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Facebook: Don’t Take a Chance, Take a Profit

Posted
9/9/2013 12:28:00 PM
By: Martin Tillier
Referenced Stocks:FB

Risk is a funny thing. It is often misunderstood. I have pointed out many times that risk and volatility are not, contrary to what your financial advisor probably tells you, necessarily the same thing. There is also an assumption, frequently encountered, that “buy and hold” is less risky than somebody holding something for only a short time before selling.

I agree that “traders” generally take on more initial risk than long-term investors, but they are also better at recognizing and controlling it. In many ways, those that are too infatuated with buy and hold assume a huge amount of risk without being aware of it. Even in the face of overwhelming evidence that their holdings are heading for troubled times they hang on, believing that time is the ultimate healer. They risk annihilation of their investment, but a pure buy and hold strategy doesn’t allow for them to do anything; they must just watch as the company fails.

Controlling and managing risk is important, then, but there is another side to that coin; taking a profit. Nothing moves in one direction continuously, and it is important to recognize when an investment has done its job. The time it takes to reach that level varies, and often the quicker it happens the stronger the case for taking a full or partial profit and stepping back for a while. So it is at the moment with Facebook (FB).

Around two months ago, when FB was trading at around $25, I wrote that the slightly more mature company was worthy of attention. I suggested that investors’ concerns about mobile presence and monetization were holding the stock back, but that any indication of improvement would see a jump in valuation.

 

Sure enough, when FB reported earnings on July 24th, the company exceeded expectations in almost every way imaginable. Beats on both the top and bottom lines were well received, but what really drove Wall Street into a frenzy was the fact that over 40% of Facebook’s advertising revenue came from mobile. All of those exaggerated fears were addressed, and the stock responded as I anticipated, gaining around 15% in after-market trading following the release.

So far, so good. What worries me now is that the market, in its usual bipolar style, has swung from being overly pessimistic to being overly optimistic. The brilliant minds at Facebook addressing investor concerns and finding solutions to problems came as no surprise, and I expect them to continue to do so, but the current valuation just looks too rich.

The stock is even higher now than the $35 level achieved in the euphoria following that release, closing last week at $43.95 and indicating another higher opening today. There is an element of a vicious (or should it be virtuous?) circle about this. The initial good news caused the stock to jump, but subsequent upward revisions of analysts’ expectations are adding fuel to the fire. Each upward revision pushes the stock even higher.

The problem is that, as Wall Street analysts compete to be the most optimistic about the future of Facebook, so those targets become less attainable. Increasing target results to more optimistic levels is fine, but when the price appreciates to where the forward P/E based on even those inflated forecasts looks high, savvy investors should pause for thought.

FB is currently trading at a forward P/E of around 55. It would seem that, at these levels, holding on to the stock is more risky than taking a profit and moving on. If you bought in June at around $25, you are looking at a profit of around 80% in two months. The stock has done its job for you.

From this point on, more appreciation is possible, but when I am given the chance to trade into possibly owning a stock at close to 10% of its current valuation, I find it hard to resist. If you did buy at $25, selling half of your holding now would leave you owning the rest at an average of $5. Now that is a position that I would be happy to hold for a long time.

In reality, I don’t think Facebook is going anywhere over the next couple of years; they are too firmly entrenched in the culture. It is possible that they will become, like Google (GOOG), an everyday part of our lives for decades to come. It is also looking more likely that they will continue to profit from that, but, for now, at over 50x recently increased earnings forecasts, there would appear to be little up-side left.

Even if you believe in FB as a long term investment, sticking your head in the sand and waiting for the stock to reach $100, $200 or $500 makes no sense. If you bought at around $25, taking at least some profit now allows you to look for the dip that I believe is coming, especially given the likely volatility in the broader market over the coming weeks, and buy back when it does.

In this case, adopting trading techniques may actually be less risky than ignoring them.