Facebook: Like The Sustainable Competitive Advantage and Growth Potential

The Thesis

Facebook offers advertisers an unrivaled combination of reach and ability to target specific audiences. This, combined with the powerful network effect and barriers to entry created by the company’s enormous base of almost 1.8bn users, give Facebook a sustainable competitive advantage over both existing and new social networks. Facebook’s competitive advantage, along with the company’s strong track-record of delivering on user monetization without compromising experience, gives me confidence that Facebook will continue to produce strong earnings growth far into the future. In my view, Facebook shares are a solid investment for risk-tolerant long-term investors, and I’ve used the recent sell-off as an opportunity to pick up shares of my own.

Even though advertising revenue growth based on ad load will be less of a driver of growth post mid-2017, FB is still a relatively new medium for advertising, so there is plenty of room for growth far into the future as more advertisers flock to the platform, spend a greater portion of their advertising budget on Facebook ads, and as Facebook continues to improve its ability to measure advertising effectiveness and its ability to target the right audience with the right ads. Additionally, continued growth in users and user engagement, in addition to efforts to further monetize core FB’s massive user base and users of Messenger, What’s App, and Instagram, should all contribute to strong future growth.

Valuations may appear rich on the surface with Facebook’s current share price at a TTM non-GAAP Price-to Earnings (P/E) multiple of 33.3x.  However, the company’s non-GAAP forward P/E multiple of 2017 earnings of 23.1x looks very reasonable compared to LinkedIn (41x) an Twitter (30x), especially once you consider Facebook’s sustainable competitive advantage and growth prospects relative to its peers.

How Facebook Makes Money

Facebook is a social media application that allows users to connect, share, discover, and communicate across the globe. Revenue is generated almost entirely from advertising, which accounted for 97% of revenue in the last twelve months (LTM) period.  Of FB’s advertising revenue, 83% came from mobile advertisements while 13% came from desktop.

facebook-total-revenue-and-advertising-revenue

Advertisements on Facebook are placed in either a user’s news feed or as a banner ad on the side of the page.   Marketers pay for Facebook ads either directly through Facebook or through advertising agencies.   To place an ad, marketers determine the budget they’re willing to spend for a given period, and they must also distinguish how they will pay or the ad.   Ads can be paid for based on the number of clicks on an ad or cost per click (CPC), the number of actions taken by users (cost per action or CPA), such as a mobile app install, or the number of impressions delivered (cost per impression or CPM).  For example, a CPM of $5.00 indicates that an advertiser paid $5.00 for each 1,000 users that saw their ad. 

Once a marketer submits a bid for how much they’re willing to pay based on CPC, CPA, or CPM, ads will be placed based on an auction process.  Assuming two advertisers are trying to reach the same customer, Facebook will place the ads giving priority to whoever placed a higher bid.   The amount an advertiser eventually pays, based on CPC, CPA, or CPM, won’t be the amount they initially bid, it will be the minimum amount possible to win the bid and have their advertisements placed.  The initial bid just indicates the max amount a marketer is willing to pay.  The actual cost paid will depend on several factors such as the quality of the ad, as determined by the interactions or engagement with the ad, the audience a marketer wants to reach and how many advertisers want to reach similar users,  the time of year,  and others.

Because of this auction process, there are numerous factors that drive Facebook advertising revenue.   For example, increasing user engagement drives ad revenue growth.  For September 2016, Facebook grew mobile daily active users (mobile MAUs) by 22% year over year (YOY).  More users accessing Facebook on a daily basis will drive more advertisement impressions and therefore more ad revenue.  Also, the more users click on ads, the more revenue FB will generate.  

facbook-mobile-daily-active-user-growth

Pricing is also a growth driver.   More advertisers on Facebook mean greater competition and demand for ad space and therefore higher prices.  In 3Q16, price per ad increased by 6% YOY.  While pricing has been a more modest driver of advertising revenue growth recently, compared to other growth drivers, in my view, pricing is likely to be a tailwind far into the future.  Social media is still in its relative infancy compared to other advertising methods.  As such, many businesses may be reluctant to devote time and resources that are appropriate given the opportunity offered by social media advertising.  Advertising on TV and search advertising have simply been around longer.  This means companies generally experience less friction when advertising on these mediums, and there’s more certainty about the results they’re likely to achieve.  As a result, I believe that Facebook has a significant opportunity to both drive more advertisers to its platform and capture a larger portion of advertising budgets.  On its 3Q16 conference call, Facebook disclosed that it had over 4 million active advertisers on FB and over 500,000 on Instagram.  In contrast, there are over 60 million businesses using Facebook pages and over 1.5 million Instagram business profiles, suggesting lots of opportunity for Facebook to drive more advertisers onto its platform. 

facebook-price-per-ad

While advertising on Facebook is still relatively new, the company’s fast-growing advertising revenues indicate that marketers are quickly learning the value offered by advertising on Facebook. This value is derived from the combination of reach and advanced targeting capabilities that are completely unique to Facebook.  The company has a vast trove of data about the demographics, likes, and dislikes of its users its nearly 1.8bn users that just can’t be found anywhere else.  For example, there’s simply no other form of advertising that would allow a marketer to specifically target college educated females in the state of Florida that like paddle-boarding.  This unique targeting capability allows advertisers to reach the people interested in their products at a lower cost.  

As a result, advertising on Facebook is delivering strong returns for marketers.  In 2012, Facebook disclosed the results of an independent analysis of more than 60 ad campaigns (45 of which were competed the 1st half of the year, away from the holiday season).  The analysis showed that 70% of campaigns delivered a return on ad spending of 3x or better, while 49% delivered returns of 5x or better. These results are certainly dated.  Back then, social advertising, which shows up in a user’s news feed, was just ramping up, and social advertising has shown the ability to deliver even better returns.  Recently, Facebook has cited a 6.4x return on advertising spend for Lowes, a 9.7x return for Garmin, and 6.4x return for Shutterfly.

Thus, I believe that strong returns will continue to drive many more advertisers to the platform, in addition to driving advertisers to spend a greater proportion of their advertising budgets on Facebook, particularly as the company continues to make improvements to the process and as marketers become more educated about advertising on Facebook.

User growth is yet another driver of ad revenue.  More people on Facebook means more impressions, clicks, and actions.    Facebook continues to grow users at a healthy pace as the company experienced 16% YOY growth in monthly active users (MAUs) in 3Q16.  In particular, user growth is being driven by the Asia-Pac region and the Rest of World (ROW).  More users connecting to the internet and the expanding middle class in emerging markets should help contribute to Facebook user growth for years to come.

facebook-monthly-active-user-growth-yoy

Lastly, Facebook can influence the number of ad impressions by increasing the number of advertisements that show up in the news feed.  Ad Load has been a significant driver of ad revenue growth, but Facebook expects it to become a less meaningful contributor after mid-2017.  We note that ad impressions, post mid-2017, should still continue to benefit from growth in users and user engagement.

ad-impression-yoy-growth

Facebook’s User Base Creates a Sustainable Competitive Advantage

Facebook dominates the global social media landscape.  The company’s almost 1.8bn monthly active users give it nearly 100% more users than the next closest non-Facebook owned social media platform, QQ, a messaging service operated out of China, where Facebook is banned.  What’s more, the company has over 4.5x the number of users as Twitter, probably the most comparable social network with a global footprint.  In the US, the most important advertising market, Facebook has over 2x the number of users of Twitter.

social-media-network-active-users

Facebook’s enormous user base creates a powerful network effect that makes it so there is very little incentive to join other social networks that provide a similar user experience and functionality.   As such, Facebook benefits from significant barriers to entry for new social networks and a strong competitive advantage that can help it compete more effectively with other existing social networks. 

These barriers to entry are probably best illustrated by the failure of Google Plus.  Even the mighty Google, who benefitted from its own massive user base for its core search application, which few other potential competitors have, couldn’t build a viable competitor to Facebook.  While there were some minor differences between the two networks, the core experience was virtually the same.  For potential users, there was just no incentive to switch from Facebook or spend significant time on Google Plus, because Facebook’s massive user base, along with its extensive features and functionality, lead to a better social experience.

network

This isn’t to say that there isn’t any room at all for other social networks.  In certain cases, other social networks have a structure and functionality that leads to a social experience that’s different from what Facebook provides. Networks such as such as Twitter, Instagram, and Snapchat have been able to achieve significant user growth by focusing on a niche social experience that differs from Facebook. The problem for competitors, especially any competitor with the hopes of completely displacing Facebook as the largest social network, is that Facebook’s vast user base gives it the ability to respond and offer a social experience similar to the niche experience it provides, in addition to the experience provided by all of the other features on Facebook.

For example, many users of Twitter use it for receiving the latest breaking news from celebrities, public figures, and organizations.  The core functionality of Twitter has always been that any user can follow any other person and receive their posts or “Tweets”.  This, along with Twitter’s rule that “Tweets” must be 140 characters or less and Twitter’s prioritization of the latest content, helped to facilitate a user experience geared to the consumption of the latest news and the sharing of content between celebrities and their fan-bases.  By contrast, Facebook’s core functionality started as more of a two-way interaction, where you both share and receive content from other users, usually close friends and relatives, after one user sent a friend request and the other accepted it.  Initially, Facebook users had no way of receiving posts or information from people such as celebrities, athletes, public figures etc, unless the celebrity accepted a friend request. As such, Facebook wasn’t particularly suited to provide users with a social experience geared toward the consumption of the latest news and Twitter stepped in to fill the niche. 

Then, starting in Sept 2011, Facebook began offering the ability to subscribe to users, which allowed users to follow and receive updates from celebrities or others users who weren’t friends.  However, by this point, Twitter was already a fast-growing social network with over 100 million users where it was already common for celebrities to share and interact with their fan bases.  Despite Facebook having largely the same capabilities by that point, a user who wanted to receive the latest updates from his/her favorite celebrities was likely to get a much better experience on Twitter.  Twitter had reached a critical mass that’s allowed it to continue its growth and remain, for many, the preferred destination for the niche social experience it offers.  This illustrates the power of social networks.  Once a critical mass is reached, it’s extremely difficult for a competitor to displace a social network that provides a certain social experience.

Still, a Twitter like experience is now much more common on Facebook than it used to be.  Frequently, organizations, even celebrities, share news and thoughts with their friends and followers on Facebook. Certainly, many people use Facebook to consume the latest news, such as the recent election. In my view, this is at least partly why, despite its much smaller size, Twitter growth has slowed with 3Q16 monthly active user growth coming in at only 3% versus 16% at the older and larger Facebook. 

With Facebook able to respond to any new, fast-growing social media trend, in my view, it’s nearly impossible that any new network could build a user base large enough to rival Facebook’s and therefore challenge Facebook as the primary social media destination.  Once a social media platform begins to gain a significant number of users by providing a niche social experience that’s different from Facebook, Facebook will just respond and offer its users a similar experience, thus curtailing the competing network’s growth before it ever reaches a size that might allow it to displace Facebook.  Facebook has shown that’s its able to respond to threats by either building out new functionality organically, such as with its updates that have made it more of a destination for news consumption, or it could simply buy the competing social network as it did with Instagram and What’s App. 

social-apps-phone

The case of SnapChat illustrates this strategy of Facebook. Snapchat originally allowed users to share images that were short-lived and self-deleting, but it quickly evolved to also allow users to share short video messages that were self-deleting.  After this functionality was introduced, Snapchat began to grow rapidly, and this caught the attention of Facebook, who made a $3bn bid for Snapchat in late 2013, which Snapchat ultimately rejected.  Since then, Facebook has responded to the Snapchat threat by adding several video features to its properties, including Autoplay Videos on core Facebook, Instant Video on Messenger, and Live on core Facebook.  True, Snapchat has continued to experience strong growth since Facebook’s introduction of its own video features.  However, I’d argue that the max amount of users Snapchat is able to garner will be limited by the number of users looking for the niche video experience that Snapchat provides, given that Facebook now offers many ways to share videos. 

One problem with Facebook is that it has occasionally resulted in negative outcomes for users that have shared risqué or controversial content.  In other cases, it’s lead to embarrassing moments when a family member views content that the user would have preferred they didn’t see. The lasting nature of Facebook content, along with the fact that almost everyone you know is on Facebook, means that posts will be available for many eyes to see.

By contrast, Snapchat “Snaps” disappear quickly and the application makes it very simple to limit your sharing to only the audience whom you want to view your “Snap”.  This limits the potential consequences of sharing on Snapchat and allows users to be more open and free to express themselves.  While free and open expression should certainly be valuable to a user of any age, I’d argue that it’s particularly important to younger generations as younger generations are likely to spend a greater proportion of their time, for lack of a better term, “getting into trouble”, or participating in activities they’re likely to want to hide from larger audiences.  As a result, Snapchat tends to be particularly popular with younger demographics.

The chart below shows Snapchat users by age demographic.  The chart indicates that about 60% of users are of age 24 or below while only 14% of users are over the age 35 or older.  Thus, I’d argue that, at its core, Snapchat is an application whose niche is allowing younger demographics to share more private content.  It’s my opinion that, as Snapchat users age, this niche social experience will likely become less important to them, which will result in Facebook becoming their primary platform for sharing their video content.  Certainly, adults also generate content for which they’d like to restrict the audience. So, perhaps many will continue to use both, with one platform used to share more private content with a more select audience and the other used for sharing with a larger audience.  But, because Facebook has the largest user base with many of these users already sharing video content, I see it as being able to provide an overall better social experience for sharing video content, for the majority of video content produced by users, simply because it provides the opportunity for more social experiences than any other platform.  Therefore, I find it highly unlikely that any other platform could displace Facebook as the primary destination for video sharing. 

snapchat-age-demographics

Valuation:  Attractive Versus Peers

Facebook trades at a non-GAAP TTM P/E ratio of 33.x, which may appear like a lofty valuation at a surface level, but considering the company’s growth prospects relative to peers and its sustainable competitive advantage, FB looks like a solid value, in my view.  Consensus expectations have 2017 non-GAAP EPS at $5.21/share for FB, up 27% YOY from the 2016 non-GAAP EPS estimate of $4.09/share.  Based on the 2017 consensus EPS estimate, FB currently trades at a forward P/E multiple of just 23.1x 2017 expected EPS. By comparison, LinkedIn has a 2017 forward P/E of 41.2x (based on MSFT’s takeout price at $196/share), above FB despite lower expected growth at LinkedIn, with consensus estimates predicting Linkedin’s 2017 non-GAAP EPS to improve 12% YOY. Similarly, Twitter is currently trading rich to FB at 30x 2017 expected EPS with estimates currently predicting 2017 non-GAAP EPS growth of 17% for Twitter.

Other valuations measure also suggest that FB offers strong relative value compared with LinkedIn and Twitter. For example, Facebook’s enterprise value (EV) per monthly active user stands at $196.6 compared with $228.9 for LinkedIn.  Although, we note that using LinkedIn’s Enterprise value based on MSFT’s takeout price may slightly overstate LNKD’s EV per monthly active user given that part of LNKD’s EV is accounted for by synergies between the two firms.  After adjusting for the value of synergies, I arrive at an EV per user of $214.81, which is still above FB’s level. See note 1 below for how I arrived at this calculation.

This means that investors are paying less for each Facebook user than they are for each LinkedIn user.  In part, this is likely because Facebook derives slightly less profit from each user. For 3Q16, Facebook generated $2.59 in EBITDA (Earnings before interest, taxes, depreciation & amortization) for each monthly active user, on average.  Whereas LNKD generated $2.86 of EBITDA per monthly active user on average.  I’ll note that the discount in Facebook EV per user relative to LinkedIn’s adjusted EV per user is 92%, roughly equivalent to the proportion its $2.59 EBITDA per user equals compared to LinkedIn’s $2.86 EBITDA per use.

However, Facebook is growing the amount of cash flow it drives from each user at a faster pace, so I’d argue that Facebook should trade at a higher EV per monthly active user. For example, Facebook’s 3Q16 revenue per monthly active user increased 35% YOY to $4.01 compared with 14% YOY growth in average 3Q16 revenue per monthly active user for LinkedIn.  Further, Facebook’s 3Q16 EBITDA per monthly active user was up 46% compared with 35% growth for LinkedIn.  Additionally, Facebook is growing users at a faster pace.  In 3Q16, total Facebook monthly active users increased 16% YOY, over 2x LinkedIn’s 3Q16 user growth of 7%.

At $35.8, Twitter’s EV per monthly active user is deeply discounted relative to Facebook.  However, Twitter derives an average of just $0.58 of EBITDA from each monthly active user in a quarter vs. $2.59 for Facebook, and this amount was up just 23.1% YOY compared with FB’s 45.6% YOY growth.

us-social-media-network-compsheet-and-valuations

The fact that Facebook trades cheap to LinkedIn is particularly encouraging and gives us confidence in the value opportunity offered by Facebook shares.  This is because LinkedIn’s valuation measures are based off Microsoft’s bid. True, Microsoft has somewhat of a track-record of making poor acquisitions (Nokia), but that was a different management team and it also provides even more incentive to be cautious about the acquisitions it makes.  As a large and sophisticated technology company, Microsoft should have a very informed view about the value offered by LinkedIn, and the company’s bid indicates that they saw good value in LinkedIn, even at valuation levels that are rich compared to Facebook.

Considering that Facebook is the fastest growing (of networks discussed) and largest social network with the strongest network effect and largest barriers to entry, I’d expect the company to trade at a premium to both LinkedIn and Twitter for all of the valuation measures we’ve looked at, but Facebook carries a lower forward P/E off both 2016 and 2017 consensus earnings estimates versus equivalent comparisons for both LinkedIn and Twitter. Furthermore, these valuation discounts for Facebook exist despite Facebook’s ownership of 3 other massive user bases (Instagram, Messenger, and What’sApp).  Given Facebook’s strong track-record of figuring out how to monetize it’s user base without sacrificing user experience, we’re confident that Facebook will, within the next couple of years, begin to derive meaningful cash flows from these applications.

Facebook’s Valuation vs a Historical Comparison

In our view, it’s hard to dispute that Facebook’s shares look to offer a strong value based on current valuation measures, but it’s also important to consider how a company looks relative to historical valuations.  This is tricky for Facebook because social-networking is such a new industry.  However, in my view, there are enough similarities between Google and Facebook to make a review of Google’s historical valuation relevant for Facebook investors as both are dominant market leaders that created new markets for connecting users with advertisers.  Further, the two company’s timelines are relatively comparable as both took a few years to begin generating meaningful revenues as the companies worked through how to monetize their respective advertising opportunities, and both brought IPOs to the market about 8 years after they were founded.  Additionally, I view the two companies as having similar growth profiles.  Beginning with 2005, the year after Google’s IPO year, and ending in 2009, Google grew non-GAAP earnings at an annualized rate of 42.6% over this 4-year period.  By comparison, beginning with the year after Facebook’s IPO (2013) and ending in the year 2017, Facebook is expected to grow earnings at an annualized rate of 62%.

To compare Google’s historical valuation with Facebook, in the chart below, we look at each company’s annual GAAP P/E multiple beginning with IPO year.  Therefore, for Google, the period titled IPO represents 2004, + 1 Yr represents 2005, etc, and for Facebook, IPO represents 2012, + 1 Yr represents 2013, etc.  For Facebook, Years 4 and 5 are based on the current share price to 2016 and 2017 expected earnings, which is why the chart is labeled + 4 Yrs Est and + 5 Yrs Est for the last two periods. The chart indicates that while Facebook has, for the most part, traded at a P/E above Google for the years after its IPO, the two are beginning to converge with Facebook’s price to consensus 2017 earnings at a level that’s basically identical to Google’s P/E at the end of 2009, 5 years after its IPO.

The chart may make Facebook look slightly over-valued relative to Google’s history, but there are a few reasons why I don’t believe this is the case.  To begin with, “The Great Recession” meaningfully depressed Google’s multiple for years 4 and 5 after its IPO.  For example, at the end of 2008 (+ 4 Yrs after Google’s IPO), Google’s stock was down 57% from the end of 2007, even though Google produced meaningful EPS growth for the year of 21%.  At the end of 2009, Google’s share price was still down 12% from the end of 2007, despite 30% EPS growth for the year.

google-historical-price-to-eearnings-vs-facebook

To show what I view as a more relevant comparison to Facebook, we’ve included an adjusted P/E for Google (dashed red line), based on Google’s share price at the end of 2007.  Once we include this adjustment, Facebook’s current forward P/E multiples for both 2016 (+ 4 Yrs post IPO) and 2017 (+ 5 Yrs) are below what Google’s comparable adjusted P/E multiples were. For example, Google’s adjusted 2004 (+4 Yrs) P/E multiple comes out to 44x, materially above Facebook’s comparable 2016 (+4 yrs Est) forward P/E of 36x. Facebook has a track-record of beating analyst estimates, so there’s a strong chance that’s its actual multiple comes in even lower!

Furthermore, Facebook had to deal with a major shift in its business model that began right around the time of its IPO.  Beginning in the 2011-2012 timeframe, Facebook users began shifting en masse from desktop to mobile, causing Facebook to have to rework its monetization model.  This unquestionably held down earnings and drove a higher multiple for Facebook.  Now that Facebook has had a few years to figure out mobile monetization (3Q16 mobile ad revenues were 84% of total ad revenue), multiples between the two companies have converged. Considering all of this, in my view, Facebook’s valuation appears very reasonable relative to Google’s history.


Notes:

1.) LinkedIn’s enterprise value of $24.4bn, based on MSFT’s bid of $196/share, partially reflects the value of synergies between the two companies.  Therefore, in order to make the enterprise value per user metric more comparable between FB and LNKD, it makes sense to back out the value attributed to synergies from LinkedIn’s enterprise value, particularly since it’s unlikely that Facebook would ever be acquired by a strategic investor. I assume that $1.5bn out LinkednIn’s $24.4bn enterprise value is attributable to synergies.  I arrived at this number by multiplying $150mm of expected cost synergies by a multiple of 10x.  I use 10x because this level is historically a standard EV/EBITDA multiple at which tech firms are valued. Additionally, I think it makes sense to use an EV/EBITDA multiple below the 22.8x multiple implied by MSFT’s bid for LinkedIn as this multiple, in large part, reflects the expected growth in LinkedIn EBITDA.  Whereas the $150mm of cost synergies should remain more stable over time.

 

 

Boost Your Returns, Think Long-Term

For stock investors looking to prudently maximize wealth creation for retirement, it’s critically important to approach investments with the goal of generating returns over the medium and long-term.  Having a long-term mindset will help investors to avoid common pitfalls that lead to sub-par returns while helping the investor capitalize on profitable opportunities that arise in the market, and a long-term focus has the added benefit of producing lower transaction costs and tax expenses, which can have a major impact on your portfolio value over time.

Short-Term Thinking and Poor Investment Decisions

To begin with, having a long-term mindset can keep you from selling stocks at exactly the wrong time and missing out on significant gains in the market or an individual stock.   In the short-term, (we’ll define the short-term as less than 1 year, the medium-term will be 2 to 3 years, and the long term will be 3+ years), stock markets and individual stocks can rise and fall for a great number of reasons.  Sometimes big declines are justified, sometimes they aren’t.  It’s the investors job to figure out the reason for the decline and then whether they should buy, sell, or hold considering various factors such as the reason for the decline and, importantly, what has happened in the past in similar situations. However, all too frequently, investors will simply sell based on the price declines because they can’t bear the thought of losing any more value.  Investors who do this are taking a very short-term approach and it’s often a big mistake, because commonly, the biggest gains come shortly after the big declines that provoke an investor to sell.

To show that this is the case, the table below shows years when the S&P 500 price index was down big (over 10%) as well as returns over the following 1 and 3 year periods. Note that our numbers do not include dividends, which would increase the returns for each period if they were included. From 1951 through 2015, there were 11 years where the annual price return of the S&P 500 index was a loss of greater than 10%, and for 8 out of the 11 years, the annual price return over the next year period was positive. Further, the market usually increased by a sizeable amount over the next year.  The median annual return, for the year following a year with an S&P 500 price decline of greater than 10%, was 18.9%.  For the next 3 years following a 10%+ down year, the 3 year compound annual growth rate (CAGR) was positive in 10 out of 11 instances with a median of 11.5%. The CAGR or annualized growth rate represents the average annual returns for the period, including the impact of compounding.

sp-500-years-with-price-declines-greater-than-10-and-subsequent-returns

Source: Yahoo Finance

Sure, this table shows that that there were a few instances when selling after a down year could have saved you from further declines, such as for the 1 and 3 year periods following 2000 and the next year after 2001.  But, more often than not, returns bounced back over the following year and in many cases, they reversed and became substantial gains.  If substantial gains didn’t materialize over the next year following a 10%+ down year, they frequently came over the next couple of years. For example, after 1969’s 10%+ negative returns, the next 1 year return was a modest 0.1%, but the next 3 year returns were strong at 28.2% cumulative and 8.6% annualized.  The 1 and 3 year returns post 1977 were a similar story.

I’m not saying that it’s guaranteed an investor will always do well by buying more or holding on after a big sell off in stocks.  Certainly, in the future, we could have more periods like 2000 when the market’s returns remain negative over an extended period.  But, history tells us that remaining invested or buying more stocks after market sell-offs has almost always been a better strategy than panicking and selling based on market losses.

Now, obviously, in an ideal world, you would sell before enduring significant losses and then buy again near the bottom. However, timing the market like this is incredibly difficult.  Even the best professional investors struggle to correctly time the market and they’re paid handsomely to follow the markets and make investment decisions. Market sell-offs and rebounds tend to happen so suddenly, that investors will frequently sell after the worst of the losses have already occurred and buy after major gains have already been realized.

In the future, we’ll explore other strategies, which are less risky than market-timing, that will help lessen the impact of down markets while allowing the investor to benefit from stronger markets.  For now, I want readers to takeaway the point that, when faced with big losses in the market, it’s historically been a far better strategy to remain disciplined and consider where returns are most likely to go in the future, over a longer time-horizon, than simply moving out of stocks in a big way.

Another reason why  holding on to stocks or buying more after a decline has been a successful strategy is the simple fact that, historically,  stock markets generally increase in value over time, and the longer the time-period, the more likely it will be that values are higher at the end. Keeping this in mind can help you make better buy decisions and keep you from making poor sell decisions.

The charts below help to illustrate the point. The first chart shows the frequency distribution of annual % changes in the S&P 500 Index price, excluding the impact of dividends on returns.  For example, the highlighted bar in red represents the median annual % price change bucket, and it indicates that there were 6 years between 1951 and 2015 when the annual % change in the S&P 500 price was between 12.5% and 15%. We can also see from the chart that annual price declines in the S&P 500 are not uncommon, as displayed by the bars from 0% to -35%.  From 1951 through 2015, the annual price return for the S&P 500 was negative about 28% of the time.

sp-500-annual-price-return-distribution

Source: Yahoo Finance

However, the picture changes dramatically when we look at annualized returns over longer time horizons. The next chart shows the distribution of annualized return %s in the S&P 500 price index over 5, 10, and 20 year periods. For example, the highest orange bar in the middle of the chart shows that, between 1951 and 2015, there were a total of 14 20 year periods where annualized returns were between 5% and 7.5%.

While declines in the price of the S&P 500 index are still fairly common over 5 year periods, occurring 23% of the time, the occurrence of declines falls dramatically to 13% of the time over 10 year periods, and to 0% of the time over 20 year periods.  Also, it’s important to note, that for both the 5 and 10-year return distributions, price declines most frequently fell into the bucket of between 0% and -2.5%.  If reinvested dividends were included, some of these periods would likely have seen increases.

sp-500-5-10-20-year-price-return-distribution

Source: Yahoo Finance

Long-Term Opportunities in Individual Stocks

So far, we’ve focused on the stock market overall, but for individual stocks, it’s also true that a period of negative returns often provides investors with a great opportunity to pick up more shares at a more attractive valuation and price level.  It may not feel good to experience the loss of value in your account, but investors who learn to ignore the short-term pain and objectively focus on whether they should buy, sell, or hold, given factors such as the reason for the decline, historical stock performance, the current fundamentals and market’s expectations, etc will be far better off than those who panic and sell just because of declining prices.

However, decisions to buy or sell single stocks are more complicated than a decision to buy into the market overall. An investment in a single stock is far more risky than an investment in a diversified mutual fund or an ETF that tracks a broader market such as the S&P 500. Diversified investments in stocks, over time, will reflect the growth of the global economy, and historically since stock markets have been around, global GDP has always improved over time. This is why markets tend to always go up over time.  By contrast, individual stocks will  reflect the health of the company, and it’s not uncommon for companies to go away entirely.  Bankruptcies happen all the time.

This increased risk is why it’s so important to be diversified and limit the size that an investment in an individual stock represents of your overall portfolio.  But, beyond diversification, investors should compensate for this increased riskiness by  devoting more time to researching individual stocks, while keeping in mind how large the investment is relative to your overall portfolio.  For example, you should spend more time evaluating a $10,000 investment in MSFT compared to a similar sized investment in SPY, an ETF that tracks the S&P 500.

When you research individual stocks, there will definitely be times when you reach the determination that a stock’s decline has occurred due to real fundamental problems with the company.  Perhaps a new competitor has entered the market and has consistently been stealing away business or maybe suppliers are going through hard times and they’re squeezing the company on the costs of the goods or services they provide. If there are problems that are likely to have a materially negative impact on financial results and the market still isn’t adequately reflecting this in the stock’s price/valuation, then maybe the right call is to sell the stock, even if you’ve only held it for a relatively short time-frame.

We’ll have more pieces in the future that discuss how to undertake the analysis required to make these sorts of calls.  For now, I simply want to drive home the point that, for individual stocks as well as for more diversified investments, it’s critical for investors to avoid fretting over and making decisions based on short-term price performance without consideration of what’s likely to happen over a longer time-horizon, given context such as the stock and company’s history, fundamental characteristics of the investment, and the market’s current expectations.

The fact is that sometimes investments take time to produce results. Microsoft (MSFT) is one fairly extreme example. The chart below compares MSFT’s weekly stock price to the S&P 500 Index adjusted price level from mid-2001 to the current time.  Again, these are price returns only.  All returns mentioned would be higher if we included reinvested dividends, which are a major part of stock investments.

From mid-July 2001 through early June 2011, MSFT produced a total price return of -13.3%, equating to an annualized price return of -1.4%.  This underperformed the S&P 500, which produced a total price return of 5% and an annualized price return or CAGR of 0.5% over the same period. But patient MSFT investors were ultimately rewarded.  For the period from mid-July 2001 through November 21st 2016, MSFT generated a total price return of 159.1% and an annualized price return of 6.4%, compared to total and annualized price returns of 81.5% and 4%, respectively, for the S&P 500 index.

Further, investors who viewed “The Great Recession” as a buying opportunity for MSFT’s stock have done very well. From early March 2009 (the depths of “The Great Recession”) through November 21st 2016, MSFT’s stock priced has returned 387.4% in total and 22.7% annualized, which compares to a total price return of 221.7% and an annualized price return of 16.3% for the S&P 500 index.

msft-weekly-stock-price-history-vs-the-sp-500

Source: Yahoo Finance

It is certainly no easy task to pull the trigger and buy more of a stock that has seen dramatic declines, particularly when there’s tremendous uncertainty like there was during the last recession. Also, it’s unlikely that you’ll be able to buy at exactly the right time, such when MSFT reached its recessionary lows in March 2009. Still, I strongly believe that profitable decisions, like the one to buy MSFT after the declines produced by the recent financial crisis, are well within the capabilities of non-professional investors.  It takes some work, discipline, the right mind-set (such as a longer-term focus), and the right analytical tools, but I firmly believe that it’s very doable for investors to make similarly profitable investment decisions, and in future posts, my goal will be to provide the necessary tools.

We’ve shown that it’s a mistake to make investment decisions based on short-term price movements, focusing mainly on the decision to sell based on declining prices, but it also holds true that you shouldn’t make buy decisions based only on recent price gains (in fact, I’m generally always more inclined to sell after any gains).  However, indiscriminate selling due to a drop in an investment’s value seems to be a more common problem, and it’s worth understanding why because it might help you avoid making the mistake.

It’s no secret that investment losses are painful.  Any investor who’s watched their portfolio value decline has experienced this and knows it’s true.  What isn’t so obvious, is that investors generally fear losses more than they like equivalent gains.  In other words, an investor would prefer to avoid a $1,000  loss over making a $1,000 gain. Because losses are so painful, the urge to sell and stop any further pain frequently trumps any expectations about the potential for future gains. This is known as loss aversion and it was first demonstrated by Daniel Kahneman and Amos Tversky.  For investors, it’s important to be aware of this cognitive bias when making investment decisions.  It may keep you from making the wrong decision!

Higher Transaction Costs and Tax Expenses

If you’re trying to capitalize on short-term price movements in a stock, you’ll be required to buy and sell more frequently than an investor who buys a stock with the intent to hold it over the medium to long -term unless there are changes that materially alter your view about the return potential of the stock (we’ll go into more detail about what can drive the decision to sell an investment in future posts). The less frequent transactions generated by long-term investors will lead to lower commission costs. While the commissions paid to a broker may appear small, they can add up quickly, and after accounting for the impact of compounding, they can have a meaningful impact on the value of your portfolio over time. Consider two investors, one that makes 10 trades over the course of a year and one that makes 100, with each trade costings $7.95.  Due to the impact of compounding, over 30 years, the commission costs from that year alone will reduce the more frequent trader’s portfolio value by over $12,000 compared to the less frequent trader, assuming 10% annual returns (the approximate long-term average for the S&P 500, including reinvested dividends). That’s a big difference and we’re only considering the costs from one year.

Further, if you buy a stock and sell within a year, the capital gains will be taxed as ordinary income.  By contrast, you’re likely to pay a much lower rate on long-term capital gains. For example, investors who fall in the highest income tax bracket will be taxed on long-term capital gains at 20%. Similar to transaction costs, tax expenses can add up over time and have a significant impact, particularly when you consider the effects of compounding.