Washington Square Capital Management Blog

One of the more notable financial news stories of the year so far is the decision of social media heavyweight Facebook to go public (an event we alluded to in our top 10 themes for 2012). The question on everyone’s mind is whether a potential $100 billion market valuation is appropriate for a company that had roughly $1 billion in net income last year. It wouldn’t be the first tech company to trade at a three digit P/E (we’re looking at you salesforce.com), but it would be the largest. We are going to leave the valuation question aside for a moment and think in broader terms.

In our view, there are a few factors to keep in mind when considering the lofty growth expectations that surround Facebook.

Fewer, poorer, new users: At 845 million relatively regular users, Facebook already has the cream of the crop when it comes to potential consumers. The economic elite — by far the most attractive consumers — are, for the most part, already on Facebook. The next billion users will have less spending power, and will not consume as many of the digital goods Facebook wants to sell them, nor will advertisers pay as much for access to them.

With the exception of China (where Facebook is banned), the network has no other large upper-middle class markets it can tap into. Since the next billion Facebook users will have more modest means and this could be a tricky cultural and business shift. Facebook initially set itself apart by limiting usage to select colleges. Over time it has successfully expanded availability to new demographics (older users and international users) . But its user base has always been the more affluent segment of each market.

By highlighting this, we’re not trying to diminish the broader value of an open social network and its ability to connect people and create opportunities for them. We hope Facebook continues to be another powerful Internet tool available to a person of modest means to foster deeper connections, expand their horizons and develop themselves. But we do recognize that social networks by definition will mirror divisions in societies, and certain virtual spaces will be more attractive than others to specific groups.

User disengagement: There’s a chance Facebook jumps the shark and usage drops. Despite its meteoric rise in recent years, Facebook operates in the notoriously fickle world of social media, where users may tire of a particular platform and seek out the next hottest thing (let’s not forget Friendster or Myspace, once robust social networking communities before Facebook came along).  While Facebook has done a phenomenal job building its user base and cornering the social media market, there are other platforms out there waiting to swoop in should there be a misstep (Google+), or capitalize if users ultimately decide they prefer to segregate their status updates (Twitter) from their picture sharing (Instagram) and location data (Foursquare).

In addition to the possibility of competitors poaching away market share, there is also a question as to how users will interact with the platform going forward.  We already see a divergence in the frequency with which men and women use Facebook. Women use Facebook much more regularly than men do. Over time, we could see photo-sharing and instant updates lose their novelty value for certain users who then disengage from Facebook.

Advertising could be ineffective on Facebook: It’s tough for an advertiser to grab a Facebook user’s attention when they are competing with photos and updates from their nearest and dearest. Ads on Google search are powerful revenue generators primarily because the user is searching for something and the ad is related to the search. A Facebook user, on the other hand, is visiting the site because they wish to see photos or updates of their family and friends. An ad on Facebook generally disrupts the user-experience.

Of course, Facebook could use the reams of data it has on each user to suggest a gift for your wife or girlfriend based on browsing or comment history; but this could easily mis-fire and be considered intrusive. Similarly, word of mouth recommendations are very powerful drivers of product sales, and Facebook is an effective medium for friends to share these; but advertisers tamper with word of mouth at their own risk. Our sense is that Facebook has become a virtual family gathering or a dinner party, and overt advertising or sponsorship will always feel slightly out of place at such an event.

On Facebook everyone knows who you really are, even if you’re a dog. All that said, there is one aspect of Facebook that sets it apart from virtually every other website and could end up being extremely valuable. From the very beginning, Facebook has insisted on “real names” and worked to keep anonymous or fraudulent identities off the platform. The result is that Facebook can tie virtually each of its 845 million users to a real-world identity. They have also built an authentication framework on their platform which other sites can use in lieu of asking users to pick new passwords or user ids. Since Facebook has photographs of all your friends, they can be used as a challenge if unauthorized activity is detected. Your ability to recognize your friends, along with Facebook’s knowledge of who they are, combined with a large photo database, makes it very difficult for an unknown attacker to try to hijack your profile. This has meant an enormous shift in the previously anonymous world that the Internet was, and it remains a rare and valuable commodity. It is a service Facebook could charge other sites for down the road. For Facebook, it may be the next big thing. Perhaps bigger than targeted ads.

Further Reading:

The genesis for this post came as a result of a wide-ranging conversation we had recently, and which led us to think about two of our favorite books…

The first is Neal Stephenson’s Snowcrash, a 20 year old book that predicted much of the impact the Internet would have on human society. No one who has ever read that book can underestimate what anonymity can lead to and what power accrues to an entity that can definitively identify 20% of humanity.

The second book is Asimov’s Foundation series, which is what got one of us interested in Economics and reinforced the constancy of human behavior.  Some of the conversation about 3-D printing and replicators also brought to mind Asimov’s gem, The Last Question.

Photo credit: Flohuels

If you’re new to investing and thinking about putting your money to work using an approach that incorporates social or ethical criteria, it’s important to know what types of strategies are available to you and how to differentiate between them.

When we consider the socially responsible investment (SRI) universe, there are five main strategies most often used by investment managers.  SRI investors will usually incorporate some combination of these five when picking their investments.

1.  Positive Screening.  With positive screening, the investor looks for profitable companies that integrate corporate social responsibility (CSR) into their business practices and operations.  Typically, this investor wants to see the company actively engaged in the following issues: environmental conservation, human rights, labor rights, fair trade and indigenous rights.  This investor may also consider companies whose products or services directly address CSR issues, like a solar power company or an organic food manufacturer.  However, it’s important to note that just because a company is engaged in a sustainable business, doesn’t necessarily mean they are exempt from other CSR considerations.

2.  Negative Screening.  With negative screening, the investor excludes certain companies that do not place a high value on CSR within their business practices.  Often times, this approach means eliminating entire industries, like tobacco companies or defense contractors.  Like positive screening, negative screening can be subjective, as each SRI investor has his or her own idea of what does or does not constitute an ethical company.  For example, an investor who uses religious screening criteria may want to avoid a medical devices company that manufactures products used in abortion procedures.  However, a pro-choice investor will likely not take issue with this company, and rather, may actually consider it as a candidate for a positive screen.

3.  Best-in-Class.  With best-in-class, the investor often targets a progressive company within an industry likely to have a poor CSR track record.  An example would be an oil company that’s an industry leader in environmental conservation.  While the type of business (oil drilling) may not be considered socially responsible, the way the company conducts their operations (making environmental protection a priority) is the chief criteria.  In a way, this investor seeks to encourage and reward good corporate behavior with their investment dollars.   It’s important to note, however, that this approach can be susceptible to greenwashing, as a company may market themselves as being an upstanding corporate citizen, but in reality, may not live up to that image.  A prime example of this would be BP, which was once a top pick for best-in-class SRI investors prior to the Deep Horizon disaster.

4.  Activist Investing.  With activist investing, the investor targets those companies with poor CSR track records in the interest of changing the company’s business practices.  This approach uses proxy votes and shareholder resolutions to pressure management to alter corporate behavior.  This approach is most effective when used by large institutional investors (mutual funds, pension funds or foundations) or a coalition of smaller investors.  The activist investor, while a bit unorthodox in their approach, can achieve significant long term CSR victories when successfully petitioning large corporations to change their business practices.

5.  Community Investing.  With community investing, the investor is less concerned about the financial returns of their investment then they are about the greater social impact.  The main goal with this approach is to deploy investor capital to individuals, organizations or geographic areas that have historically been denied access to capital by traditional financial institutions.  Often times, this style of investment is done by larger institutions.  Individuals can also take part in this approach through microfinancing, for example.

In addition to considering the social and ethical approaches discussed above, it’s also important to make sure that an investment is a good fit for you, especially in terms of risk tolerance (how much risk you are comfortable taking – some investments can be riskier than others) and time horizon (when you will need access to your money – investors with short time horizons generally should stick to less risky investments).

As always, if you need help finding a socially responsible investment that’s a good fit for you, let us know and we’d be happy to schedule an introductory phone call.

Image Credit: Tom Magilery