reasoned thought for an age of uncertainty
These past couple of weeks have been exciting for the economy, with social networking tech companies bursting onto the public stage. LinkedIn broke news of an IPO this year, speculation was all a-tweet about a Twitter public offering, and investors are fretting over the Holy Grail of social networking: Facebook, which has been arranging to sell a $1.5 billion piece of its business to Goldman Sachs for distribution to their private equity clients. In addition, unemployment figures are down (ok, but so are jobs…), the stock market is up, and Wall Street is happily rubbing its fingers together in anticipation of a long overdue good year.
A peek at the list of top internet sites shows why Wall Street is so giddy about social networking: the list is dominated by websites that connect pools of information to users, like Google, Facebook, Amazon. As the web continues its transition to its upgraded Version 3.0, users themselves have become pools of information, and it is websites like Facebook, LinkedIn, and Twitter which are connecting these user pools to the rest of the digitized world. In short, the web is getting smarter, and it knows better than ever what you want. While sites like Google provide the freeways of internet commerce, it is Facebook and LinkedIn that make the cars we drive on those freeways. So the bright news is that companies like Facebook truly are adding real value to the economy and developing something new.
The down side is that while investors have woken up to the fact that social networking has taken the business world by storm, most people have little idea how these companies make money, which means that the value of social networking giants will be left up to “the market.” But can Wall Street price social networking companies accurately? The answer, it seems, is a resounding NO, for two reasons. First, Wall Street is bad at pricing anything with an intangible value. While an apple can be eaten and a car broken down into parts and sold, social networking is a far less quantifiable innovation. Just as in the first tech bubble and the mortgage securitization crisis, we have a product whose value is very difficult to measure, and which few people fully understand. This means that the value of stock in social networking companies will be driven by investment demand, NOT the projected value-added of social networking services. (In fact, the FT is already quoting the skyrocketing “implied value” of Facebook and Twitter).
So that brings on the second reason: if Wall Street quants do not check market forces, price will be driven by behavioral factors. As discussed in my previous post, the makeup of American society has changed dramatically over the past 30 years so that income is increasingly concentrated in the hands of the wealthiest earners. In order to hold onto this income,these high-earners must reinvest their income. As a result, our economy has a massive pool of investment demand waiting to pour into investment opportunities. This investment is necessary for both wealth retention (by the top earners) and wealth distribution (to hungry capitalists), which means that everybody has an incentive to believe that the more they buy and sell stock, the better off they will be. So, now enter Facebook with its shiny new social networking credentials.
But wait! you may say, is it not the job of Wall Street to value these companies correctly and to fix inaccuracies in value? Ok, nobody actually says that anymore. Wall Street, of course, makes a lot of money from investment products, so they have a conflict of interest and are very bad at valuing their own products. Basically, they just want to be at the center of the party, and if the drinks (stocks) are over-priced, they don’t care, because they’ll be the first ones to cash out when everybody sobers up. So as soon as a legitimate investment opportunity rears its head, Wall Street grabs the reigns, the money comes pouring in, and there is no telling when we’ll stop.
Here’s the bottom line: Goldman Sachs has already invested $450 million for private equity in Facebook, which it plans to turn around to sell to its premium investors. This is the cream off the top of the social network bubble. Unfortunately, because Goldman has been skirting SEC disclosure rules, their private offering won’t be available in the U.S.,which means that the cream off the top of your Facebook account will be shipped overseas (a scary thought, given China’s information security). Eventually, Goldman and Facebook will arrange an IPO to sell more stock in the company. As part of the transaction, Goldman will have a greenshoe option to take a bit more of that cream for itself at rock bottom prices. When the stock goes public, institutional investors will take a little more off the top, and by the time regular investors can get at it, they will be buying at way above the IPO price. Then the game begins as market forces drive the prices up and up, until that fatal day when people realize that Facebook cannot generate the kind of returns so many investors demand. The only question is, who will be the one holding the cup when everyone realizes what they thought was a frothy cappuccino is really a grainy Turkish coffee. Just hope you don’t get stuck with the grains.