Washington Is Coming for Google and Facebook Profits

The regulators are coming for Google and Facebook. Company executives have taken note, and investors should, too.

The latest call for regulation came this week, when, as Bloomberg News reported on Tuesday, Google parent Alphabet Inc. disclosed that “Russian-linked accounts used its advertising network to interfere with the 2016 presidential election.” That follows recent disclosures from Facebook Inc. that it was paid by Russians for election-related ads.

Regulators didn’t need any more reasons to target Google and Facebook. As my Gadfly colleague Shira Ovide recently pointed out, they are the new media barons, wielding “enormous power over what news and entertainment get made.” They’re also the second- and fourth-largest U.S. companies by market capitalization, respectively. It’s hard to see why they should be exempt from an otherwise highly regulated industry.

The two barons are taking the threat seriously. Google convened a retreat last month with 200 policy experts to debate whether its size makes it an attractive target for regulation. (Answer: Yes.) Facebook has hired two crisis PR firms, and CEO Mark Zuckerberg and COO Sheryl Sandberg are reaching out to members of Congress. Both companies are also spending record amounts on lobbying.

Google and Facebook are hugely profitable, and regulation would be a drag on that. Facebook and Google’s profit margins were 42 percent and 14 percent, respectively, as of the end of the second quarter. That’s well above the S&P 500 Media Index’s margin of 10 percent and the S&P 500’s 9 percent.

The risk that regulation may dent Google and Facebook’s profits may help explain an enduring mystery in finance.

It’s well known that certain styles of stock-picking have historically beaten the market. Value investors have enjoyed higher returns than the broad market since 1926. So, too, have investors in small-cap stocks. These so-called value and size premiums are either compensation for taking more risk, or simply investors in beaten-down and smaller companies exploiting other investors’ preference for larger and growthier companies.

Either way, the value and size premiums make intuitive sense. It’s reasonable to assume, for example, that Westmoreland Coal Co., one of the smallest companies by market cap in the Russell 2000 Value Index, is riskier than Apple Inc., the largest company in the S&P 500. It’s also clear that more investors want to own Apple than Westmoreland. Investors deserve extra compensation for taking a chance on the riskier, less-loved company.

Now for the mysterious part: A third style of stock-picking that has historically beaten the market is profitability. The Fama/French U.S. Big Robust Profitability Research Index returned 11.2 percent annually from July 1963 to July 2017, including dividends, while the S&P 500 returned 10.1 percent.

Unlike value and size, the profitability premium defies intuition. Highly profitable companies such as Google and Facebook appear to be a better bet than less-profitable companies. And investors love them — Google and Facebook are two of the coveted FANG stocks.

Why should investors earn a premium for owning highly profitable and sought-after companies?

Part of the answer may lie in the regulatory threats surrounding Google and Facebook.

One way to think about the profitability premium is that companies have different levels of expected profitability but also different probabilities of achieving those profits.

There are many variables that can affect the probability of capturing outsize profits. One variable is that a disproportionate amount of the profits of growth companies such as Google and Facebook is expected in the future, which makes those profits more uncertain. Another variable is competition: Highly profitable companies have a way of attracting challengers.

And yet another is regulation. There’s less regulatory uncertainty for companies that are already highly regulated, such as JPMorgan Chase & Co. or Ford Motor Co., for example. So their regulatory burdens are baked into their expected profitability. The probability that their profits will materialize, in other words, is higher than that of Google and Facebook, which face considerable regulatory uncertainty.

Investors may collect their profitability premium from Google and Facebook. But every time their executives are summoned before Congress, it’s a reminder their profits are far from certain.

Source: Bloomberg Gadfly, https://bloom.bg/2lWTiPC