Valuentum Exclusive Analysis for the Discerning Investor

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"I'm completely baffled by Facebook's pricing action, and I still think this one will again return to new highs." -- Nelson, December 20, 2018, with shares trading at ~$130 each. Shares of Facebook registered an all-time closing high of $218.30 per share January 9, 2020.

By Brian Nelson, CFA

We lost so much business at Valuentum because of our call on Facebook. Let's talk about it.

Facebook (FB) has been one of our best calls since it was added as an idea to the Best Ideas Newsletter portfolio. Facebook was first added to the Best Ideas Newsletter portfolio in late January 2016, and on a price-basis, it has more than doubled since then, outerperforming the S&P (SPY) by about 40 percentage points. Just a reminder, too, that the percentage of global stocks outperforming the S&P 500 has been among the worst in a very long time. For example, according to Societe Generale, there was only a 22% chance of picking a stock that outperformed the market during the past couple years. We're not trying to brag, but instead, provide the context to explain how difficult it has been to be a stock picker the past couple years. 

Facebook's ride hasn't been a smooth one. In fact, it has been really painful and has made us look really bad. However, let me explain how we were able to use our methodology with Facebook to keep adding substantial alpha to the Best Ideas Newsletter portfolio.

First, let's talk about how it looked like we were going to be so wrong on shares, to our complete embarrassment. In early 2018, specifically in two instances, the stock registered a 10 on the Valuentum Buying Index (VBI), at $173.93 and $193.28, respectively. A couple months later, shares rocketed to a closing high of about $217 per share or so, but then it had a terrible quarter, its second-quarter 2018 report.

Though Facebook was a big winner in the Best Ideas Newsletter portfolio through that time, the decline made it look like the stock collapsed right after we had highlighted it as a 10 on the VBI, but in fact, shares surged after registering the VBI rating of 10, and then collapsed. Despite the setback, which we thought was flat-out ridiculous, we did nothing with the idea in the Best Ideas Newsletter portfolio. In fact, here's what we wrote July 30, 2018: 

We maintain our view that shares of Facebook are underpriced. We now assume revenue growth will fade to 12% by Year 5 in our valuation model, and that the company’s operating margin will fade to 35% over the same time (its operating margin was 44% in the second quarter). We use a near-9% cost of capital assumption to discount future free cash flows, and we’re modeling $15+ billion in capital spending in the out-years. The low end of our fair value estimate range is ~$190, which itself is a far cry from where shares are currently trading ~$170.

We’re not happy to have been blindsided by management guidance that we think may turn out to be overly conservative, as the management team is under considerable public and Congressional pressure, in our view. Our updated fair value estimate is $236 per share, and Facebook’s Valuentum Buying Index rating is now a 6. We continue to like shares, but we’d like to see market support behind them as evidenced by an advancing stock price. Facebook’s updated 16-page report is now available for download. Shares were first added to the simulated Best Ideas Newsletter portfolio in January 2016 at ~$112. 

So, in July 2018, we had been blindsided by Facebook's disappointing guidance, almost right after it registered a 10 on the VBI. Granted, the stock had already surged following the 10 rating on the VBI, so the methodology worked, but the market, in selling shares off aggressively made us look really, really silly. In any case, we still did nothing with the Facebook weighting in the Best Ideas Newsletter portfolio. On September 6, 2018, we thought the best move was still to wait and see. 

The market is truly challenging our conviction in Facebook. As with many market participants, we were blindsided by a second-quarter report that essentially revealed the company taking conscious efforts to slow growth and increase spending, impacting the magnitude of expected profit performance in coming years. Though we thought Facebook's shares were undervalued going into the quarter, and even after factoring in reduced expectations after the quarter, the stock just flat-out is not acting “right" these past few weeks. The market is well-aware of Facebook’s massive net cash balance sheet position, considerable network effect (one of the best competitive advantages), and its solid free cash flow generation, but the selling doesn’t want to let up for some reason.

Facebook’s COO Sheryl Sandberg and Twitter’s CEO Jack Dorsey testified at a Senate panel September 5, and investors continue to be on edge about whether regulatory and legal action might heat up against social media (SOCL) entities, but still, the sell-offs across the social media arena, including Snapchat (SNAP), have been considerable. We continue to like Facebook for myriad reasons, but if Facebook and Twitter believe that they will be able to spend to "police" their websites, effectively “controlling speech,” we don’t think it can be done, nor should it be done. We think the best move for investors is to wait and see how things pan out in the coming quarters, but we just can’t help but feel we might be wrong on the Facebook idea given its pricing action of late. 

On September 28, 2018, we said the following:

In other news, Facebook noted that “on the afternoon of Tuesday, September 25, (its) engineering team discovered a security issue affecting almost 50 million accounts. (The company is) taking this incredibly seriously and wanted to let everyone know what’s happened and the immediate action (its) taken to protect people’s security.” The investigation remains in the early stages, from what we can tell, and we’re glad to see that the company has acted quickly in notifying law enforcement.

We continue to like shares of Facebook, and we maintain our view that the social-media giant's long-term outlook remains extremely bright, despite near-term challenges related to the Cambridge Analytica scandal and now this event. It is possible that there may be more bad news to come, but as the company continues to increase the security of its platform and make it better, it only enhances its competitively-advantaged profile. 

We value shares of Facebook at $233 each. It has been a rare highly-rated stock on the Valuentum Buying Index that has not worked out (yet), unfortunately. 

We were still expecting big things at Facebook, and our valuation was largely unchanged since July 2018. By late September 2018, Facebook's shares had traded down from all-time highs of about $217 in early 2018 to the mid-$160s, and while we were still up very nicely since the time we added it to the Best Ideas Newsletter portfolio in January 2016, the stock's technicals had broken down.

Nonetheless, we felt something was wrong with how the market was pricing the stock (it was being too punitive). The market was acting completely irrationally, in our view. By October, however, the stock had hit the mid-$150s. I must admit; I was somewhat embarassed (and a little angry). I just knew that Facebook would come roaring back, but the market was just simply nuts.

We stuck with Facebook in the Best Ideas Newsletter portfolio, and I even apologized to members, despite Facebook still being up from when we added it in the Best Ideas Newsletter portfolio.

We’re not exactly happy with how things have transpired in the simulated Best Ideas Newsletter so far in 2018, and we hit a very high-profile setback with Facebook. Frankly, we can’t believe how the market has soured on its prospects, and we’re even a bit puzzled by management almost purposefully hurting its own stock on the second-quarter conference call. Through the summer, Facebook had been a big winner on the year, despite the Cambridge Analytica debacle, but guidance for the next couple years, as outlined in the second-quarter call, sent many investors running for cover. Frankly, however, the guidance wasn’t that bad, still implying considerable earnings expansion in coming years. Sell-side analysts are now throwing in the towel on the company, too, as it just looks bad to defend it now that it has caught the ire of public opinion given alleged data misuses. I can’t begin to tell you how frustrated I am -- Facebook had been a top idea, and we highlighted it big time. I’m beyond upset by its performance. I’m sorry.

By December 20, 2018, things weren't getting any better; instead things were getting even further out of whack (even more so than before). That's when we started pounding the table on Facebook again, at almost at the exact bottom, in the low $130s. Here's what we wrote about Facebook then:

Just when it looked like Facebook was getting back on track, the company gets pummeled on old news. I really can't believe it. The market loves to hate Facebook, but this weakness won't last forever. Yesterday, the attorney general of the District of Columbia filed suit against the company regarding the Cambridge Analytica scandal, and the media outlets, which compete against Facebook for advertising dollars, are running with every bit of bad press they can find. Bashing Facebook unfortunately is not going to win them more business. I'm completely baffled by Facebook's pricing action, and I still think this one will again return to new highs.

On December 26, 2018, we had had enough. We went to fully invested in the newsletter portfolios, making Facebook one of the top weightings in our Best Ideas Newsletter portfolio:

Well, we've made our call heading into this year with an "overweighting" in cash, and it panned out relative to those that were fully invested. We're now moving our cash "weightings" in both the simulated Best Ideas Newsletter portfolio (5%-30%) and simulated Dividend Growth Newsletter portfolio (7.5%-20%) to 0% and distributing the balance proportionally to each idea in the simulated newsletter portfolios.

From that point on, Facebook's stock has pretty much gone straight up and to the right, now at new all-time closing highs, January 9, 2020. Since December 26, 2018, Facebook has advanced 62% on a price basis compared to 31% of the S&P 500. Let me repeat: since it was originally added to the Best Ideas Newsletter portfolio in January 2016, it outperformed the market by ~40 percentage points. Since we added to the position in December 2018, it has outperformed the market by roughly 30 percentage points. [We also added to the position in Facebook July 19, 2017, at $164.77; shares have trailed the market by a few percentage points since that add, but not to the point that would not make Facebook a huge winner.]

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But what about the VBI rating assessment? On January 7, 2019, Facebook registered a VBI rating of 10 with shares trading at $142.53; our fair value estimate was $226 at the time. On February 18, 2019, Facebook registered a VBI rating of 10 with shares trading at $162.29; our fair value estimate was $228. On April 26, 2018, shares registered a VBI rating of 10 while they traded at $173.93; our fair value estimate was $240 at the time. On June 4, 2018, shares registered a VBI rating of 10 while they traded at $193.28; our fair value estimate was $250 at the time. On average, a 10 VBI rating translated into roughly a 31% return on those four instances of Facebook, and how about the conviction of our enterprise valuation process to hold our fair value estimate well above the stock for so long! 

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Why have I dedicated your time to this case study on Facebook? Well, because a lot of people think we have been wrong on Facebook. Since it was added in January 2016, it has generated more than 40 percentage points of return outperformance. Since we added to the position in December 2018, it has added another 30 percentage points of return outperformance. The decision to add more to it in mid-2017 can hardly be viewed as a mistake even though Facebook trailed the market return a little bit since then--but nowhere near to the tune that would negate it being a great call, especially in the context of few stocks outperforming the S&P 500 during the past few years. Further, the average return of a VBI of 10 in Facebook's case was roughly 31%.

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It's hard for me to accept that our call on Facebook during 2018 contributed to churn in our business, but I truly think it did. I really think it hurt Valuentum quite a bit. When you think about how good of a call Facebook was, and how it hurt our business, you can truly understand how difficult it is to be in the publishing business. In any case, I wanted to share this experience with you, so we are all the wiser. From my perspective, in the context of this market environment where few stocks are outperforming and few money managers are outperforming, we hit the ball out of the park with our call on Facebook--and it cost us business. Know that we will continue to do our best work and that our methodology is sound. Thank you so much!

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Related: TWTR

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Brian Nelson do not own shares in any of the securities mentioned above. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.