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A Moment of Sanity

Richard Croft
May 19, 2012
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7 minutes read
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In what was the most hyped initial public offering (IPO) of all time, Facebook (NASDAQ: FB, Friday’s close US $38.23) hit the market walking. Trading was delayed by an imbalance of orders until finally, at 11:30 AM eastern standard time, the first trade crossed at US $42.05 which was 10.6% above the IPO price. After an initial flurry that took the stock to US $45 per share, it hit a wall and tumbled back to the IPO price. Take away that initial exuberance and Facebook spent the remainder of the day range bound between US $38 and US $41.50 per share, ultimately closing at US $38.25.

The first day’s dénouement is instructive on a number of fronts; notably on how a moment of sanity will impact Facebook as a company, its’ bearing on the tech sector and ultimately how it will influence market sentiment.

At the company level the premier social network may have been its own worst enemy. When you think about it, social networking above all else, levels the playing field. It was the communication platform that toppled governments during the Arab Spring. It launched the 99% protests around the world. And during its first day of trading users contributed to the hype and eventual sanity that stuck it to Wall Street and the hedge fund community.

It turns out that a number of stock savvy Facebook users were lamenting the fact that few had any access to the IPO. The network was animated with comments ranging from anger at having to watch from the sidelines to words of warning about the risks of trying to buy Facebook shares in the secondary market at any price. No one can quantify how this affected the first day of trading but there was clearly a stick-it-to-1% feel about the message.

At a sector level the tepid response in the secondary market had an immediate residual affect on other social networking companies like Linkedin (LNKD, US $99.02) which sold off 5.6% on the day, and Zynga Inc. (ZNGA, US $7.16) which hit an all time intraday low. Even Google (GOOG, US $600.40) which is trying to build its own social network, fell more than 3.6% on Friday.

Across the spectrum one could argue that the fallout has yet to be fully priced into the tech sector which, by all accounts, was influential in leading the market higher through the first quarter.

Longer term, this may be a good thing. If nothing else it suggests that any speculative frenzy around everything social and by extension everything tech, in no way resembles the dot.com bubble. It proved that investors are not trying to establish P/E multiples based on dot.com imagery like eyeballs and page views (i.e. numbers of regular users on the site) but rather, are focusing on business metrics like free cash flow, margins, earnings and growth rates. Certainly on these metrics, Facebook is a real company with real cash flow, real earnings, above average margins and an above average growth rate.

But, as with any company’s valuation investors are, and should be, mindful of the risks. Notable among them being the fact that most of Facebook’s revenue comes from advertising which makes it susceptible to the vagaries of product placement. While social media works well today one has to wonder how long users will buy into “product endorsements” from so-called “friends.” It clearly did not work for General Motors which recently dropped its’ advertising on Facebook.

Then there are those pesky privacy issues. Facebook views privacy as a nuance, politicians see it as a hot button. Governments can be very litigious if elected officials think they can access deep pockets to generate political capital. I would not be surprised to see a rewrite of privacy laws that will squeeze Facebook at some point in the future. Never forget that anything entrepreneurial sprit can build questionable government intervention can destroy. Just ask any major European money center bank!

Closing the circle we come to the macro level. There were those, including myself, who believed that enthusiasm around Facebook would lure retail investors back to the market. Sentiment plays such an important role in valuations!

So far that has not happened and with the hype behind us, you have to believe that sentiment will shift to Europe which, among other things, is a political catastrophe predicated on the madness of crowds.

There is no quick fix solution for Europe. In fact there will be no solution until growth resumes which will not happen until the Union purges member States that are not contributing. This will inevitably happen but not until we experience months of political wrangling from the socialist left that, by the way, just received a shot in the arm from the recent French elections.

I find it difficult to imagine a macro catalyst, including the ever increasing likelihood the US Federal Reserve will engage in another round of quantitative easing (i.e. QE III), that will improve sentiment to a point that will induce retail investors to make a long term commitment to stocks.

In short I expect that the moment of sanity that prevailed in Facebook’s initial experience as a publicly traded company will reverberate across the macro spectrum turning midsummer night dreams into midsummer night sweats.

For option traders, this is the ideal environment in which to hedge. The use of bear call spreads which will mitigate some of the risks associated with any potential increase in volatility, or the outright purchase of low cost index puts (currently trading at reasonable implied volatilities) seems to be the appropriate strategies to any midsummer night sweats.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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