Does the Snap flotation mean stock markets will keep crackling or go pop?

Older, grizzled heads (like the one belonging to this column) will sigh and think back to the boom-and-bust days of 1998 to 2000. Younger, more tech-savvy, social media-aware advisers and clients may get what the service does, even use it. And both will be wondering whether Snap will be the next Facebook or Twitter and have a positive or negative impact on funds in their portfolios.


The camera company, as it describes itself, floated on the US stock market at $17 a share and promptly soared to more than $24 on the first day of trading, to give it a market capitalisation in excess of $25 billion.

That was enough to rank the firm within the 25 biggest firms by market cap in the FTSE 100, had it chosen to list over here - good going for a firm with annual revenues of $404 million that is yet to make a profit.

Sceptics will say this is a valuation that cannot be justified. Bulls will say the bears don’t ‘get it’ and that the massive growth prospect mean the risk is worth it.

Only time will tell, but the Snap float raises three issues, all of which are relevant to advisers and clients’ long-term portfolios in a wider context than this specific stock. They are:

  • the role of indices and the ongoing debate between passive and active investing
  • the importance of (corporate) governance
  • valuation and how it is the ultimate arbiter of the return from any investment

This column shall now address all three in order, after quickly looking at the Snap deal itself.

Snap

If attention and column inches had any bearing upon a stock’s valuation then Snap would deserve every cent of its current worth. Even though they don’t, there are reasons why the company could merit its huge initial price tag.

  • First, its S-1 regulatory filing document shows that Snap has 158 million daily active users and is growing rapidly. Sales surged to $404m in 2016 from $59m in 2015 and investors are still hungry for stocks which offer the prospect of secular growth, even allowing for the bout of optimism engendered by President-Elect Trump’s tax and deregulation programme.
  • Second, Snap’s prospectus makes it clear the firm has more to offer than just the instant messaging service which made its name. Snap is positioning itself as a camera company and one that offers experiences that are much richer than a 10-second conversation.
  • Third, shares in its established internet and social media peers like Facebook, Alphabet, Alibaba and Tencent have done very well in the last 12 months.

Social media and internet peers Alphabet and Facebook have ultimately performed strongly

Source: Thomson Reuters Datastream

However, there are also three good reasons to be sceptical that the valuation will prove sustainable.

  • First, Snap is selling shares which will have no votes, so shareholders will have no voice or say in how the company is run. This may seem a good idea but it could leave investors high and dry if and when anything goes wrong - and not all gifted entrepreneurs make great business executives or managers.
  • Second, Snap is losing money by the bucketful. Net losses surged to $514 million in 2016, from $373 million the year before, despite the huge surge in users and revenues. Ultimately, it is profits and cash flow that support and drive a company’s valuation, not just the number of customers it has. The company clearly has plans to develop new services – and potentially acquire other firms – but fund managers will be taking a lot on faith to price this into the valuation before they can see what these strategic initiatives might be. Snap’s main source of income at the moment is selling advertisements targeted at its core youthful demographic, although the younger generation isn’t the one that has all of the money, so it remains to be seen whether advertisers feel they get value for the exposure Snap can offer.
  • Third, Facebook, Alphabet, Alibaba and Tencent have all done well but they all have bigger user bases and more diversified revenue models. For the moment, Snap more closely resembles Twitter, which also floated on the back of rapid user growth and plans to increase revenues by increasing customer engagement, initially saw its shares do well but they have subsequently collapsed as a series of new service offerings have failed to drive any profits or positive cashflow. Twitter now trades at $15 a share, below not only its near-$70 peak of early 2014 but also 2013’s $26 flotation price.

Twitter’s failure to monetise its user base is a potential warning to holders of Snap stock

Source: Thomson Reuters Datastream

For this column, the most important line in the entire S-1 regulatory filing comes from the ‘Risks’ section on page 19 where the company states: “We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.”

Crackle

Whatever you make of that, Snap’s flotation raises three bigger issues beyond the fate of the individual stock, the details of which are likely to be beyond the remit of most advisers and clients.

  • The role of indices in passive and active investing. One of the bull cases for Snap lay in its potential inclusion in a broad index such as the S&P 500, owing to its monster market capitalisation. Passive funds, like trackers or Exchange-Traded Funds (ETFs) would then be obliged to buy it while active funds would be tempted, especially if they were closet trackers. This reaffirms the importance of researching funds, their benchmark and their philosophy before committing capital. Passive funds are cheap but they can lead to exposure to stocks which may not fit with an adviser or client’s overall strategy or – worse – to something that may be egregiously overvalued. Active fund managers – or at least those worthy of the name – can at least take a view on whether to get involved or not and this is how they seek to earn their fee.
  • The importance of corporate governance. This column views the capital structure at Snap as pernicious for those who hold stock, either directly or via a fund. Thankfully there are active and passive funds which place great emphasis on good governance and screen for stocks accordingly. Snap may not earn a place within them, unless something changes, so advisers and clients will have passive and active options available to them even if Snap does make it into the big benchmark indices.
  • Valuation. This lies at the heart of the Snap debate but also any discussion of markets in general. This column remembers gasping when Pets.com raised what seemed like the massive sum of $82 million when its flotation was priced at $11 a share in 2000, especially as the firm’s disclosed annual revenues were less than $750,000. This column also remembers sniggering when the online pet store’s stock went from a high of $14 to under $1 in less than a year as Pets.com went into liquidation. This is not to say a similar fate awaits Snap, not least as the billions in cash on its balance sheet will enable it to make heavy losses for some time to come.
  • But the valuation paid is everything when it comes to investment returns and this can be shown by looking at the history of the UK and US equity markets.

Pop?

It will not be to the taste of every adviser and client, but one valuation metric which offers a long data set (back to 1881, in fact) is Professor Robert Shiller’s cyclically adjusted price earnings (CAPE) ratio, which uses a 10-year rolling historic earnings number, rather than one-year forward analysts’ forecasts as its basis.

This next chart plots the CAPE ratio against historic 10-year rolling compound returns from the S&P 500 index. Not surprisingly, the higher the valuation, the higher the index has gone (even allowing for earnings growth) and the better the historic returns.

The US stock market is trading at a CAPE valuation seen in 1998 and 2007 …

Source: www.econ.yale.edu/~shiller/data.htm, Thomson Reuters Datastream

But what this chart also subtly shows is the higher the price or multiple paid the lower future returns become. This makes sense. Companies will only generate so much profit and cash, and pay so many dividends, in their lifetime, so the more you pay now the less your return going forward and vice-versa.

To show this, the next chart sets the CAPE ratio against the compound annual returns earned over the following 10-year period. This makes the link much clearer.

… and which in the first instance ultimately presaged of negative compound annual returns a decade after the peak

Source: www.econ.yale.edu/~shiller/data.htm, Thomson Reuters Datastream

The same exercise can be carried out using what Warren Buffett used to say was his favourite metric, market cap to GDP.

This next graphic looks at America’s aggregate market cap, using the broad Wilshere 5000 index, and runs historic 10-year returns against the rating. Again, the higher the valuation goes, the better returns have been.

Higher prices and higher market cap-to-GDP valuations told of strong historic gains from US stocks …

Source: FRED, St. Louis Federal Reserve database, Thomson Reuters Datastream

But the chart that looks at future 10-year returns shows an inverse relationship, whereby the higher the price paid now, the lower future gains are.

…but also left stockholders facing meagre (or negative) long-term returns

Source: FRED, St. Louis Federal Reserve database, Thomson Reuters Datastream

The same trends, over a shorter time span, can be seen from the UK’s FTSE All-Share.

Higher prices and higher market cap-to-GDP valuations told of strong historic gains from the FTSE All-Share …

Source: Federal Reserve Economic Data (FRED), Thomson Reuters Datastream

…but also exposed advisers and clients to poor 10-year returns from UK equities, had they bought near the top

Source: Federal Reserve Economic Data (FRED), Thomson Reuters Datastream

This is not to say the FTSE All-Share or S&P 500 (or Snap) are going to hit a brick wall anytime soon. Nor is it to say anyone should start trying to time market tops and bottoms. This column’s crystal ball is not that powerful.

But what it does suggest is we are nearing valuation levels which have historically been followed by returns on a 10-year view that became cramped at best. And since equities are a long-term investment, where the power of dividend investment only becomes apparent after 10 years or more, it may pay to focus on risk management and downside protection – unless advisers and clients are prepared to argue that it is “all different this time.” Snap could be good value on that basis. But then that was the investment case for Pets.com too and sending huge bags of pet food out by mail to online customers turned out to be a dog of an idea.


Pets.com’s sock puppet mascot from 1999

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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