Beware the social media network investing hype, says RE:CM

The recent clamour for stakes in social networking companies has highlighted the growing trend by investors to invest in what they believe will be ‘the next big thing’ in this burgeoning industry. However, Paul Whitburn, analyst at asset management company, RE:CM, says that while there will undoubtedly be some winners among these companies, there is currently very little margin of safety in these shares and they should be treated with caution by investors who cannot afford potentially large capital losses.

Shares of social networking site, LinkedIn, jumped nearly 90% on its first day of public trading, pushing the market capitalisation of the company to about $8bn, trading at 12 times revenue with only $16mil of net profit in 2010. Whitburn says this type of speculation raises concerns that the social network investment trend is starting to mirror the late 1990s IT bubble.

According to Whitburn, social networking shares have no barrier to entry and there is always a new type of technology and trend to displace existing networks. He says that much like Yahoo dominated the early years of search engines and has now been surpassed by Google, the social network industry will constantly be evolving.

He says RE:CM believes the hype of investing in social network shares will be short lived. “Personal networking businesses have still not demonstrated their ability to leverage their networks in order to generate returns.

“The valuations placed on social networking businesses are excessive. These networks do not have a proven business model and form part of a sector that will constantly continue to attract capital and new competitors. This is more than likely a bubble that will eventually end.”

He says that an additional concern is that social networking sites are very often strong in a particular region and not on international terms. “This makes it difficult for social networks to grow globally and achieve critical mass in local regions. A very good example of this is social networks,Tencent in China and VKontakte in Russia, which have both not expanded beyond certain regions.”

There has recently been large capital raisings by social networking businesses globally, and the valuations placed on these initial public offerings have been excessive. Whitburn says that in many cases the developers of these businesses are selling their stakes to the market at inflated values. “This is causing large amounts of capital to enter the market rapidly, much like the technology bubble of the 2000.”

He says that because these business models are generally capital light, they should not need to raise capital. “It seems that the people who understand the business models best are selling to less informed investors.”

Whitburn says that instead of investing in social networking businesses, RE:CM currently sees value in technology shares such as Intel, Dell and Vodafone. “These technology businesses meet our three key criteria for investment in that they are individually the best or of the best quality in their respective industries, they are cheap on an absolute basis compared to our estimates of intrinsic value and they are currently seen as an unpopular investment by investors. We know through practical experience that investors who emphasise these factors in their investment approach can achieve attractive returns over full market cycles.

“Some social networking businesses may become successful in the future, but I think as an investor the odds of making a good return over the long term is very low,” concludes Whitburn.