The falls that have come with Facebook’s high-profile woes over its collection of users’ personal data should serve as a stark reminder of the dangers when buying richly valued companies, according to Schroders’ Juan Torres Rodriguez. 
The social media giant has seen its share price slump in 2018 after it become embroiled in the scandal surrounding British political consulting firm Cambridge Analytica. Facebook has said that up to 87 million users’ data was improperly shared with the firm, while Cambridge Analytica claims its work helped Donald Trump win the US presidency.
But while the Cambridge Analytica story has dominated the headlines, the issue that many investors are also worried about is slowing user growth – and if this will worsen following the data sharing scandal.
Rodriguez, a research analyst in Schroders’ equity value team, noted that Facebook had been “a hugely appealing story” for growth-orientated investors until it hit some challenging conditions in the first quarter of 2018.
Performance of Facebook over 5yrs
Source: Google Finance
Facebook’s fourth-quarter results showed that the platform has 1.4 billion daily users, representing a 2.18 per cent increase on the previous quarter. However, the pace of daily user growth had slowed from 3.8 per cent.
“For businesses looking to advertise their products and services to particular demographics, the company offers all sorts of tools to target specific elements of an almost two billion-strong database that of course, if it were a country, would easily be the most populous one on the planet,” the analyst said.
“Growth, however, is a slippery and unpredictable beast – not that that stops people trying to forecast it – and when expected growth fails to materialise, the market can be unforgiving.”
Rodriguez cited US hedge fund manager Seth Klarman, who pointed out that even small differences in an estimate of annual growth rates can have “a tremendous impact on valuation” for fast-growing companies.
“So while 10 per cent is objectively a very good growth rate, if the market was expecting 15 per cent from a business, its share price will have to adjust for that,” Rodriguez added.
“Add in people’s misguided yet abiding confidence in their ability to forecast an unforecastable future and, as Klarman notes: ‘With so many investors attempting to buy stock in growth companies, the prices of the consensus choices may reach levels unsupported by fundamentals.’”
In Facebook’s defence, the analyst conceded that the social media firm is sitting on plenty of cash and has no debt whatsoever on balance sheets – which means its valuation has never looked as stretched as that of tech peers such as Twitter or Amazon.
Performance of tech index vs global equities over
Source: FE Analytics
However, Rodriguez added that buying into Facebook at its high valuations can be seen as one of the ‘consensus choices’ highlighted by Klarman and it resulted in a share price that gave investors nowhere to hide if a rough patch was encountered.
Benjamin Graham, the father of value investing, coined the term ‘margin of safety’ and espoused that the price paid for any investment should allow for a range of unexpected adverse outcomes.
“In short, there was no margin of safety in [Facebook’s] share price and so, when these data-shaped clouds suddenly appeared in what the wider market had taken to be a clear blue sky, it was only going to head in one direction,” the Schroders analyst concluded.
“No doubt Facebook will adapt and work to protect itself and its database going forward but the episode seems very likely to have wider regulatory implications that few will have expected to happen quite so soon.”
David Coombs, head of multi-asset investments at Rathbones, added that the all-out growth story that has become attached to social media firms such as Facebook could start to weaken as users become more protective of their personal data.
Coombs has never invested in directly in Facebook or any other social media company due to concerns about data security, privacy and fickleness of fashion, which he admitted that until recently looked “naïve”.
“Data security concerns are probably obvious for such conspicuous data goldmines, and, of course, this is a risk for all companies these days,” he said. “However, I believe at some stage even Generation Z will realise the drawbacks of living such public, daily-documented lives.”
The manager added that many people have moved on from incumbents like Facebook towards more focused rivals such as LinkedIn. Facebook’s early growth was based on it luring users away from other platforms and the company is not immune from being hit by this itself.
“Don’t get me wrong, I am not predicting Armageddon for social media,” he said. “I do believe, however, that as governments catch up, finally, with policing the internet and social media, we may see the days of unchallenged exponential growth come to end.”
Not all investors are downbeat on the outlook for Facebook, however. Stephen Yiu, manager of the LF Blue Whale Growth fund, argued that the recent sell-off in the tech sector was fuelled by concerns over global growth prospects rather than any worries about its long-term health.
However, he added that tech appears to be the only sector that can achieve meaningful sustained growth in revenue and earnings over the next five years, making it the most attractive area for finding companies that can significantly outperform the market.
“The market got very excited about the Cambridge Analytica story which put some initial pressure on the Facebook stock which was followed by high levels of volatility coupled with plenty of algorithmic-driven selling. From our perspective we try to ignore market sentiment and focus on long-term fundamentals,” Yiu continued.
“Do we believe everyone is going to delete Facebook? No. Do we believe expenditure on digital advertising will continue to grow? Yes. Will there be more regulation? Sure, but the regulator will want to work with Facebook – if they destroy it, they create a huge vacuum for a host of unregulated social networking companies to fill which becomes even harder to police.
“We think Facebook’s business model is still intact and when you remember they also own Whatsapp and Instagram, the current valuation is compelling.”