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Why We Shorted Social Media Stocks (SOCL) And Biotech (IBB) On February 20th?

|Includes:AMZN, FB, GILD, GOOG, IBB, LNKD, Global X Social Media Index ETF (SOCL), TWTR, XBI

In trading markets this year, our strategy is guided by the words of Horace: "Many shall be restored that are now fallen and many shall fall that are now in honor."

Last year, social media stocks were up 63% on average while the biotech industry was the top-performing sector with a 66% gain in the Nasdaq biotech index. Since the 2009 low, biotech has caught fire and the group has put in an impressive return of 346%, clearly outperforming the S&P 500 which has risen a meagre 182% in comparison.

Before we move on, I must confess that both sectors are not my strong suit.

I'm technologically challenged.

I don't tweet. I don't share pictures on Instagram. I'm not on Pinterest and you can't add me as your friend on Facebook. I'm cool enough to carry an iPhone but not savvy enough to have more than five apps on it. It has been more than a decade since I last downloaded a song or a movie online.

No, I'm not kidding. It has been twelve years to be exact. See, I told you, I'm technologically challenged. I'm not proud of it. I just can't help it. I like keeping things simple and this new wave of technology just seems to add clutter in my life.

Now, when I hear about WhatsApp being sold to mighty Facebook for $19 billion that piques my interest. I force myself to overcome my shortcomings, even if just for a little while. Of course, I don't get the deal. I mean I get the deal, I don't get the price. If I was the kid from Instagram I'd be pretty angry at myself for selling out so cheaply. All of a sudden that deal looks like a steal. Mark Zuckerburg is growing up to be a true value investor.

According to a recent Forbes article, WhatsApps' 470 million users have already erased $33 billion in SMS revenue from wireless carriers. That's not chump change and a great example of creative destruction. The company makes $20 million in revenue but the founders believe they can get to $1 billion by 2017 as the service grows and billing falls into place. They charge nothing for the first year and then ask the user to pay $1 a year thereafter. It costs WhatsApp only five cents to support each user, and it's charging customers in only a handful of countries at the moment, like the US and England, where mobile payments are relatively mature. Even if the financial goals are unmet, however, which is highly likely in my view, well that's okay. Apparently Mark Z has promised the WhatsApp founders "zero pressure" to make money, saying, "I would love for you guys to connect 4 to 5 billion people in the next five years."

I don't read Forbes. But I came across another interesting article yesterday thanks to Barry Ritholtz of The Big Picture blog. It was a great interview with Bill Janeway of Warburg-Pincus on tech valuations and the innovation economy. This is what we had to say: "Obviously, the valuations are huge relative to any set of metrics. It is new ground. Each one of these companies represents a new foray into what appears to be a limitless market space with evidence from Google and Facebook and potentially Twitter, that it can be monetized and generate positive cash flow over time. Think about what happened in the 1880s, as Railway Express provided the layer of "infrastructure software" on top of the railroad network in North America, which in turn enabled Montgomery Ward and Sears Roebuck to deliver the "killer app" for the railroad age known as mail order retail, which completely transformed the economy, created national brands like Procter & Gamble and re-architected the physical and economic architecture of North America. That is the kind of phenomenon that Google, Facebook, Amazon, EBay, Twitter represent. Trying to value them on a net present value of expected cash flows is just not relevant yet. Sooner or later, it will become so. The value now is driven by supply and demand amongst speculators who have liquidity and will not have to stick around to find out what the fundamental value turns out to be over time. Having said all that, I actually think the value of social media companies have relatively trivial significance to the overall health and prospects of the innovation economy."

I find it interesting that Bill Janeway compares today's social network stocks to railroads. In many ways, social network stocks are the new railroads. After all, they're building and connecting the information highways for the future. I get it, it's revolutionary. I wanted to get a historical perspective on railroads so I turned to Edward Chancellor (the authority on manias) and pulled up an article he wrote in the FT back in 2010. As with all bubbles, it appears that railroads too entered a self-promoting cycle based on extreme over-estimation of the potential market size (think of Bill's "limitless market space"). Railroad entrepreneurs found a ready market for their stocks and bonds to fund their massive expansion plans. Investors accepted uncritically their magical vision and chose to favor over-optimistic speculation. Of course, this ended badly. Shares collapsed once valuations reached bubble territory and investors realized that railroads were not as lucrative as they were led to believe.

Could we be making the same mistake again?

I was still a tad bit confused so I reached out to Amad, my younger brother who is also a much better looking version of me and a rising star in Dubai's social media and tech scene, to help me understand what's actually going on here. He got super excited since he's obsessed with technology. He stopped playing with his porn star moustache and started talking, "Don't you see it, the desktop age is over. The world is moving to mobile now and we are still early in this major transition. Never before has there been a device that can give you the power of your desktop computer yet sit in your pocket and give you direct contact with businesses and even government services now. The newness and exponential growth of smartphone platforms has left room for innovation in all business categories. I think Facebook gets this better than most and they want to be the leader in mobile. Mark and Sheryl realize how big of a market it will be, and that's why they have adapted their strategy to develop and buy-out multiple apps for mobile. Google owns desktop. They want to own mobile."

I was losing interest but he continued anyway, "Currently on my phone I have 4 apps that are somehow linked to Facebook. When I download other apps on my phone I don't put my email, I choose to connect with Facebook instead, it is easier and faster and at the end of it Facebook already has my data so why not just simplify the use of mobile apps given my short attention span."

I agreed with his short attention span.

"We are going to see a mobile war in the next ten years," by now he was becoming even more animated in his discussion and I was only wondering how long it must have taken him to grow that sexy moustache. "People are still underestimating the power mobile holds in our daily lives. The very first and last thing we do is check our phones, and we tend to check our phones over 100 times a day, even at 15 second spurts when we are out and about, looking to buy, to research and to visit. We have gone one step ahead with our customer purchase cycle on mobile, now its just finding a way to capitalize on the users journey and give them the right information at the right time in the right manner."

I don't usually listen to my younger brother but he makes some valid points in this case. He's making a secular change argument and I understand that now. However, the way I see it, we are in the first innings of the new social media revolution. In this phase, social mood is most elevated and valuations reach bubble territory fairly quickly and before the underlying story is even given the chance to be fully validated. This mix subsequently leads to a bust and then a far more gradual grind higher as reality and perception merge over the long-term. We saw a similar dynamic play out in the solar industry and it is probably occuring in the 3-D printing stocks as well.

Social network stock prices have seen a more than three-fold surge since mid-2012. These basket of stocks are trading at 12 to 13 times sales (almost equivalent to valuation levels at the peak of the tech bubble) and their average P/E ratio is meaningless as a majority of them are yet to report any earnings. As Seth Klarman notes in a recent letter to his investors, "In Silicon Valley, it seems that business plans - a narrative of how one intends to make money - are once again far more valuable than many actual businesses engaged in real world commerce and whose revenues exceed expenses."

I have not built-up a multi-tab financial model for these stocks and I admit to having no insight into their prospects for future profit growth. Like I said, I'm no tech expert. I was simply following the words of Horace when on February 20th (the day Facebook created even more billionaires) we opened a trifling short position in the Global X Social Media Index ETF (NASDAQ:SOCL) which has Facebook, Twitter, Yelp and Google among some of its major holdings. I feel the WhatsApp purchase may mark a peak of some significance for this exuberant sector over an intermediate horizon. And just in case we're wrong, we have a tight stop in place. We believe in being open-minded and flexible when challenged by the market.

Moving onto the biotech industry quickly, it is easy to see the sector has become massively overheated. According to The Economist, the current biotech boom has seen more firms go public and more money being raised than at any time since 2000, which was known as the golden year. I totally get that big pharma companies are suffering from weak product lines and patent expirations and that smaller biotech firms have now become research engines for the larger firms and are at last starting to reap the rewards of studying the human genome. Naturally, there is an avid interest from the larger players to support and acquire cutting-edge biotech companies. With cheap availability of credit, the M&A boom is unlikely to run out of steam anytime soon. However, hot money flows into the biotech group have driven up valuations to nosebleed levels. For instance, the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) is currently valued at 9 times average book value.

According to Abdulaziz Shikh Al Sagha - a young analyst based in Dubai who knows more about this space than any other person I know - the biotech sector is collectively worth more than $500 billion now which is more than the aerospace and defence industry and the automotive industry combined. Does that make it a bubble? No. However, Boston Consulting Group reckons that 90% of the money spent researching new treatments goes on drugs that ultimately fail. Does that make me worried? Yes.

After a near vertical ascent, technicals are also begninning to appear way too stretched for the parabolic advance to continue at this pace. IBB is trading at a very strong Fibonacci and upward-sloping channel resistance which I don't expect to be cleared right away. A sizeable price decline is probably around the corner and we have initiated a short position in IBB as part of a tactical pair trade to take full advantage of the overextension.

It feels absurd to chase these high-flying stocks even higher. I'd have better luck chasing Jennifer Lawrence.

Disclosure: I am short SOCL, IBB.

Additional disclosure: We went short on February 20th and we will alert our real-time subscribers once we cover those positions. Visit for additional information.