Beware Facebook, Buy LinkedIn: A Big-Picture Guide to Investing in Bright, Shiny Tech Stocks

The three most important trends to pay attention to: (1) Audiences are sprinting to mobile; (2) Niche social media is gaining on Facebook; (3) Ad-based models are losing to sites that get people to pay.

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Reuters

Following a week where Facebook and Zynga both disappointed investors in their earnings releases, investors interested in new Internet companies need to understand why valuations aren't driving any of these stocks right now, and where the opportunities lie.
 
Over the past year the following 10 private companies have all achieved $1 billion valuations based on rounds of equity raising:
 
Twitter - $8 billion
LivingSocial - $6 billion
Dropbox - $4 billion
Spotify - $3.5-$4 billion
Square - $3.25 billion
Pinterest - $1.5 billion
Airbnb - $1.3 billion
Yammer - $1.2 billion (purchased by Microsoft)
Evernote - $1 billion
Instagram - $1 billion (purchased by Facebook)
 
For comparison, here are the valuations of 7 billion dollar Internet companies that went public since the start of 2011, along with some valuation and performance metrics:
 

Here's why public markets are wrong: In a post-2008 world, the day a company goes public, all of the existing investors are employees and venture capitalists who own the stock from much lower prices. They are only going to be sellers, not buyers. They are fairly valuation-insensitive and have restrictions on when they're allowed to transact. I got caught in one of these with Zillow back in November, as insiders were given their first chance to sell and the stock fell 25% in a handful of days. All of the likely buyers are hedge funds and day traders, for whom a company is only as good as its chart or its last quarterly earnings report, and mutual funds, who in a world of relentless equity outflows have to sell something else to buy a new stock, and thus are unlikely to be big buyers of new issues, especially ones with short-term hiccups.

Companies that do everything right, as Zillow and LinkedIn have in their brief stints as public companies, can go up. All others are just a misstep away from a 40% decline, regardless of whether it makes fundamental sense.
 
Here's why private markets are wrong: In pre-IPO companies, only the company call sell shares in order to raise capital to fund growth. And the only buyers are well-funded venture capital firms that think about the long-term potential of a firm. Short-term progress is taken into account but it's not the be-all and end-all. And all it takes is one high bidder to set the price. In a world with a lot of tech innovation taking place, unattractive yields in other asset classes, and potential cash-rich acquirers looking for growth, it means private markets will be more kind to companies than public markets.
 
Imagine you're looking to start a new NBA team where you can purchase the rights to both existing NBA players or amateur players. And imagine four NBA teams have declared bankruptcy and are looking to sell their players for whatever prices they can get. Why overpay for a high school sophomore when you can potentially get an NBA all-star at a discount?

3 SIMPLE TRENDS
 
Markets have priced in three trends so far this year.

  1. Desktop/Web usage is losing share to smartphones and tablets.
  2. Facebook is losing influence to other, more open platforms, and to targeted verticals (LinkedIn for professionals, Instagram for photos, Pinterest for fashion).
  3. Display ad-based business models are losing out to those that have something for which people will pay.
As I look at that list of new public internet companies again, and think about what the consumer internet will look like in three to five years, here are my conclusions:

-- Avoid Facebook. It may just end up being the AOL or Yahoo! of the social Internet that tries to create a walled garden that's everything for everyone, hasn't evolved past display ads, is very expensive for its growth profile, and has billions and billions of insider sales coming down the pipe over the next three to six months. As we've seen with Zynga, when you have slowing growth and a wave of sellers, valuation doesn't matter on the downside. Facebook needs to figure out how to monetize its API, which is its longer-term value proposition, not visits to the site.

-- Avoid companies overly reliant on display ads (Facebook, Yelp).

Presented by

Conor Sen, a former hedge fund analyst, works for an Atlanta-based financial technology startup.

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