella covers much more than that (cloud, AI, autonomy, media content, etc). This gives me greater peace of mind, while still allowing me to have exposure to the high growth digital ad space.
It’s rare that I sell shares without damaging my income stream. However, since Facebook was one of the few companies that I owned that didn’t pay a dividend, this sale gives me more flexibility than most moving forward (typically, I like to replace lost income when I’m making trades). I plan on putting the proceeds from my Facebook sale back to work in the technology arena. Right now, I’m taking a close look at Oracle (ORCL) as it sells off post earnings after hours. I’m also considering adding to my large Microsoft (MSFT) stake. Facebook was a large stake for me with a weighting approaching 2%. Taking a ~2% weighting that didn’t pay a dividend and transferring that exposure to equities that do contribute to my income stream will make a noticeable different in my annual dividend income.
I’m also considering adding to shares to my Chinese growth basket featuring Alibaba (BABA), Tencent (TCEHY), and JD.com (JD). I like the long-term growth prospects of each of those names; I’ve been doing some work on Baidu (BIDU) as well and this might be a good opportunity for me to add that company to my Chinese basket. Typically, I have a hard time selling shares to buy assets like these because they don’t offer much (if anything) in terms of a yield. However, since Facebook also didn’t pay a dividend I wouldn’t be damaging my income stream with the trade. In a similar (yet much more defensive) mindset, I’ve considered using some of the Facebook proceeds to add to my Berkshire Hathaway (BRK.B) position.
And last, but not least, I may just wait and see how FB’s weakness shakes out. I see support in the $155-160 range (this represents the bottom of its long-term trend line; a line that it has touched and bounced off of several times in its long-term uptrend). I’d be happy to add some shares in this range unless news gets worse, forcing the company to break down further.
In the meantime, I don’t mind holding onto cash while I make a decision. Cash isn’t necessarily a bad thing in this market environment. During February’s volatility, I realized that I was probably too overweight equities, which made up ~93% of my portfolio. In the low volatility bull market environment that we’d experienced for a couple of years, I was concerned with the opportunity cost of holding cash, but things appear to have changed and with 300-400 swings of the DOW a regular daily occurrence now, I place a higher value on the flexibility that comes from holding cash.
Taking profits from highly valued stocks (especially if they don’t contribute meaningfully to my passive income stream) has been a trend of mine during the recovery since mid-February and so long as the yield spread narrows towards a potentially inversion (which has been a historical recessionary signal), I expect for this trend to continue for me personally. In other words, I think we’re much closer to the end of the bull market run than the beginning which means that my focus in ever more in high quality holdings and my income stream rather than maximizing growth via speculation. I’ve seen economist signal 4 rate hikes in 2018 rather than the 3 that I expected coming into the year and I believe this will be yet another headwind for the markets. Washington D.C. continues to be a circus with the Mueller investigation and concerns that the POTUS could fire the special council, putting both parties in Congress in an interesting bind. Needless to say, risks are abound and personally, I’m happy to take risk off the table and enter into a wait and see mode.