Sunday, December 16, 2012

Why Warren Buffett Did Not Invest In The Facebook IPO

December 04, 2012

After more than a year of speculation on when and if it was going to happen, social media giant Facebook (Nasdaq:FB) issued shares to the public back in May. The initial public offering (IPO) price was $38 and raised an estimated $16 billion for company insiders and other earlier investors. The stock briefly traded above $40 per share, but has fallen steadily since.

 Warren Buffett advised against buying into the stock at its IPO price and appears to have been proven right so far. Below are three key reasons why he did not invest.

Buffett Generally Avoids Technology

Buffett has a reputation for investing in companies with business models that will stand the test of time. Coca-Cola (NYSE:KO) is a great example. For the past century or so, it has sold its namesake soft drink throughout all parts of the globe. Regardless of what happens on the Internet or across world economies, people will continue to demand carbonated drinks mostly made of sugar.

Coke has been one of Buffett's most successful investments and is a position he has held for a number of decades now. In contrast, most businesses in the technology space move rapidly. As a result, their business models are extremely difficult to predict. Facebook may currently be growing rapidly, but a similar competitor named MySpace was also growing briskly several years ago. MySpace has nearly fallen off the earth in terms of popularity and the ability to attract advertising dollars. This could just as easily happen to Facebook within a few years.

He Also Tries to Avoid IPOs

In addition to generally avoiding investing in technology companies, Buffett is skeptical of companies that go public through an IPO. This is for a good reason, but company insiders and investment banks try to bring a company public at the highest price possible. They will look to do it when market sentiment is positive or when investors are overly positive on a particular industry or popular business model.

Facebook's timing wasn't perfect, but it was speculated that company insiders rushed to sell shares in the IPO. Sales of shares, when the company was public, kept ratcheting up the overall implied value of Facebook. It even reached around $100 billion at one point, even though it is projected to reach about $5 billion in sales for all of 2012. At this point, insiders that owned shares are still fantastically wealthy on paper. Investors that got in on the IPO price lost a huge portion of their initial investments.

Facebook Is too Difficult to Value

Buffett recommends that investors develop a circle of competence and only invest in what they know and understand. He suggests that investments not falling into this category be placed in the too-difficult-pile, or namely an investment candidate that is likely too hard to value with any level of accuracy.

Buffett has been quoted as not being interested in investing in Facebook. His reasoning follows the above. Its business moves too fast, there was too much hype during the IPO process and the company is simply too difficult to value. He did state Facebook has an extraordinary business, but these are famously difficult to come to an investment opinion on.

The Bottom Line

Investors that followed Buffett's advice to avoid Facebook from its IPO price are doing pretty well; the stock is down to $27 per share. The stock market capitalization is down to $58 billion, but still discounts many more years of rapid growth to get sales up to where sales multiples look anywhere near reasonable.

At the time of writing, Ryan C. Fuhrmann did not own any shares in any company mentioned in this article.

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