To the untrained observer, social media companies are often a bit of a mystery: Many of them are receiving huge valuations while operating at a loss. Some do not even have a clear business model yet; they are loosely based around the idea of advertising, or for the more adventurous, the notion of giving something away for free while selling premium upgrades.
American firms that fall into this category include Facebook (NASDAQ:FB), LinkedIn (NYSE:LNKD), Groupon (NASDAQ:GRPN), Yelp (NYSE:YELP), Pandora (NYSE:P), Zynga (NASDAQ:ZNGA) -- with many more in the pipeline, including Twitter, AirBnb, and Foursquare among others. The Social Media ETF (NASDAQ:SOCL) is a way to play this via ETFs, although it should be noted that SOCL has over 70% of its holdings in social media companies domiciled outside of the U.S.
How can investors better identify whether these companies are worth it? Here's a standard checklist of sorts I use:
Is it small? The main thing about these Internet companies is their ability to re-organize how the world is coordinated. To deeply understand this issue, I recommend reading Ronald Coase's essay, "The Nature of the Firm," which notes the purpose of the firm is to reduce contract costs of collaboration. The Internet reduces collaboration costs without the need to create a corporation -- thus we are able to see things like Wikipedia, a peer-produced encyclopedia with just 35 employees as of 2010, and Craigslist, which also has just over 30 employees. This is the right model for the Internet, and the real Internet winners will be those with extraordinary per employee metrics: Revenue, profit, and market cap per employee are the numbers to watch. Once you see an Internet social media company start hiring tons of employees, you immediately can see that their per employee numbers will not be that good, and that they probably are not doing a great job of coordinating the world outside of their firm. One benchmark I like to compare Internet companies to is Silver Wheaton (NYSE:SLW), a precious metals royalty company that has the highest market capitalization per employee of any U.S.-listed stock -- including Apple (NASDAQ:AAPL). The best Internet companies will have the potential for a market cap/employee metric that surpasses both Silver Wheaton and Apple. I find 150 employees -- Dunbar's number -- to be a worthwhile metric in determining whether a company is small enough to have solid per employee metrics and be compatible with the nature of the Internet. Pandora has over 600 employees; Yelp, has over 900, and LinkedIn seems to have over 3,000. These companies are too big and bloated -- which is a big part of why they should be passed on. The bigger the social media companies grow in terms of employees, the more they will compete with Internet titans like Google (NASDAQ:GOOG), Apple, and Amazon (NASDAQ:AMZN). That is a game I am confident they will lose.
Does it have a niche focus? Related to the idea of being small is that of having a niche focus. If the customer is simply "everyone," or some generic user, the company will put itself squarely on the path to competing directly with the established aforementioned incumbents.
Does the monetization system rely heavily on cost per click (CPC) or cost per thousand impressions (CPM) advertising? This is Google's bread and butter, and so a startup that tries to build a business model on such grounds is aiming to compete head on with Google on its most prized turf. That's a losing proposition, in my opinion. Social media companies are better off capturing a piece of the transaction, or charging for content placement.
The Real Opportunity is in Overcoming Peak Everything
The real opportunity in the social media space, which many companies are addressing, is that of coordinating society in a way so as to overcome "Peak Everything" -- a world in which resources are increasingly scarce and unable to support a burgeoning global population. Although statistics are hard to accurately assess here, my hunch is that scarcity is largely a problem related to distribution and governance of shared commons. As social media companies have the abililty to facilitate resource-sharing and distribute goods and information in new ways with unprecedented efficiency, I think there is an enormous opportunity for Internet companies to use resource sharing to alleviate scarcity resulting from Peak Everything. Car-sharing services like GetAround, house sharing services like AirBnb, and online gold services like Bullion Vault and GoldMoney are prime examples of the early stages of what I'm referring to.
As this trend grows, social media companies will find themselves increasingly in conflict with the nation-states of the world. Indeed, the world has already gotten a taste of the "Twitter Revolution" that occurred in the first half of 2011. That "revolution" was a bit incomplete, but I do believe it will grow in strength and significance in future incarnations.
Bottom line: Companies with business models that do not depend on CPC/CPM advertising, that have less than 150 employees, focus on a niche, and address the issue of resource scarcity are going to be huge opportunities for investors. Unfortunately, many of them will be private market opportunities that may come to public markets at full valuation, if at all. But it is one of the best opportunities I see out there. I think the right social media company, if it can come to public markets at a reasonable valuation, could give investors Apple-like returns.
Disclosure: I am long SLW.