Few products have experienced rapid growth and global impact equal to that of the social networking website Facebook. But having a good product doesn't always mean the business is an attractive investment.
Most readers are probably aware that Facebook Inc. held its record-breaking initial public offering last month. Around 70 mutual fund companies participated in the deal, but Heartland chose not to be one of them.
Facebook's story has been tremendous. The company currently has more than 900 million users, up from less than 200 million users just 3 years ago – remarkable growth.
Why is that?
The stock market, as measured by the S&P 500 Index, is currently trading at around 12.5 times estimated earnings. The S&P 500 Information Technology Sector is trading for about 12.8 times.
Ideally, we like to own stocks that trade at or below the broader market. Compare that to Facebook. At the initial offering price of $38 per share, Facebook was trading at 76 times estimated earnings!
That level represents a nearly 600 percent premium compared to the broader information technology sector. What's more, it's even greater than what information technology stocks traded at during the height of the dot-com bubble over a decade ago.
Why do we like owning companies that trade at lower prices when compared to their earnings? Our thesis is based on decades of historical price performance, which shows that companies trading at low multiples to earnings have historically outperformed the broader market and provided a potential measure of downside risk protection to shareholders.
Facebook may be a great company, but great companies are not always great investments. We look for companies that trade at attractive valuations, as well as those offering a catalyst for recognition among investors that has the potential to bring prices up over time. We think this is a commonsense way to invest.