SHARES

Should I buy shares in social media companies?

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Even if you don't use social media, you're probably aware of its popularity with users and investors alike. Facebook has over 1.5 billion active users while WhatsApp, owned by Facebook, has 900 million. Even smaller niche sites such as Pinterest and LinkedIn have 100 million users. Surely a sector like this has lots of potential for investors?

Silicon Valley clearly thinks so. After dining out on the raging success of Google, Amazon and Netflix, cashed-up venture capitalists and wealthy private investors threw their cash at the social media sector, and are still doing so.

There are three reasons why you should not follow in their footsteps. First, the bets by the smart money were placed years ago. Facebook listed in 2012, Twitter in 2013 and LinkedIn in 2011. That was the point when some of their money was taken off the table, right at the time when ordinary investors were being asked to lay their bets. Since then, it's been a rather unpleasant ride for Twitter and LinkedIn investors but a good one for Facebook's.

social-media-stocks

This history hints at the second reason to avoid the sector. At the time of their IPOs, none of these stocks had been around for very long. Each had a business model that was unproven. That made these companies a bigger gamble than more mundane ASX-listed businesses such as Woolworths and Scentre Group. Their ubiquity among users makes them seem safer than they are to investors.

In the past few years Facebook has refined its model and appears to be well on the way to monetising the huge traffic it generates. Twitter and, to a lesser extent , LinkedIn are struggling. Although Facebook's success might appear to be a predictable outcome, back in 2012 it was anything but. Investors were taking a punt on a genuine, sustainable business model emerging. One managed the transition. Two others remain challenged.

The third reason is wrapped up in the second. Now that some predictability has taken hold in Facebook's revenue model, investors are being charged the earth for a piece of the action. Facebook's price-earnings ratio (PER) is over 80, four times that of a good Australian growth stock like GBST, which trades on a forward PER of less than 20. Even a promising company like Facebook needs to grow exceptionally fast to justify that kind of valuation.

As for LinkedIn and Twitter, neither is making money, and they're struggling to establish a revenue model that gets close to justifying the massive market capitalisations ascribed to them. Both may yet emerge victorious but there's no way of avoiding the obvious: investors in these stocks are taking a huge punt that they'll be the next Facebook and not the next MySpace.

Indeed, there's a question mark over whether Twitter can ever become profitable. Whereas Facebook is more pervasive, collects more data, has more regular users and can twiddle more knobs to deliver high-quality advertising, Twitter's character limit makes it ill-suited to advertising. Perhaps the best outcome would be an acquisition by another social media company, although hoping for a takeover is never a good reason to invest.

This difference makes clear the nuances within the space. Many markets operate on a winner-takes-all basis, or perhaps two winners. Social media isn't like that. The network effects of a huge user base work exceedingly well for Facebook but don't exclude sites like LinkedIn from carving out a niche. And there remains the ever-present threat of another social media platform coming from nowhere and destroying the joint, much as Facebook did to Friendster.

With expensive price tags, unproven business models and the risk of being quickly superseded, how can investors make money from the social media boom? Facebook looks the best placed but it's still way too expensive for us. There is, however, another way to play it, via an ASX-listed company as it happens.

iSentia grew out of a business called Media Monitors but also trawls through what the social media companies call their firehose - a feed of all the messages and files exchanged through their respective sites. iSentia then aggregates this content and sells it back to companies that want to find out what people are saying about them.

This is a high-quality business with excellent financial performance and a huge market share in an industry that adds a lot of value. In terms of business quality, it beats the social media businesses hands down. It's cheaper, too, although we'd need to see it firmly below $3 before we added it to our buy list. One for the watch list for sure.

This is often the best way of playing a trend: to buy stock in a business that services the sector rather than actively competes in it. If you think of selling shovels to miners rather than buying the gold they find, you're on the right track.

Disclosure: Staff members of Intelligent Investor may own securities mentioned in this article.

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John Addis is an editor at Intelligent Investor (under AFSL 282288), owned by InvestSMART Group Limited. John founded Intelligent Investor in 1998 and is the editor-in-chief of InvestSMART, where he gets to indulge his favourite interests: the shape and form of words; investing psychology; the odd, fascinating and frustrating world of macroeconomics; and great stock opportunities. To unlock Intelligent Investor stock research and buy recommendations, take out a 15-day free membership.
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