The Next Stock Market Bubble

In December of 2001, the Journal of Finance published a study titled “A by Any Other Name” by Michael J. Cooper, Orlin Dimitrov, and P. Raghavendra Rau that studied the bubblicious effects of companies renaming themselves something with in the name. The price of stocks adding .com gained an average of 53% above companies without the in the corporate name, and the authors concluded the following: “We argue that our results are driven by a degree of investor mania–investors seem to be eager to be associated with the Internet at all costs.” The fact that the Nasdaq took fifteen years to return to its 2000 high is a shorthand way of describing the bubble conditions that existed at the turn of the millennium.

On March 4, 2008, the professors Shih-An Yang, Robert C.W. Fok, and Yuanchen Chang wrote a paper titled “The Wealth Effects of Oil-Related Name Changes on Stock Prices: Evidence from the U.S. and Canadian Stock Markets” that examined the effects of companies adding the word “oil” to the name, and found that it resulted in an abnormal gain of 81% against the performance of an index continuing companies with the same business model. The word bubble is an exaggerated term to describe the oil stock valuations, especially if you are using the 1990s internet stocks as a reference point, but it is true that 2007 is one of the few years in which a heavy investment into the oil sector will result in subpar long-term returns.

And although I don’t have something as tidy as corporate name changes to show you in order to make my case, it is likely that we have come full circle in the past three decades and are now back to the internet tech sector–the social media companies in particular.

I’m looking at SOCL, the Global X Social Media ETF, and some of the holdings are just begging for disastrous long-term returns. It has almost 10% of its portfolio in LinkedIn stock. That is not what you do when you’re looking for a high probability of gains for 15+ years, nor is it something you buy when you are looking for conservative asset management. It’s entirely the realm of short-term traders.

LinkedIn loses $175 million per year, and it has a market value of $30 billion. The rosiest analyst predictions call for $500 million in profits by 2020. If those optimistic predictions come true, and the stock traded at 25x earnings then, the company would be valued at $12.5 billion. You’re staring at losing two-thirds of your money if the best case earnings scenario works out.

Ahh, but that is not the entire story. LinkedIn also heavily dilutes its shareholders, as executives receive share compensation and the company must issue new shares through secondary offerings because it regularly loses so much money. It had 100 million shares in 2011, and has 130 million shares now. If you assume 165 million shares of LinkedIn will exist at the time it makes $500 million, the company will make $3 per share in 2020.

Assuming a 25x earnings valuation, that actually means the stock would trade at $75 per share around 2020. It currently trades at $240. And I should mention those are optimistic estimates. The consensus calls for under $200 million in annual profits and $1.25 per share in earnings. It’s also generally true that stocks revert towards 20x earnings when they reach maturity. The math under a scenario in which the earnings greatly disappoint investors, and the P/E plummets, is even a worse story.

You could perform a similar analysis on the rest of the Social Media Fund’s holdings. It has 5% of the assets in Pandora. How could someone think that is a good idea? Pandora has never been profitable, and is expected to lose somewhere between $40 million and $50 million over the course of 2015. It has over 200 million registered users, and almost two-thirds of them use the service at least once during the month. The problem is that royalty music payments are so high, and the advertising between songs is so low, that there is not a self-evident way to deliver strong earnings growth. In fact, that’s why the company is still losing money. And advertising rates tumble at a rate far in excess to any potential tumble in music royalty demands from premier musicians during economic recessions, making Pandora particularly risky in the event that we see another 2009.

When I look through the fund, the only thing I’d ever consider as part of a long-term portfolio is the former Google: Alphabet Inc. (GOOG). But it is currently valued at $500 billion for a P/E ratio of 33. That needs to come down to hailing distance of 20x earnings before it makes sense for a disciplined investor to add it to the portfolio.

Buying those companies in the social media index, which is currently fashionable on Wall Street, is exactly how you go about participating in a stock market bubble and lose a large chunk of your investment money. The signs are all there: a poor earnings growth model that is not impressive right now but actually runs the risk of substantial declines during troubled times, ongoing share dilution on a regular basis, operations in an industry with a low barrier to entry, and obscene valuations that are in no way tied to fundamentals. I suspect we will eventually see a study in retrospect on the poor performance of companies that used the term “social media” in its business model description during the 2010s. Does anyone out there actually think their retirement in the 2040s will be funded by LinkedIn dividends?


Originally posted 2015-10-30 18:17:48.

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