Why Investors Keep Buying Social Media Stocks, Even if They're Overvalued

NEW YORK (TheStreet) -- It's no secret that social media stocks are overvalued now, especially if you look at the fundamentals. Yet investors keep buying them, pushing their prices up even further. The question is why?

We've already seen the mania around companies like Twitter (TWTR) and Amazon (AMZN) (for years), and the recently IPO'ed Lending Club (LC) . This year brings us more copy-cat stories: Instagram and Snapchat.

Jim Cramer's charitable trust Action Alerts PLUS owns Twitter. Read AAP's analysis of Twitter's earnings here.

Instagram, just a social-media app for sharing prettied-up photos, was apparently valued at $33 billion by Cowen Group this month, and at $35 billion by Citigroup in December. Even at the lower level, that would put its valuation at 47 times projected revenue for 2015 -- never mind its earnings multiple. Snapchat is an even more excessive example: It's reportedly seeking to sell a $500 million stake that would give it a valuation of between $16 billion and $19 billion -- up from the already huge $10 billion valuation implied by its last funding round in December. Here's the kicker: Snapchat only began to generate revenues ... last month.

The whole valuation basis of these companies rests on the assumption that their rapidly growing numbers of users can, sometime soon, be leveraged to lure in a massive amount of advertising revenue. But according to Asawath Damodaran, a professor of finance at NYU's Stern School of Business, "the total advertising market is not there, which means something has to give. A lot of the companies you think are big winners are going to fall off the table.... The market is using the same story for company after company after company. If you add up the stories, it doesn't make sense."

In fact, it's not clear that any type of objective financial analytics can be performed on these companies at this stage and at these sorts of excessive valuations. The more interesting question is: Why this is happening? What could possibly fuel the type of mania that would induce investors to pay these prices? And why specifically in the Internet social media?

Profit Is Nice. Keeping Up with the Joneses Is Nicer.

One way of attacking this problem is through the following question: Just because these stocks are demonstrably overvalued based on the fundamentals, should you be shorting them (if you could)? My answer is no -- or, at least, not necessarily.

We are dealing here with a large -- and, in fact, common -- dislocation between market value and fundamental value in these stocks. These dislocations are endemic to markets and can last a long time. Markets are regularly quite irrational -- gaps between market and fundamental value are not always rapidly arbitraged away as the efficient market hypothesis would like us to believe.

There's a quintessential behavioral finance experiment that can provide some insight into this. Imagine you're told you must chose between these two options: A, you receive $100, while a colleague receives $150; or B, you receive just $80, but your colleague also only gets $80. If people behaved as pure profit maximizers, we would naturally chose option A. You're better off with $100 than $80, so what does it matter that someone else got $150? But in fact (and researchers have run this experiment many, many times), the most common answer is B: Most people will take less money to prevent someone else from getting more than they do.

It turns out that this socially competitive aspect of humanity is foundational to our investment behavior. People spend all their time looking over their shoulders at how others are doing. My absolute performance is important to me, but just as important (perhaps more important) is my relative performance. Man is, to quote Aristotle, a "zoon politikon" -- a "social animal" --  and emotional matters such as our perceived place in the pecking order, our ability to "keep up with the Joneses", jealousy and social reciprocation all turn out to have a major impact on how we invest.

In the case of social media and Internet stocks, there's a whole zeitgeist surrounding them. We think of them differently than other investments -- as cutting-edge businesses, driving change, transforming the world. We commonly hear about "disruptive" technologies -- but without much in the way of an explanation about what that might really amount to.

Certainly, a few of these companies may well bring transformatory change (as Microsoft (MSFT) , Apple (AAPL) and others did, for example). And early  investors in such winners will enjoy huge profits from getting in on the ground floor of genuine dynamic change. But it's likely to be a very few companies, and a few investors.

Everyone Wants to Be in the Club

This creates the perception of a type of "inner circle club," a group of people who are really hitting it big from the Internet and social media revolutions. And that is precisely where the psychology of behavioral finance takes over. The average investor perceives (or believes he perceives) this inner club. He wants to be part of it. So surely he should play these stocks too, become a member of the club, and benefit from the eventual windfall.

This has led to an intense groupthink phenomenon around these stocks. In their desire to join the elite innovator club, everyone piles into these equities, turning what might have once been an unusual choice into its opposite - a new form of herd behavior.

This groupthink develops well before the public market is involved at the IPO stage. The crowd of private venture investors are another huge cohort of sheep, entranced by the same mantra, believing they are somehow uniquely understanding the innovation cycle, alone in seeing the true value when they price a company like Uber at $40 billion. I've even heard that many such investors say they were perfectly happy to have been invested in failed start-ups, just for the privilege of having been there, members of the club.

In other words the famous "greater fool paradox" is now hard at work: These stocks keep rising because if you buy shares today, you can feel confident that another lemming will come along behind you willing to buy them at a still higher price later. Eventually, one lemming will be left holding the bag, but who knows when that peak will come.

So that's what's going on with all the stocks thriving in the social-media mirage. Their prices have nothing to do with the businesses fundamentals, and everything to do with fundamental human nature. But that doesn't mean I'm suggesting you don't pile in. Just understand why you are piling in: You are buying these stocks hoping to ride a pattern of herd behavior, and gambling that you'll be able to jump out before it collapses -- not because you have any real insight into the value of the relevant stock, nor in the quality and sustainability of its business.

One last thing: Human talent is generally "normally" distributed -- and that includes investment talent. That means most of us are somewhere near the norm, skill-wise. But a few, are way, way out at the thin end of the curve: the Warren Buffetts, the unique and consistent players who have outperformed others over time. Of such outliers, I will just say this: I am not sure these unique investors do ever join the herd, nor do they covet a spot in those illusory "insider clubs."

Meanwhile ... keep buying social media stocks.

Jeremy Josse is the author of Dinosaur Derivatives and Other Trades, an alternative take on financial philosophy and theory (published by Wiley & Co).

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

More from Stocks

Deploy the Airbags, Fiat Chrysler Stock Is Set to Decline Further

Deploy the Airbags, Fiat Chrysler Stock Is Set to Decline Further

Smart Devices the Size of Dust Particles Are Coming; Here's How to Play It

Smart Devices the Size of Dust Particles Are Coming; Here's How to Play It

Dow Leads as Stocks Rally Out of the Red

Dow Leads as Stocks Rally Out of the Red

General Electric: Another Look at the Fundamentals and the Charts

General Electric: Another Look at the Fundamentals and the Charts

'Crypto Hangover' Crushes Nvidia Stock As Wall Street Reins in Targets

'Crypto Hangover' Crushes Nvidia Stock As Wall Street Reins in Targets