Lessons Re-Learned: A Good Company Does Not Mean a Good Stock to Buy

A lot of frenzy over “hot” tech companies has been engulfing the business and tech media in the past year or so. Journalists and bloggers have been running over each other, proselytizing to everyone what a great and safe investment buying stock in Apple, Facebook, Zynga, etc. would be. The Facebook saga over the past weeks finally prompted me to write a few lines on that topic, myself.

The main goal of this post is to remind everyone (especially those tech gurus who have the right sense to admit they’re not business or finance experts) that there is a huge difference between a good company and a good stock to buy. If you need a refresher on this simple fact, keep reading.

Rule 1: Buy Low, Sell High
The number 1 rule that every college student learns in Finance 101 is simple: “buy low, sell high.” This rule is such a common sense that somehow most people ignore it and completely forget about it when they start their real lives after school. The people that became millionaires and billionaires from Facebook got into the business at the very beginning or in the early stages of growth. They bought (or earned) their shares extremely low, and now they can sell extremely high. This is why they became super rich over night on Friday, May 19 2012, when Facebook floated its stock on Nasdaq. Consider the very telling (albeit ridiculously sounding) story about graffiti artist David Choe, who was invited to paint murals on the walls of Facebook’s first real office. For a job that reportedly would have been worth a few thousand dollars, he chose to accept 3.77 million company shares rather than cash. At $38 a share, Mr. Choe became $143 million richer on Friday. But he did not accomplish this miraculous feast because he got in on the IPO bandwagon. He achieved it because he bought very low and sold very high.

So one moral of the story is: The price on the day of the IPO was already set high — that was the right price for Mark Zuckerberg, Eduardo Saverin, Sean Parker, U2’s Bono, Russian oligarch Yuri Milner, and the rest of Mark’s circle of close buddies to cash out at. That price was not meant for the “average Joe” investor to buy in and get rich.

Rule 2: Beware of Being Crowded Out
Another trap that most techies (and Facebook fans) fell into is the belief that they could benefit from a large “pop” in the stock price on the IPO day. The “pop” that most fans were anticipating is one of those elusive myths that they constantly get exposed to in countless movies about Wall Street, reinforced by myriad sensational articles in the financial press. The “pop” does exist but is a rare animal that comes only once in a while. Hoover’s corporate database lists LinkedIn as the biggest first day winner as its stock started floating at $45 on May 19 2011 (almost exactly an year before Facebook’s debut) and closed the first day of trading 109% higher, at $94.25. So, in a way, all the Facebook fans expecting a “pop” had some reason for their optimism. One thing they were unaware of, however, was that in most cases the average investors are crowded out from the trading. The big underwriting investment banks would execute the first (most profitable) trades for their “whale” (or “high net worth”) clients. If the price starts climbing fast, the “whales” will keep buying until they deem the price is not low enough any more. By the time the “average Joe” investor gets to buy, the price will already be inflated (and the trade will most likely be unprofitable).

A second moral of the story is: Unless you are a “high net worth” investor with a good private banker, you can only enjoy an IPO “pop” as an observer on the sidelines. IPO “pops” are spectacular to watch, but dangerous to dip one’s feet in.

Rule 3: Sensational IPOs are Dangerous
Most money to be made on the stock exchange is in companies that have not been widely recognized as “hot” by the investors. A company may be very solid in its financials and operations but if it has not surfaced on top of the general public’s radar screen, there is a good chance that its stock price is still attractive. The moment the Wall Street Journal and the Financial Times pick up on that company, the stock price will start adjusting. By the time you start reading about that company on Yahoo! News and even your grandma asks you about it, it is too late — the stock is most likely already overvalued. The company may very well remain very healthy, but the stock has quietly but steadily become toxic. This is the case with all the hype surrounding Facebook’s valuation — I remember the sensational articles and TV coverage about the expected record-breaking IPO that were brainwashing the general public almost two years ago. Another good example for this is Apple. Everyone these days believes Apple is a money-making machine. So they flock to that company’s stock. Apple may very well be a true money-making machine and remain one for the foreseeable future, but its share price has already been driven through the roof. If you wanted to make lots of money on that stock, you should have invested in 2005 when the stock was trading for $70-75 a piece, not now — when its price hoovers above $500 and flirts with the $600 threshold.

The third moral of the story is: It’s hard to beat the market. Those who do beat it consistently have been professionally involved in investing for much longer than you can imagine. They spend their entire days looking out for undervalued companies. They don’t get their tips from TechCrunch or Huffington Post, not even from the Wall Street Journal and Financial Times. Let them do their jobs, and focus on doing the job you pride yourself on even better.

Rule 4: Remember the Past!
Bubbles often start to burst when the hype reaches impossible heights. If you see a company or a person being elevated almost to the status of a deity, run away far and fast. The fact that a company starts floating at 100 times its earnings is a sure sign of the type of exorbitant hype and mindless herd mentality that can only bode misery for those who buy into it. This was the story in the late 1990s with the “dot.com” bubble burst; this was the story with the real estate extravaganza in the 2006-2008 period; this will probably (and sadly) be the story with the SoLoMo craze (for those who don’t dwell too often on techie blogs, SoLoMo stands for the convergence of the ubiquitous Social, Local and Mobile apps and services that you keep stumbling upon in your everyday lives nowadays).

Yet another moral of the story is: History tends to repeat itself, for good or for bad. If you know that bubbles have burst in the past, look out for signs of the next bubble. If you see a price of a certain asset sky-rocketing and people buying based on emotion and not reason, stop yourself and search for the inner voice of reasoning.

Rule 5: Growing Users Does Not Equal Making Money
Last night I perused a hilarious self-interview by BuzzFeed’s CEO Jonah Peretti. He was reminiscing on the power of the network, and on how Facebook has served as an enormous social experiment proving and even taking to the next limit the “6 Degrees of Separation” theories of 1960s and 1970s sociologists. I was sitting on the couch, laughing out loud (or LOL-ling as most SoLoMo fans would put it), wondering if Jonah Peretti actually takes his stuff seriously or is just doing it for the kicks. Granted Facebook’s user base has grown faster and to a greater degree than any other service’s in the past. However, unlike many other services, it is not clear how exactly an extra added user on Facebook’s network can bring the company incremental revenue. For almost 900 million users (which is approximately a twelfth of the world’s population), Facebook has managed to generate $3.7 billion revenue. Can we expect that Facebook will grow its revenue by 12 times if it one day becomes every individual person’s preferred way to spend their spare time? Is it realistic to expect that Facebook can one day have every single person in the world as a user? Even if it is, does a $44 billion revenue (i.e., 12 times the 2011 revenue) guarantee the stock price will continue to be so high? Of course, I’m grossly over-exaggerating here. Facebook will never cover the entire world’s population. Revenue is not a linear function of the number of users (the advertising potential for middle-income users in the developed world is not the same as the advertising potential for “bottom of the pyramid” users living on less than $1 a day in the world’s poorest countries). The arguments can go on and on. But you should get the point by now, I hope.

So the final moral of the story is: Never forget that impressions, marketing “eye balls,” number of users, etc. are mere proxies for revenue and profit potential. They should always be regarded as what they are meant to be — proxies. They are not equivalent to revenue and profit. They do not guarantee revenue and profit. It is OK to base expectations on these proxies at an early stage of a very young company, simply because it is perhaps too premature to expect big revenues and earnings. But when a company was founded eight years ago (in February 2004 to be precise) and is only six years younger than Google but continues to be evaluated on number of users and other such proxies, then there may be something wrong. Take a deep breath, put on your “accounting glasses” and start looking for whatever is wrong. Sooner or later, you’ll find it. I am almost 100% sure.

That, my friends, has been the lesson re-learned that I wanted to emphasize today. I hope you enjoyed reading it (and found it useful). In the meantime, I’ll continue observing Facebook’s post-IPO stock’s performance from the sidelines and congratulating myself for keeping my senses together and not getting on that bandwagon.

Facebook’s Stock Price in the First 3 Days after the IPO (Graph by Google Finance)

I’ll also be praying that the guy from work who bragged about buying 1,500 shares at $40 on the IPO day was lying and did not really spend $60,000 of his hard-earned money, hoping to retire early due to a Facebook “pop.” I really hope he was just bragging and not really doing that, I do.

What are your thoughts on the Facebook IPO debacle? Drop me a line or two in the Comments section.

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