Mega problems in equity research

On February 3, 2022, Facebook (now called Meta) suffered a loss of more than USD 250 billion of market capitalisation. This is a flabbergasting amount of money. I won't make embarrassing conversions to other currencies or to countries' GDP etc., but suffice to say that there are only about 30 companies in the world whose entire market cap is more than this sum. It is also a monument to the utterly embarrassing state of ... not Facebook but of equity research and institutional investing in general.

I say that because there is no earthly reason for this to have happened at this pace. The quarter of a trillion dollars of value that Facebook lost was never there to begin with. Facebook is now roughly down to the value it had around May 2020, when the initial panic from the Chinese virus had died down. Essentially, the froth that accumulated in some stocks after that has been skimmed off the top in Facebook's case.

I suspect very few of my readers have any direct investment in Facebook, although some would have exposure to the stock via Indian mutual funds that invest abroad. However, the way Facebook lost this value is actually the real problem. Not just that, this problem is very much there in the Indian stock markets too.

Facebook crashed as if some hugely shocking and absolutely unpredictable surprise had happened and Wall Street - basically institutional investors - ran into a true black swan event. And what was this event? Apple has changed the way app privacy works in the new version of its mobile operating system, iOS 14. This is going to reduce Facebook's revenue by a large amount. How large? Facebook estimates USD 10 billion for 2022 (2021 revenue was USD 119 billion). Other analysts estimate as much as 25-30 billion.

That's certainly a justifiable reason, but here's the strange thing - this has been known for months. iOS 14 was announced in June 2020 and became available in September that year. The App Tracking Transparency privacy protection feature, which has destroyed Facebook's ad business, went live in iOS 14.5 in April 2021 but its details were known for months before that. Almost immediately afterwards, advertisers started talking about a collapse in ad efficacy and one could hear rumblings of ad budget cuts if ad efficiency did not improve. On social media, some advertisers were reporting an 80-100 per cent drop in ad response and said that they were going to basically stop spending on Facebook.

If you Google for discussions reports like this, you'll find any number of them starting soon after the feature was launched. Everyone who tracks digital advertising knew about it. Except, apparently, one section of people: Wall Street, meaning the US equity investing community. It was a complete secret from them. During this entire period, when the Facebook disaster was fructifying, Wall Street boosted up the company's share price to all-time highs in September 2021, to a market cap of more than a trillion dollars. After that, the stock prices drifted downwards but it was nothing compared to what happened on February 3, 2022.

This shows that essentially, Wall Street was doing no research on Facebook. They had no idea what the company's customers (advertisers) were experiencing. They woke up only when Facebook itself confessed to the truth. And this, for a company that they had valued more than one trillion dollars just months ago!

What does this show? I believe it's a combination of the following: incompetence, laziness and complicity, and these are not specific to people who are analysing Facebook or even just the US companies. I see this as much in India. For a variety of reasons, the effect is worse in internet-based businesses. These businesses are hard to value, no doubt, but equity analysts and investors are far too willing (even eager) to swallow whatever optimistic tales the companies themselves put out. It doesn't help that optimistic tales are the only thing some of these businesses have.

50 per cent of good equity research arises from scepticism. When you hear a company say anything about itself, a good equity researcher should say, "Let me examine this statement and see where the lie is." Guilty until proven innocent: that should be the motto of equity research.