Social media – how can investors separate opportunity from hype?

Social media is a huge part of our daily lives. Recent weeks have seen the sector dominate newsreels, thanks to the ongoing saga of which tech giant will successfully do a deal with video-sharing app TikTok. At the time of writing, Oracle and Walmart look like the front runners. But with conflicting statements and different stories being published daily, nothing seems to be certain yet.

Social media giants will always get tongues wagging if there’s so much as a whiff of a story. Their huge reach into our lives and boundless popularity means it would be easy to assume companies in this sector make for good investment opportunities.

But it’s important to consider that, as with any sector, there are risks and opportunities to be considered. No two companies are created equal.

This article isn’t personal advice. If you’re not sure if an investment is right for you make sure you ask for advice. All investments and any income they produce can fall as well as rise in value. You could get back less than you invest.

Let’s start with the bad stuff

There are some inherent risks in this sector. The biggest one is regulation.

As a relatively new industry, the big players are expected to be social and moral gatekeepers. Official regulation is in its infancy, and there will be more to come. Privacy, misinformation, fraud and data protection are just some of the topics that are constantly under the microscope.

Social backlashes add fuel to the fire. Instagram owner Facebook’s had to contend with celebrity and advertising boycotts in recent months, relating to its perceived mishandling of misinformation. Twitter’s bowed to pressure for not doing enough about misleading tweets too. It’s now commonplace for accounts to be temporarily barred, or flagged as potentially misleading. Even the US president isn’t exempt.

This culture affects companies because it increases the risk of official fines, as well as increased costs to try and avoid the next scandal. The Cambridge Analytica scandal cost Facebook around $5bn. That’s equivalent to around a quarter of annual profits, so it gives you an idea of how seriously these issues are taken.

Fines that large really hammer the potential returns a company can make if they become a regular occurrence, as well as undermining people’s perception of the service. That could have an even more detrimental effect on long-term value creation. Reputational damage can permanently depress share prices if severe enough.

The other thing to consider is competition. The industry has low barriers to entry. In its infancy Facebook was nothing more than a website, and the likes of Snap Inc or Twitter aren’t that complicated either. That means there are higher risks of competitors stealing market share. Just think how quickly Bebo and MySpace evaporated when Facebook stepped onto the scene. Or how TikTok, now one of the world’s favourite social media apps, seemingly sprung up overnight.

Now we’re not blind to the fact that the big social media companies have built up enormous scale now, which means they’re offered a certain amount of protection. But maintaining market dominance requires staying relevant and reacting to changing habits or customer needs, and that requires spending heavily on research and development. These companies tend to have deep pockets to throw at Research and Development (R&D), and that’s a good thing.

But investors need to consider if a company’s R&D spend is swelling uncomfortably. It’s not necessarily a good sign if a business has to invest heavily simply to keep hold of existing market share. One way for investors to assess this is to compare R&D spending to revenue.

Facebook R&D spend compared to revenue

Source: Facebook annual results 2015-2019

We can see here that Facebook’s R&D spending as a proportion of revenue has actually tempered in recent years, but started to tick back up in the aftermath of Cambridge Analytica. We aren’t worried about the proportion of R&D spending in this case, but it will be worth monitoring to make sure it doesn’t start to spike.

We aren’t saying that investing in social media companies is a bad idea. But it’s important to understand that just because they’re big companies, and operate in a growing market, doesn’t mean they can offer a bump-free ride.

Deciding how at-risk individual companies are from the challenges we’ve discussed here is ultimately up to individual investors. However, we try to make this easy for existing or prospective shareholders in our share research. We discuss what we consider to be the most important issues for specific companies.

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The good news

There are some very powerful tailwinds in the sector.

We’re more virtually connected now than ever before. That’s a trend that’s only been boosted by coronavirus. Time spent on our screens isn’t likely to go down any time soon, and that’s clearly good news for the platforms that provide us with social networks.

Also consider that younger people tend to be the most politically and socially engaged. A generation that wants to have its voice heard, and to be able to disseminate information and opinions from anywhere, at any time, clearly lends itself well to the social media sector.

This demographic is becoming harder and harder to reach through traditional channels like TV, radio or magazine ads. Above the line advertising (think TV ads and billboards) has been in decline for years – ITV’s broadcast revenues (which are largely made up of ad revenues) only rose to £2.1bn from £1.8bn between 2010 and 2019.

TV ads have been particularly sensitive to downturns in the economy too. This means the less expensive digital advertisers are in a better position as we continue to navigate the current crisis. (Digital advertising revenue does still wax and wane with the wider economy, but it tended to be less severely affected).

That gives Twitter and Facebook a favourable environment to work in. We think Snapchat’s hefty investment into data analytics (making itself more attractive to marketers) is interesting too, and is a sign of how the marketing game has changed.

Not many people will think of social media investments as a way to gain exposure to emerging markets. But this is something else to keep in mind.

As developing countries become wealthier, and their populations continue to mushroom, this is a perfect combination for social networks to thrive. For Facebook owned Whatsapp, India is a key market to test plans to monetise the app through an in-app payment service.

Facebook’s average revenue per user was $41.41 in the US & Canada in the last quarter of 2019. That drops dramatically to $3.57 and $2.48 for the Asia-Pacific and Rest of World regions. As developing nations continue to evolve, there’s serious scope for social media companies to raise prices outside the US.

We think the big social media players could offer potential in the long run – supported by genuine structural growth opportunities. But in the meantime, there are some potentially major speedbumps these companies will need to circumvent, and that means ups and downs are to be expected.

What should I do with this information?

Don’t be blinded by block-bluster sectors. Just because a sector dominates headlines and is the ‘cool kid’ on the block, doesn’t mean it will turn out to be a good investment. There’s always more to consider underneath the hood of an individual company than headlines suggest and remember past performance is not a guide to the future.

Always do your research. In this case, investors should be keeping an eye on research and development spending. As well as keeping a keen eye out for potential long-term growth opportunities, like with higher-risk emerging market exposure. If you are at all unsure whether an investment is right for you, you should seek advice,

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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