For the past nine years, Ultimate Stock-Pickers’ primary goal has been to uncover investment ideas Morningstar equity analysts and 26 top US equity fund managers find attractive, in a manner timely enough for investors to gain some value.
When looking over trading activity during the third quarter and October of 2018, we find that those 26 funds continued to have more selling conviction than purchasing conviction. This could be indicative that money is flowing from active products to passive products, rather than being indicative of any widespread bearish sentiment.
We highlight that the Sequoia Fund made a conviction purchase into wide-moat rated Facebook (FB), the world's largest social network, that our research indicates is materially undervalued.
Taking a closer look at the high-conviction buying that we uncovered during the most recent period, there was little overlap with the same list last quarter. The only name appearing on both this list and last quarter's list is wide-moat Facebook.
The conviction purchase by the Sequoia Fund and non-conviction purchases by Diamond Hill Large Cap, Oppenheimer Global, and Markel Corporation allowed this stock to remain on our top 10 conviction purchases list. Facebook was one of the worst performers for several of these funds, but a few of these funds actively defended their holding. Diamond Hill Large noted:
Shares of social media company Facebook declined as the company provided a downside outlook for the second half of 2018 and guided for declines in operating margins as it invests heavily in improving security and privacy on its social-media and messaging platforms. Facebook is trading at a discount to our estimate of intrinsic value, and we expect the company to retain its attractive network economics and manage user privacy concerns well without impairing the value of the business over the long term.
Oppenheimer Global also defended its position in Facebook by stating:
Facebook Inc. has been weak this year, after the Cambridge Analytica controversy in the spring and lowered guidance following its Q2 earnings report. Despite this, we find appeal in the shares and see no reason to alter our thinking about its long-term potential. The shares are now very cheap. Some clarity about the durability of its business model will likely be seen in coming earnings releases, and we expect the share price will likely respond accordingly.
What the Analysts Say
Morningstar analyst Ali Mogharabi maintains that the shares of the wide-moat, high-uncertainty name have been oversold, with the company's shares now trading at a material 24% discount to his fair value estimate of $186. The investment argument is that Facebook's sustainable network effects remain intact and that advertisers will continue to pay for access to Facebook's users.
Mogharabi argues that Facebook has built sustainable economic advantages as the largest social network in the world, with more than two billion monthly active users. The growth in users and user engagement, along with the valuable data that they generate, makes Facebook attractive to advertisers in the short and long term. The combination of these valuable assets and expected continuing growth in online advertising bode well for Facebook, as the firm generates strong top-line growth and remains cash flow positive and profitable.
Mogharabi contends that the company’s offerings, consisting mainly of Facebook, Instagram, Messenger, and WhatsApp, have generated network effects for the firm, where all of these platforms become more valuable to its users as people both join the networks and use these services.
These network effects serve to both create barriers to success for new social-network upstarts, as well as barriers to exit for existing users who might leave behind friends, contacts, pictures, memories, and more by departing to alternative platforms. Beyond network effects, Mogharabi also believes that Facebook has developed additional intangible assets.
Unlike any other online platform in the world, Facebook has accumulated data about each individual with a Facebook and/or an Instagram account. Facebook has its users’ demographic information. It knows what and who they like and dislike. It knows what topics and/or news events are of interest to them. In addition, without the need for cookies enabled on desktop or mobile browsers, and based on the Facebook Login, the firm knows its users’ browsing history on many non-Facebook sites or apps.
With access to such data and to billions of photos and videos uploaded by its users, Facebook continues to enhance the social network by offering even more relevant content to its users. This virtuous cycle further increases the value of its data asset, which only Facebook and its advertising partners can monetise. Mogharabi's thesis posits that Facebook will continue to benefit from an increased allocation of marketing and advertising dollars toward online advertising, more specifically mobile and social-network ads where Facebook is especially well positioned.
Mogharabi supports this thesis through the facts that Facebook app, along with Instagram, Messenger, and WhatsApp, are among the world’s most widely used apps on both Android and iPhone smartphones. Facebook is taking steps to further monetise its various apps, such as launching interactive video ads and chatbots. Recent quarterly results demonstrate that demand for Facebook’s ad inventory remained high as shown by the 7% increase in ad prices while ad load sold was up 25%.
While ad inventories sold will likely continue to increase as Facebook begins to more aggressively monetise Instagram, IGTV, Stories, and Facebook Watch, Mogharabi expects slower average revenue per user growth as ads on those other platforms are priced lower than ads on the News Feed. To Mogharabi, Facebook is now transitioning from complete dependency on its News Feed to providing more options for its users that could improve monetisation in the long run for a few reasons. First, he thinks that with a strong network effect moat source, Facebook will be able to attract users to its Stories (whether on Facebook or Instagram), Facebook Watch, and Instagram and its IGTV.
As the firm maintains more users on its overall platform, Mogharabi predicts that user engagement will stay at the current levels, which have been stable for some time. Second, with stability seen in user engagement, Mogharabi remains confident Facebook can effectively monetise its new products to partially offset deceleration in News Feed ad revenue growth during the next 12-24 months.
While ad prices on Stories and Instagram currently trail those of News Feed, with further user adoption, Mogharabi anticipates that demand for the ads will grow, possibly driving prices higher. And third, he thinks that there is further room for growth in ad inventories sold on Stories and Instagram. Although the firm is experiencing a slowdown in ad revenue and user growth, monetisation of users on News Feed remains impressive as shown by the 20% year-over-year growth in revenue generated per user.
