AAII Investor Update: Is Facebook an Investment or a Trade?

Should you buy Facebook (FB) or avoid it? The answer depends on whether you are looking to speculate or invest.

Benjamin Graham defined speculation in his classic book “The Intelligent Investor” as primarily “anticipating and profiting from market fluctuations.” Conversely, he defined investing as “acquiring and holding suitable securities at suitable prices.” Notice the final two words used to describe investing: “suitable prices.” When it comes to investing, valuation matters—always.

If the name of the company and the fact that it is involved in social media were hidden, Facebook’s initial public offering would be completed at a far lower price than the $38 per share price assigned to it tonight. (The offering equates to a market capitalization of $104 billion.) The CEO is very young, has no experience running a publicly traded company, and has the final say over all decisions—including who gets elected to the board of directors. His short stint as CEO has been marred by various lawsuits and customer complaints. Customers are switching to mobile devices, a platform that the company has yet to figure out how to monetize. The company’s product continues to be blocked by the Chinese government. An article in yesterday’s issue of The Wall Street Journal reported that General Motors (GM), the third-largest advertiser in the U.S., has concluded that ads running on Facebook’s website have no influence on customers’ buying decisions. Finally, the majority of the proceeds from the offering will not go to the company, but rather to insiders seeking to profit from their pre-IPO investments.

Yet this is Facebook, the 800-pound gorilla of social media. Due to this very factor, enthusiasm for the offering is extremely high—so high that the stock could easily fetch a price-earnings ratio of 100 or more once its shares start trading publicly tomorrow. This valuation, by any measure, is excessive.

An excessive valuation means high risk, but, over the short term, it does not always equate to a falling stock price. Quite the opposite; a hot potato stock can continue to rise in price as greed overtakes thoughtful analysis. As John Maynard Keynes is attributed as saying, “The market can stay irrational longer than you can stay solvent.”

This brings us back to the key difference between an investment and a speculative trade. An investment is a commitment to holding reasonably priced securities as long as their underlying fundamentals and business models remain attractive. A speculative trade is a short-term position designed to take advantage of expected price movements. A planned long-term investment can turn into a short-term trade if the price unexpectedly jumps, but a short-term trade should never turn into a long-term investment.

If, despite its risks, you are interested in acquiring shares of Facebook, treat it as a speculative trade. And keep in mind that Graham pointed to three top cases in which speculation can be “unintelligent”:

1. Speculating when you think you are investing;


2. Speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and


3. Risking more money in speculation than you can afford to lose.

Model Portfolios Updated on AAII.com

Want to be notified directly about updates to the Model Portfolios? Sign up for the new AAII Model Portfolio Update email.

There were no new transactions in the model portfolios.

After starting the year strong with three months of gains, the market pulled back during April. Generally, smaller-cap stocks underperformed larger-cap stocks. Although this was the case, the Model Shadow Stock Portfolio still managed gains.

Last month, the Model Shadow Stock Portfolio gained 0.8%. The portfolio outperformed both the Vanguard Small Cap fund (NAESX), which lost 0.9%, and the DFA US Micro Cap fund (DFSCX), which lost 1.4%. For the year, the Shadow Stock Portfolio is now up 20.0%, outpacing the 11.9% gain achieved by the Vanguard Small Cap fund and the 10.7% gained by the DFA US Micro Cap fund.

The Model Mutual Fund Portfolio lost 0.7% in April. This compares to the Vanguard Total Stock Market fund (VTSMX), which also lost 0.7%. For the year, the Model Mutual Fund Portfolio is up 9.3%, while the Vanguard Total Stock Market fund is up 12.2%.

The Model ETF Portfolio lost 0.9%. The 80% SPDR S&P 500 ETF (SPY) and 20% iShares MSCI EAFE Index ETF (EFA) comparison index also lost 0.9%. The Model ETF Portfolio is up 9.9% year-to-date, while its comparison index is up 11.2%.

See the AAII model portfolios.

More on AAII.com

Value Investing: A Look at the Benjamin Graham Approach – This 1996 AAII Journal article explains the criteria Graham suggested using to determine if a stock is trading at a suitable price. (The article is in PDF format.)

How to Set and Revise Realistic Price Targets for Your Stocks – A key part of valuation analysis is determining the likelihood that someone would pay a higher price for the stock in the future. This article gives guidance on how to set a price target.

Is Facebook’s Valuation Too High? – I originally asked this question in January. Given tomorrow’s IPO, I’m going to ask for your opinion again. Tell us what you think on the AAII.com Discussion Boards.

Don’t forget to take the Sentiment Survey.

The Week Ahead

Approximately 15 members of the S&P 500 will report quarterly results next week as first-quarter earnings season winds down. Included in this group will be Dow component Hewlett-Packard (HPQ), which will report on Wednesday.

The first economic report of note will be April existing home sales, published on Tuesday. Wednesday will feature April new home sales. April durable goods orders will be published on Thursday. Friday will feature the University of Michigan’s final May consumer confidence survey.

Two Federal Reserve officials are scheduled to make public appearances next week. Atlanta President Dennis Lockhart will speak on Tuesday and Minneapolis President Naryana Kocherlakota will speak on Wednesday.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

AAII Sentiment Survey

Bullish sentiment is near a two-year low in the latest AAII Sentiment Survey, while bearish sentiment has spiked by 17.5 percentage points over the past two weeks.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 1.8 percentage points to 23.6%. This is the lowest level of optimism recorded in the survey since August 26, 2010. This is also the seventh consecutive week that bearish sentiment has been below its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 2.1 percentage points to 30.4%. This is the just the second time in the past eight weeks that neutral sentiment has been below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 3.9 percentage points to 46.0%. This is the highest level of pessimism recorded by the survey since September 29, 2011. This is also the sixth consecutive week that bearish sentiment has been above its historical average of 30%.

The difference between bullish and bearish sentiment, the bull-bear spread, widened to -22.4 points. This is the most negative the bull-bear spread has been since September 22, 2011.

Bullish sentiment is unusually low, but it would have to fall below 18% to be considered extraordinarily low (two standard deviations below average). Similarly, bearish sentiment above 50% or a bull-bear spread below -29 points would be more correlated with market reversals. Last year, bearish sentiment topped 46% three times during August and September.

The two-week decline in stock prices, renewed uncertainty about Europe, and signs of slower U.S. economic growth have combined to fray the nerves of individual investors. The 17.5 percentage point rise in bearish sentiment over the past two weeks shows that many investors are second-guessing their prior short-term outlooks.

This week’s special question asked AAII members if they are concerned that a repeat of last year’s market correction could occur this summer. The overwhelming majority of respondents said that yes, they are concerned that a correction will occur. Most of them cited Europe as the primary problem. The minority of respondents who were not concerned either thought that the negative headlines were mostly priced in or are planning to buy stocks on any summer decline.

Here is a sampling of the responses:

• “I feel like the issues in Greece, France and Spain are going to cause an economic downturn here in the United States.”
• “Yes, my primary concern is Europe and its unsettling influence on the U.S. markets.”
• “Yes, I’m concerned because of the European banking crisis, particularly Spain and the possibility of a Greek default.”
• “I’m concerned about it, but I think there’s good a chance that the market is recovering, albeit with a bumpy ride.”
• “No, I’m not concerned because if it does recur like last year, August—September could become a likely timeframe to buy into stocks.”

» Take the sentiment survey