The media buzz around the upcoming Facebook IPO has a lot of people considering investing. A prudent investor should look at Facebook's business model in the same manner as they would look at investing in a traditional brick-and-mortar business. Namely, customer behavior and the business fundamentals, to say nothing about potential competition. A big part of legendary investor Peter Lynch's success in picking the right investments was related to properly identifying and gauging consumer behavior. Mr Lynch ran the Fidelity Magellan Fund from 1977 to 1990, and beat the S&P in 11 of those 13 years. He previously pointed out that many of his best investment ideas were found while he was shopping with his family, not on Wall Street. In a similar manner, many investors today can beat Wall Street by observing consumer behavior while both online, and in the flesh, so to speak.
There are some good basic questions that an investor should ask before investing. Can Facebook find a way to improve click-through rates for its advertisers, without disenfranchising users? Can the company develop other ways to monetize its unique knowledge of the connections between people? Could Facebook act as a broker between anyone wishing to make a connection outside of their own friends list? How deep and wide is the moat around the company, preventing competition from making inroads? How much money does the company need to spend in order to satisfy the seemingly endless demand for storage of various media? Could the company be liable for policing copyrights? And perhaps most importantly, how much of an understanding of consumer behavior does the company possess?
We'll first address the last question here, because it is the most difficult to grasp, and often leads to the demise of seemingly sound businesses. This is because consumer behavior is very hard to change, even when they are presented with few alternatives. There was once a thriving trading post halfway between Santa Fe and Albuquerque, New Mexico called Budaghers founded in the 1950's. But after Interstate 25 was built traffic declined, so the owners expanded and built the New Mexico Outlet Center mall in 1993, hoping to give people more of a reason to visit. On the surface it seemed like a good idea to place an outlet mall less than half an hour drive between two major cities. The owners made the mall easy to get to, even getting their own Interstate exit named the 'Budaghers Exit'. As a result every New Mexican knew and occasionally thought about Budaghers, at least while driving by. It was essentially the only major stop between the two large cities. But the outlet mall struggled until it eventually closed in 1997, and re-opened briefly in 2000 under a different name. Today the property sits abandoned.
So why did most people choose not to hop off the highway for some quick and easy shopping? The failure of The New Mexico Outlet Center mall was due to an insufficient number of people that interrupted their journey between two cities to shop. In short, it was not the intended destination for most trips between Albuquerque and Santa Fe. In a similar manner this is perhaps Facebook's greatest challenge, changing visitor behavior when the intention is to hop on the site to share a song. How can Facebook lure someone who is catching up with their high school friends, to make a detour that will lead to a sale?
Can They Make It Up On Volume?
Already there's evidence of this challenge for Facebook. A recent commentary on Bloomberg by a former Facebook advertiser named Mark Gimein points to an extremely low success rate of ad campaigns run on Facebook. Mark reports paying $3.09 per click on one campaign that had a click-through rate of 0.013%. The click-through rate measures the percentage of people who click on an ad displayed on their browser. His results were that his ads were shown 182,901 times, which resulted in 26 click-throughs to his web-site. Mark had ads with different images, text options, offered discounts, and even sneaked an ad with an image of a painted nude. For his trouble Mark made no "connections" with potential clients. Facebook earned $72.80. While one disappointed customer does not mean that most advertisers on Facebook are unhappy, it is a sign for new investors to dig deeper.
So potential investors should ask themselves why advertising click-through rates are significantly lower on Facebook than at other sites such as Google.com? The majority of people go to Facebook to get an update on what their friends are up to, and check on the latest video and picture uploads. There's a good chance that they are not shopping. While there is no doubt that we do find highly targeted advertisements on Facebook, site visitors seem to have their attention focused elsewhere. Another question to ask is "How can Facebook alter consumer behavior where others have failed?"
More Construction Ahead
Aside from looking at "traveler" behavior, potential Facebook investors should also consider the company's plans for the money raised during the public offering. In the Letter From Mark Zuckerberg to investors published on Wednesday February 2nd, 2012, Mark immediately points out that he did not set out to build a company, rather it is "to make the world more open and connected". While that's a noble goal, it leaves a potential investor wondering what the company's commitment is to new shareholders. But the most concrete caveat emptor comes later in the letter. Mark explains that they are likely to be spending significant amounts of money: "The scale of the technology and infrastructure that must be built is unprecedented, and we believe this is the most important problem we can focus on." Right away an income focused investor should look elsewhere, as it would not seem likely one could expect dividends from Facebook anytime soon.
For the growth oriented investor Facebook could become an outstanding investment if the company can overcome these challenges. The prudent investor that utilizes an Off-Wall Street approach to investing, such as described by Peter Lynch many decades ago, would probably be cautious with this stock either way. No matter what happens to the stock price for FB when it goes public, investors should keep an eye for how the company treats all of its customers, paying or not. Until the company demonstrates that it can develop new connections on the Information Interstates benefiting both consumers and vendors, it should be regarded more as a speculative play. Investors don't want to end up owning the virtual equivalent of ghost retail space, somewhere in the New Mexico High Desert.