The Lato Letter: Volume 1, Issue 15.

The Lato Letter: Volume 1, Issue 15.

The investment business and the confidence of investors have not been served well by the events surrounding the initial public offering (IPO) of Facebook (FB, NASDAQ).

Facebook was easily the most anticipated and publicized IPO in the history of the equity markets. It is a company that has thoroughly dominated social media with worldwide users in the hundreds of millions.  Those users have translated into billions of dollars in revenues and a billion dollars in net income in the last twelve months.

As I had discussed verbally with many clients, those favourable attributes of the company did not necessarily mean it would be a great investment.  The pricing of the IPO would help to determine that and when initial rumours on that pricing discussed a trailing twelve months price/earnings multiple of 75 or 80 times, the issue was being priced far too rich for my liking to be a good investment.

Last week when Apple (AAPL, NASDAQ) was one of my top picks on BNN’s Market Call Tonight at $558.22, I had mentioned to clients that there was little logic in buying Facebook at that multiple when I could buy AAPL at 13.5 times the trailing twelve months earnings.  Following that BNN appearance, AAPL promptly declined 5% in the next three days as investors (I believe with perfect hindsight) raised cash to participate in the Facebook issue.

Then, the perfect storm happened.  The underwriters, led by Morgan Stanley, raised the issue price to $38.00, the very highest end of the range and also increased the issue size to the maximum previously discussed.  That $38.00 issue price represented a trailing twelve months multiple of close to 100 times.

Many investors who had “padded” their orders for Facebook to ensure they received an adequate number of shares, all of a sudden had all of the shares they had asked for and more than they really wanted, particularly at that issue price.  The final part of the perfect storm was when all of the initial trading, said to be 82 million shares in the first 30 seconds, overwhelmed the NASDAQ and created significant confusion among investors who didn’t know whether they had completed their buy or sell orders for several hours.

With an issue that was priced based entirely on the hopes of future earnings and not the current fundamentals of the company, the combination of these events has severely damaged the stock in the first few days of trading.  As I write, Facebook is currently trading at $32.11 or over 15% below the issue price while investors have swarmed back to Apple, eradicating all of last week’s losses and then some $568.58 at the time of writing.

The events surrounding these two stocks have left investors confused and for buyers of Facebook, disenchanted.  However, it does serve to reinforce the premise that day-to-day market activity can many times be clouded by happenings that are simply “noise” in the long term.  In the long term, stocks represent a piece of ownership of a business and that business must be purchased at a reasonable price, if it is to have the potential to be a favourable investment.

Facebook may still prove to be a good investment at some point but even at the lower price, we are still not at that point.  Looking at future estimates, my question remains “why should I buy Facebook at 16 times what it is expected to earn in 2015 when I can buy Apple at 12 times this year’s earnings?”.

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