The growth trajectory on Facebook (NASDAQ:FB) is pretty well understood, but some have voiced concerns that Facebook may not sustain price appreciation for much longer considering the relatively high market capitalization when compared to peers.
At least according to Kevin Landis (Chief Executive) of Firsthand Technology Value Fund:
When people look at us today they see that our two biggest positions are Facebook and Twitter (NYSE:TWTR). And we did a pretty good job of hanging on and doubling our money. If Facebook were to triple from here, it would find itself among the biggest tech stocks in the world, bumping up against Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL). So, we don't need to top tick it. It is probably time for us to ease on out of it. The principle will go back to be re-invested in the fund, but the profit will get distributed to the shareholders. The way I look at it, I know it is at best a three-bagger from here, and I can get a ten-bigger in the private market, so why top tick this?
While Kevin Landis makes some fairly strong points, I think that dumping Facebook in favor of a smaller businesses may offer a worse risk to reward, for those who aren't able to do as thorough of due diligence. While, it's a well-known fact that small businesses offer better growth simply due to size, there's also the fact that Facebook's dominance in social networking, paired with useful demographic data gives it a sizeable competitive advantage. We could compare Facebook's positioning to that of Intel (NASDAQ:INTC) in the semiconductor space. Sure, every now and then, we hear the bear case on Intel, and it's usually a rehash of some sort of competitive dynamic that could put Intel at odds against AMD (NYSE:AMD). But year in and year out we see Intel widen its economic moat against competitors.
I'm afraid Facebook is in a very similar position to Intel, and while I'm not impressed by Intel's recent earning slump, I'm convinced that Facebook operates a sort of monopoly; making it a star performer. In this specific case, there's no point in dumping a company that may return investors a 4 or 5 bagger in favor of a smaller company that may end up losing investors their hard earned money.
To drive my point home, I'm going to present you the investment returns of a small-cap technology fund.
Not to knock on the Small Cap Tech ETF (NASDAQ:PSCT), I'd gladly take a 15.93% annualized return over a 3-year period, but unfortunately it underperformed the S&P Small Cap 60 Index over the same timeframe. Furthermore, small technology companies don't always exhibit high growth rates, as some of them are niche plays that have limited growth potential. In many instances I run into tech companies that are borderline value traps, as they do grow, but grow slowly. The management teams at these small tech companies saturate a very small market, but fail to invest into new initiatives to grow the business outside of its core competencies. Not so surprisingly, the management becomes conservative and relies on share buy-backs, and organic growth to sustain earnings growth. Sometimes this works, and sometimes it doesn't. Average the performance out over an index like the one you see above, and it becomes easier to explain why Facebook offers a great risk to reward even when compared to smaller tech companies.
Facebook is both big and it grows revenues at absolutely breath-taking rates (100% year-over-year growth is expected for the current quarter). To me, Facebook is one of those rare investments where it makes sense to buy into a big company rather than a small company, as the risk-to-reward and predictability is well defined. Global advertising is a massive market ($500 billion according to Magna Global), giving Facebook plenty of room to grow. Facebook has the best platform for advertising because it is disruptive and drives productivity gains. Looking over industry wide results, mobile ad-spending grew by 105% in 2013. The industry's growth rate was primarily driven by Facebook's successful transition from desktop ads to mobile ads. Pair that with a successful track record for acquiring companies and you have a very well-run business despite the puzzling valuations that Mark is willing to pay for smaller companies.
In other words, on a portfolio basis buying all small caps versus all big caps makes sense. Average the performance out and you'll come ahead by a couple percentage points (based on the benchmarked returns of the S&P Small Cap 600 Index versus the S&P 500 over a ten-year period). However, when you have the opportunity to be more selective than an ETF, you have to weigh risk-to-reward. When you can buy a big company like Facebook that also generates high growth rates that are very predictable, it's hard for me to recommend a smaller company that may or may not succeed.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.