Since the common stock market investors lacks the financial and informational wherewithal to make direct venture capital investments, they should consider the next best alternative: backing recent IPOs and small cap stocks. Emerging companies that just went public have the potential for strong returns akin to those in venture capital. While a $10,000 investment in the S&P 500 a decade ago would be worth just $11,239 today, the same investment in the Vanguard Small-Cap Value Index Fund (VISVX) would be worth $17,507 - an outperformance of more than 6,250 basis points!
In my view, the reason why small cap value firms outperform larger peers is because their future streams are more heavily discounted due to risk perception. Just like how government debt yields a lower return than equities due to the greater demand for the former's security, growth stocks underperform value stocks. When the fundamentals prove the risk perception to be overblown, appreciation follows. In this article, I will compare four different companies that have recently gone pubic and are possible substitutes for venture capital investments. Like any venture capital investment, I recommend broad exposure in case one busts. The one caveat is that I would stay away from Groupon and invest in the other three only if you are willing to take on considerable risk.
Since going public around 7 months ago, the stock has lost nearly two-thirds of its value. In my view, this was the result of a lack of fundamentals to justify the valuation. The main problem with Groupon is that it is not necessarily sustainable given competition. New entrants and the old-fashioned competition of magazine coupons is a reality that Groupon can't really defy no matter how zoomy their website looks.
Sadly, I do not believe that the firm has much of a future for current investors. The only way for Groupon to address competition is to diversify elsewhere and doing so would be a shift away from the core business. Unlike other tech companies that can find synergistic value in another segment, there really is few areas that can cross-over costs or sales in a coherent model. At the end of the day, coupons are just coupons.
LinkedIn was initially speculated to be the way to play potential momentum at Facebook (FB). But the Facebook IPO turned out to be an immediate flop, and the market took this as a sign that the current social networking investors were, well, breathing "hot air". Since the Facebook IPO, its "professional cousin" fell by 5.8%.
I actually find it very interesting that value decidedly continued on a negative turn as soon as Facebook went IPO. Being a sympathizer of the efficient market hypothesis, I anticipated a local market correction before Facebook's decline. Indeed, LinkedIn's decline began two days before the IPO, but the decline was much less than what it should have been. After all, the much smaller firm trades at 276.2x 2011 free cash flow versus the still sizable 65.3x for Facebook.
Like Facebook, LinkedIn will have to generate impressive momentum to justify its current valuation. By my calculations, even if the company grows at just 40% annually over the next six years at a discount rate of 10%, the stock would fall by the double digits.
On the other hand, LinkedIn may be a surprising value play. Unlike for Facebook, too many investors relatively - and "relatively" being the key word - discount future diversification. In my view, LinkedIn is less of a fad than Facebook. Like instant messaging, online chat systems have historically been ephemeral. On the other hand, there is a strong need for improvements in HR management. I could see, for example, LinkedIn helping users connect with corporate recruiters for a price.
Zynga is yet another company that is likely to correlate with Facebook's momentum, as it actually represents 15% of the social networking site's business. And, again, the "momentum" has not been good. Since Facebook's IPO, Zynga has lost 38.3% of its value. This represents much of the value lost since the social game developer went public mid-December last year.
Assuming that the company grows operating cash flow 30% annually in the intermediate-term and the multiple falls by 30%, the stock price is still positioned for double-digit appreciation. The case for this bull thesis is certainly there given that analysts model 23.3% per annum growth over the next half decade.
Street optimism is also reinforced by the company's early mover advantage. Revenue nearly doubled to $1.14B in 2011 off of the preceding year. The average volume for Zynga has been high at 25.3M, which means the firm will be quick to correct when Facebook releases its quarterly results in about one month and a half.
Like the other three firms above, Pandora has also been on a precipitous decline since going public. It is down 39.4% and faces significant competition from Sirius XM (SIRI) in its quest for growth. Sirius has rightfully been likened to a monopoly and generated better-than-expected momentum. This kind of contrast makes Pandora, an emerging social company, appear badly - like a bunch of "hot air" that will never rise against the insurmountable competition.
With that said, I actually like Pandora. In fact, I am listening to the "Simon & Garfunkel" station as I publish this article. Occasionally, Pandora prompts me to confirm that I am indeed listen and candidly confesses that it doesn't want to "play to an empty room" in light of licensing costs. Just like Netflix (NFLX), the costs of acquiring media content is evidently high and best absorbed by the strongest provider, Sirius. I am still optimistic that Pandora will penetrate radio and innovate the market through empowering users to create their own stations. Accordingly, I recommend opening a long position in the firm.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.