Here’s What to Expect From Facebook

In many ways, the stock market is nothing more than a large pool of data. That means whenever something happens, even something that appears to be unprecedented, that is almost certainly a precedent.

That’s the case with Facebook (Nasdaq: FB).

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  • A Bad Earnings Report Becomes a Very Bad Day for the Stock

    Facebook released its earnings for the second quarter shortly after the market closed last Wednesday. The stock sold off on the report which was not as strong as analysts had come to expect. As the conference call with management began, the stock was off about 10%.

    The problems began with revenue. Despite growing more than 40% compared to the same three months a year ago, sales were below analysts’ expectations.

    As The Wall Street Journal explained, “In a call with analysts, Facebook Chief Executive Officer Mark Zuckerberg called the results “another solid quarter”—but those comments were quickly overshadowed when other executives warned that tougher privacy laws, a shift toward less lucrative advertising products and currency headwinds would clip revenue growth.

    They noted that the revenue growth rate fell seven percentage points in the second quarter compared with the first three months of the year and said the company expected quarter-to-quarter revenue growth rates to decrease by “high single-digit percentages” in the second half of 2018.

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  • The company also said its expenses would rise faster than revenue in 2019 and projected that its operating-margin percentages would be in the mid-30s over the next several years, due to higher spending on product and infrastructure. The second-quarter margin was 44%.

    On the call Wednesday, Mr. Zuckerberg acknowledged that Facebook needed to invest more in security measures to prevent the platform from being manipulated. He also pledged that the company wouldn’t stop building new products “because that wouldn’t be the right way to serve our community and because we run this company for the long term, not for the next quarter.”

    By the end of the call, the stock was down about 23% and the next day ended with the stock 19% below its previous close. In dollar terms, that decline marked the largest one day loss for a company in Wall Street history.

    Looking at History

    The stocks in the Nasdaq 100 are volatile and serve as a test group for crashes like this. The test will include the entire trading history of the stocks in the index as of now. This will include the time before they were in the index to capture as much volatility as possible.

    Using stocks that suffered large one day declines after making a new 52-week high as FB did last week yields a sample size of just nine trades. The results were mixed with five trades showing a gain a month later and four showing a decline.

    To expand the sample size, we looked at the history of the stocks before they were in the index. They were smaller companies at that time and the stocks were more volatile. This gave us a sample size of 72 trades in the last twenty years, a rather small number but large enough to analyze.

    The short term results are not promising for the bulls. One month later, just 38.9% of the trades were winners. Among the winners, the average gain was just 7.1%, far from a full recovery.

    Looking out three months after the big drop, the results are still not promising for bulls. With this holding period, 47.2% of the trades were winners. But, just six of the wins were larger than 3%. Most of the trades were for a gain or loss of less than 1%.

    Holding for six months shows a win rate of 45.8%. But, 25% of the trades gained at least 5%. There were some stocks that continued lower but in most cases, the stock was either up or down slightly.

    What’s Next?

    Now that we understand the history, we can evaluate the likely path of FB shares in the short run.

    The stock is now below the level it was at the beginning of the year. Investors worried that they missed out in the stock’s earlier gains might view the sell off as a second chance to get into the stock.

    But, it is important to remember that almost all investors who rushed into the stock over the past three months show a loss. That could create downward pressure on the stock price.

    The next chart shows the trading history of FB since the company went public in May 2012.

    The stock fell more than 40% in the first three months and was down more than 60% sixteen months after the stock’s initial public offering. The stock took almost six years, 71 months, to reach the level seen in its first month of trading.

    That demonstrates it could take time for the stock to recover. This confirms the results of testing shared above. And, it confirms the headline of The Wall Street Journal’s Heard on the Street column the day after the crash:

    “Facebook Isn’t as Cheap as It Looks: Controversial outlook takes down stock’s valuation, but unique risks still aren’t priced in”

    The article points out that valuation metrics are more attractive now. “Facebook’s valuation fell to 23 times forward earnings, which is close to its lowest multiple on record and down 23% from just a year ago, thanks to the company’s sharply growing bottom line.

    Facebook’s multiple drops to 21 times excluding net cash, which puts it at a 16% discount to Google-parent Alphabet Inc. on the same measure.”

    But, unique risks include new laws in Europe and California affect the business models of all internet companies and Facebook has yet to face harsh regulatory actions for its own missteps regarding the privacy of user data.

    Controversies associated with data sharing and fake news, along with important decisions that have to be made about censorship, also hang over the company.

    The Journal concludes, “It is simply too early to tell if that decline is a blip or the beginning of a sustained downturn.”

    History tells us the same. Traders should wait for the company’s next earnings report because odds of a rebound within the three months before that report are low.

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