Are investors finally fed up with Facebook?

By John Stepek

published 26 July 2018

180726-facebook — Mark Zuckerberg: the mud may finally be starting to stick

Markets are all about anticipation.

Markets don't price what's happening today. They price what they expect to happen tomorrow.

And when markets are on a roll, they start to believe that tomorrow will always be better than today.

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Get a good bull run going, and eventually expectations get out of control. Fireworks and champagne become the norm.

And then woe betide you if you turn around and disappoint them with sparklers and spumante.

Which is exactly what Facebook a member of the most hallowed group of stocks in the world right now, the FANGs did last night.

Facebook could be running out of room for growth

Social media giant Facebook was trading at an all-time high as it issued its second-quarter results in the US yesterday.

The high did not last for long. Investors were not at all happy about what they saw.

The number of users rose by 11%. Ad revenue rose by 42%, year on year.

That doesn't sound terrible, but investors expect nothing less from Facebook than perfection. And what it gave them fell far short of that.

The company is no longer growing in North America. And overall, in the last quarter, it added fewer users than at any point since 2011 (which is when it started publishing these figures).

There are two explanations for this, and neither of them makes particularly happy reading for Facebook shareholders.

Firstly, the mud may finally be starting to stick. Facebook has had a habit of crossing the line and then half-heartedly apologising afterwards. It's an attitude you can get away with when you're a feisty little "change the world" start-up, but it's not as endearing when you're an established media giant.

So the scandals over privacy, data misuse, and the constant efforts to duck responsibility for the content that is published on its platform might have reached a tipping point.

Secondly, and maybe more worryingly, Facebook might simply have reached saturation levels. As tech website Recode points out, nearly half of the population of US and Canada uses Facebook every day. If you're not on it already, then you're probably never going to bother getting on it.

This is bad news for those who had been hoping for ongoing stratospheric growth which is what was priced in to the stock. You see, while Facebook is a baffling website to anyone who doesn't use it much (I am not a fan, personally), its business model is pretty simple.

Facebook makes money by selling advertising. Its sales pitch to advertisers is that they can target audiences more selectively when they use Facebook (or its other platforms, such as Instagram or WhatsApp), because Facebook knows its users almost as intimately as they know themselves.

So Facebook's business model relies on two things: it needs to maintain and grow its audience, and it needs to be able to "monetise" that audience parcel it up and sell it to advertisers in ever-more creative ways.

Certain audiences will generate more revenue than others. For example, that all-important North American audience which many advertisers want to target makes Facebook $25.91 per user.

If growth there has stopped, then it means that supply of Facebook's most profitable product the dedicated attention of the North American consumer has hit a ceiling.

Of course, Facebook could try to make more money per user. That probably has to involve exploiting their data more than it already does. However, what with the privacy backlash, that's almost impossible to do too.

So in effect, both growth avenues are running out of room.

Is this the Wile E Coyote moment for markets?

In after-hours trading, Facebook at one point saw its share price drop by more than 20%. We'll get a better idea of how big the fallout is when the US market opens later and investors have had time to adjust mentally.

But what does it mean for the wider market?

There is no obvious read-across from Facebook to the other FANG stocks. Amazon is an online cash and carry. Apple sells hardware and software services. Netflix sells content, rather than ads in fact, you could argue that it's pretty much the exact opposite business model to Facebook.

Even Alphabet (Google's parent company), which also sells advertising, is not vulnerable in the same way that Facebook is. I don't have the data to prove it, but I'd wager a significant chunk of money on the belief that most people would abandon Facebook rather than stop using Google.

However, a bigger worry for the market is in what this says about investor psychology right now. It's only a few months since people were talking about the "death of Facebook", and how privacy issues were going to bring the social media giant down. The share price back then dropped sharply.

But then, investors decided that it was just a buying opportunity. They suspended critical thinking, and piled in. It was a case of "buy the dip".

And this is the more important issue. The current market is thriving on this willingness of investors to suspend their disbelief. "The market is more expensive now than at any point in history bar the tech bubble? Ah never mind, it's different this time."

When a big headline-grabbing stock like this slips up and falls flat on its face, that faith is rattled. It's like that moment in the old Roadrunner cartoons where Wile E Coyote pursues the pesky bird off the side of a cliff. They both keep running in mid-air, until the roadrunner turns around and stops and holds up a sign saying: "Look down".

Facebook's big earnings disappointment is the equivalent of that sign. I don't believe that Facebook alone is enough to rattle faith sufficiently to cause a significant correction.

But the slide comes just as the tech-heavy Nasdaq had hit a new high. That's a lot of good news being priced into the market. As Facebook shows, the consequences for those who fail to deliver that good news will be severe.

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.