Thinking Away from the Herd: A couple of real-world examples

1. Thinking Away from the Herd: A couple of real-world examples Abdullah KaratashHead of Investments at a major Gulf financial institution Yale SOM Class of 2005 Securities Valuation

2. Introduction • Finance 101 teaches us that when a credit rating is downgraded, especially for a sovereign credit, the credit (bond) should sell off. Historically this has always held true, with one notable exception. • What actually happened to the price of U.S. Treasury bonds when the U.S. sovereign credit rating was downgraded from AAA to AA+ on August 5, 2011 by rating agency Standard & Poor's? Securities Valuation

3. 10 year US Treasury yield S&P downgrades U.S. credit rating from AAA to AA+ (8/5/11) Securities Valuation

4. The Herd • The lesson to take away from this real-world example (which is a lesson that was reinforced right here in this very class by Professors Sunder and Spiegel) is that things do not always play out the way everybody (the herd) expects things to play out. • In the real world, sometimes (more often than not), it pays to think away from the herd. Securities Valuation

5. The Herd • That is easier said than done. • Behavioral psychology teaches us that people find comfort in crowd-thinking and often, real-world incentives reinforce this kind of behavior. • For example, in the money-management sphere, the whole concept of the "benchmark" and "beating a benchmark" even as one delivers absolute negative returns is a classic case in point. Securities Valuation

6. Fundamental Analysis • So how does one muster the confidence to stand away from the herd at the risk of their professional standing? • The answer is simple: through rigorous fundamental analysis. Securities Valuation

7. Fundamental Analysis • This class will train you to ask some very simple and obvious questions about investment theses. • Questioning some very basic assumptions sometimes exposes some very obvious flaws in investment theses (that are easily overlooked by the herd). • Training yourself to ask the right questions is one major step in the right direction. Securities Valuation

8. Fundamental Analysis • At a micro / idiosyncratic level, a great recent example of an investment thesis that caught most (but not all) off guard is the case of Facebook. • While the business media salivated and fawned over Facebook (most business reporters have never taken Security Analysis), savvy investors took a step back and challenged some very basic assumptions about the company. Securities Valuation

9. First the Pros • Facebook is attractive by virtue of its 900 million user base; the company had almost 60% of all Internet users in the developed world. • But it's what Facebook could potentially do with those users that seemed so incredible. • Facebook knows more about more people than any company in history. And to date, it's done very little to "monetize" what it knows. Securities Valuation

10. Facebook • The average cost per thousand impressions on the Web is about $2. Facebook sells for a mere 20 cents! • With a better sales force the thinking went that Facebook could leverage its massive database to target its ads more effectively. • Not to mention the untapped market of China (a billion plus extra users?). Securities Valuation

11. Facebook • So why would anyone be skeptical about Facebook before the company went public in May? • At the most basic level, Facebook's greatest strength (its extensive user base) is also its greatest weakness. • The minute the company tries to monetize that user pool and treasure trove of information, it risks shrinking and alienating its user base. • Additionally, based on anecdotal conversations, it became apparent that many long-time users log in far less frequently (maybe once a month?) than compared to when they first joined the site (several hours per day?). • So it's difficult (and inaccurate) to extrapolate user habits in a linear fashion. Securities Valuation

12. Valuation • From a valuation perspective, if the company priced at a hypothetical price of $40 per share on 2.3 billion shares, it would give the company a valuation of $92 billion. • That monster valuation would be 93x earnings and 25x revenue. • (The company ultimately priced at $38 per share). Securities Valuation

13. Facebook Valuation • How does that valuation for Facebook compare with growth stocks like Google or Apple? • Back in May, Google and Apple both traded for roughly 16x earnings. • Why would an investor pay 6x more for Facebook considering that Google or Apple both had way more cash on hand than Facebook would raise from its IPO? Securities Valuation

14. Facebook Valuation • Facebook projected 2012 earnings of 50 cents per share on revenues of $5 billion. • If the IPO came out at $35, the high end of the predicted $28 to $35 range, that would be 70x 2012 earnings and 18x revenue. • It goes without saying that those multiples are absurd (at the time, Google traded for 15x profit and 6x revenue). • And then Facebook actually boosted (that's correct, increased) its IPO price by almost 10% to $38. Securities Valuation

15. Facebook Stock Price Since IPO Securities Valuation

16. A Closer Examination of the Price • We have not even factored in the "technical" pressures that would exert downward pressure on the stock price: nearly 2 billion shares were held by insiders and as their lockups expire they would sell at any opportunity. Securities Valuation

17. Conclusion • In conclusion the post IPO stock performance of Facebook vindicated all skeptics (including this one). • Facebook was obviously ridiculously overvalued if anyone actually took the time to look at the company from a fundamental perspective and question some very basic assumptions. Securities Valuation

18. Thanks for your time and good luck in your careers. • If you would like to stay in touch, I can always be reached at: abdullah.karatash@aya.yale.edu Securities Valuation