Too often, we have seen investors pass on a fundamentally sound stock or ETF based simply on its valuation. Valuation is certainly a very important metric, but it must not be the only metric considered in making an investment. Chipotle (CMG) is a prime example of this.
We recommended Chipotle on October 6, 2011. The reaction to the article was as expected. Many commenters were critical, arguing that the stock is too expensive to invest in, that it is poised to fall sharply. And yet, readers who invested in Chipotle at that time are up more than 41%, nearly twice the performance of the S&P 500 [We are not writing this to debate where Chipotle goes from here. Rather, we are using it as an example of the fact that valuation is not the only aspect that should be considered in making an investment].
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No investment should be bought into or avoided solely on the basis of its valuation. With that in mind, we turn now to the social media sector.
GSV Capital & The Firsthand Technology Value Fund: Valuations are Relative
For readers unfamiliar with these two companies, GSV Capital (GSVC) and the Firsthand Technology Value Fund (SVVC), are two publicly traded funds that investment in a variety of private companies. These funds are most notable for holding stakes in Facebook (FB). GSV Capital holds currently holds 350,000 shares of Facebook, while the Firsthand fund holds 600,000 shares. Both funds have done well year-to-date, with the Firsthand fund putting in an especially great performance.
Given the rise of these funds, especially the Firsthand fund, it is inevitable that some will claim that they are overvalued. We do not believe that this is the case here, and we examine their valuations below.
GSV Capital's net asset value per share was $12.95 at the end of 2011, and it closed on Thursday, April 5 at $18.07 (the most recent trading day as of this writing). GSV Capital trades at a premium of 1.4x stated NAV. The Firsthand fund had a net asset value per share of $23.92 at the end of 2011, meaning it trades at 1.63x stated NAV as of this writing (it closed at $38.93).
[These NAV measures do not take into account recent activities, such as a secondary offering by GSV Capital, or valuation changes in underlying investments. We have calculated updated net asset values per share for both funds, and have arrived at net asset values of $14.06 and $25.12 for GSV Capital and the Firsthand fund, respectively. These values were generated by updating valuations to reflect the most recently available private market valuations (from SharesPost), or the last closing price for publicly traded securities. For GSV Capital, the most recent stock offering is included, but the recently disclosed offering for the Firsthand fund is not, since it has not yet been priced. Full data for these update NAV's is available for download here.]
Most investors would likely think that any deviation of an ETF of fund from its NAV is an ominous sign of overvaluation. But in this case, we do not believe that NAV is the proper way to value these two funds. At least not to the market.
Net Asset Value: What Is It Worth?
Traditional mutual funds, the kind bought from Fidelity, TIAA-CREF, etc., are bought and sold at NAV. But ETFs and publicly traded funds like these are bought and sold at market price. Furthermore, for most retail ETF investors, the concept of NAV does not mean much. How can we say that? Are we saying that valuation does not matter? Not quite.
When it comes ETFs, such as the SPDR S&P 500 (NYSEARCA:SPY) , or the Dow Diamonds (DIA), they do not necessarily have to trade at NAV. Many ETFs trade very close to NAV, but it is not required that they do. Their prices are set by the markets, and as such they may diverge from NAV. The only way to buy shares of ETFs at NAV is directly from the fund company via creation units, usually in blocks of 50,000.
GSV Capital and the Firsthand fund are not true ETFs, for they are structured as business development companies. We believe that it is more prudent to look at these funds from a book value per share perspective, even though the numbers are all the same.
Book Value per Share: Facebook Shares at a Discount to the Market?
From a mathematical standpoint, 1.4x NAV or 1.63x NAV is the same as saying 1.4x book value or 1.63x book value, since by definition, net asset value is assets minus liabilities, or the same as book value. In essence, GSV Capital and the Firsthand fund trade at a price to book ratio of 1.4 and 1.63 respectively. And we do not think that this is an outrageous multiple by any measure. And in fact, this is a discount to the broader markets as a whole.
The SPDR S&P 500 ETF, the largest index ETF, trades at a price to book ratio of 2.24 (the Dow Diamonds, which tracks the blue-chip Dow, seen as a bastion of value, trades at a price-to-book ratio of 2.83, making it even more expensive than the broader S&P 500). If the social media stocks that made GSV Capital and the Firsthand fund trade at such a large premium to NAV are truly in a bubble, then how can they trade at a P/B ratio below the market?
We do not think that NAV is the proper way to value these two funds. Large ETF's trade near NAV because it is far easier to eliminate any potential divergences between the price of the fund and its underlying securities, because the underlying securities are usually publicly traded stocks or bonds. Not these two funds. The kind of arbitrage seen in large ETFs like the Dow Diamonds or the SPDR S&P 500 cannot be carried out with GSV Capital or the Firsthand fund, as the securities they hold are, for the most part, private company stock [with the exception of Yelp (YELP) and Groupon (GRPN).] We see no valuation issues with these funds, for even 2x book value would be inexpensive, especially given the fact that they invest in rapidly growing companies such as Twitter.
A Note of Caution
While we are fundamentally bullish on GSV Capital and the Firsthand Technology Value Fund, we must issue a note of caution to readers. Both funds can be volatile, as evidenced by recent trading action in the Firsthand fund. These securities are not meant for passive/casual investors, but for those who are actively managing and trading their portfolios on a daily basis. Investors must take volatility into consideration when making an investment decision.
We do not think that GSV Capital or the Firsthand Technology Fund have valuation issues. They may trade at a premium to NAV, but the nature of these two funds, in our opinion, makes NAV a flawed method to value them. Looking at them from a price-to-book perspective is in our opinion a better method. And given that mathematically, net asset value and book value are the same, we see no issues with such an approach.
At 1.4x and 1.63x book value, we believe that GSV Capital and the Firsthand Technology Value Fund offer investors an attractive way to invest in leading private (and some soon to be public) companies such as Facebook, Dropbox, and Twitter.