Why I Underestimated LinkedIn

"Fool me once... shame on you. Fool me -- you can't get fooled again." -- Former President George W. Bush

One of the best ways to grow as an investor is to study mistakes. The cheap and easy way is to study the mistakes of others. It's free, there are plenty of mistakes to choose from, and you don't have to lose your own money in the process.

The most valuable lessons are hard won, though, and they usually involve skinning your own knees. Taking trips down haunted memory lanes isn't fun, but it will help you to avoid making the same mistakes twice.

One of my biggest whiffs over the past two years has been LinkedIn (NYSE: LNKD  ) . I haven't shorted the shares or been on a crusade against them, but I didn't pull any punches on our podcasts in the months after the IPO when I said the shares were grossly overvalued. Meanwhile, the shares have almost quadrupled since the start of 2012.

So what did I get wrong about LinkedIn? And, more important, what can we learn from the experience so that we don't repeat those mistakes?

I'm a big fan of the product... but ignored that.
I've been a big believer in the value of using LinkedIn almost since it launched slightly more than a decade ago. The value of a living, breathing CV and the ability to tap into networks of friends and colleagues was stunning. In classic network-effect fashion, the benefit of being active on LinkedIn grows with each new user -- and user growth has been booming for years now. If anything, I couldn't understand why it took so long for so many professionals to register and get active.

There's more. Not only was I sold on the value of LinkedIn's user proposition, but our own HR department at Fool HQ is in love with its services. LinkedIn allows employers and recruiters to hyper-target job ads to candidates with just the right mix of skills. LinkedIn also acts as a virtual showroom for all its users, allowing employers to walk in, scope out the human merchandise, and reach out to right talent.

The unique combination of value to free users (which builds the network) and new, valuable recruiting tools (which monetizes the free users) is a tremendous one-two punch. And LinkedIn's network effects become more ingrained and powerful with each new user who signs up and each new employer who posts a job advertisement.

It's hard to believe that I didn't buy into this beautiful business from the start, particularly when you consider the scalable, capital-light model and miles-long growth runway. Unfortunately, I didn't. Even worse, I've made the mistake of not following my consumer nose before!

This is a bad habit of mine. I ate Chipotle burritos with voracious abandon before the business went public and was tempted by the company's tasty economics -- but I balked because I thought the shares were expensive. I owned back in 2002 at about $16 -- I loved buying books from Amazon and still do today -- but the shares' volatility was too much for me, so I sold. And I bought shares of Apple for my grandmother back in 2003 at a split-adjusted price of around $8, recognizing that iTunes was the long-awaited panacea for those of us who wanted digital music, didn't like downloading it illegally, and wanted it all bundled up in an easy-to-use package. I sold shortly thereafter because I talked myself into thinking technology companies were too difficult to understand.

Yes, I've missed out on several multibaggers whose products I adored. As an aside, I'm glad you can't see my face right now. On the bright side, consider this a lesson taken to heart. Better late than never.

I didn't give a long valuation leash for a first-rate business.
As Warren Buffett might say, it's better to own a great business at a fair price than a fair business at a great price. Yet, despite that, here I was missing out on all these multibaggers of great companies whose products and services I used and respected.

I chalk this miss up to two specific points. The first is that, personally speaking, I tend to underestimate operating leverage when valuing companies. That's caused me to cash out of capital-intensive businesses turning corners at too-low prices and undershoot on high-growth, capital-light businesses with relatively fixed cost structures. Given LinkedIn's torrid growth and light model, it's safe to assume it will be one of those corporate Annie Oakleys that shoots the margin lights out over the next few years.

The second valuation trap I've fallen into with high-growth companies is not fully wrapping my head around the power of their exponential growth. Consider, for example, two businesses -- one growing at 20% over five years and another at 25%. Sounds similar, right? Compounded out, though, you'll see that the business growing at a 25% clip will have grown 200% while the 20%-grower clocks in at a much-smaller 150%. Such growth, when you can find and correctly forecast it, goes a long way toward making up for a full-bodied valuation.

Filtering stocks based on valuation heuristics causes you to miss out on outstanding businesses with multibagger potential. Not all growth is good and no business is a buy at any price, but you can't let a high price tag distract you from the right approach to valuation: Start with the business, end with the valuation.

And in case you're wondering, no, I'm not abandoning the value-conscious strategy that recently led The Wall Street Journal to name my U.S. service, Inside Value, the best-performing investment newsletter of the past five years. I'll dance with the one that brought me -- but I'll also learn new moves.

What's next for LinkedIn?
A lot of growth. Maybe decades' worth. It'll need it to justify its current price tag of more than 140 times forward earnings, but this is not a business I would bet against. Its moat is widening every second as users flock to the service and employers and recruiters follow suit. I'd wager that in 10 years there will be very few businesses that have as ironclad a grip on their industries as LinkedIn will.

And me? I'll pay more mind to my nose, give great companies longer leashes, and keep learning from new mistakes I'll make along the way. I hope you do the same.

Want to learn more about LinkedIn? Watch our jaw-dropping investor alert video today to find out why The Motley Fool's chief technology officer is putting $117,238 of his own money on the table, and why he's so confident this will be a huge winner in 2013 and beyond. Just click here to watch!

Read/Post Comments (12) | Recommend This Article (39)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 03, 2013, at 11:56 PM, TMFTomGardner wrote:

    An excellent article, a detailed explanation, an acknowledgment of what we all know to be true -- we all make mistakes.

    Mathematically, the greatest investment mistakes of our lifetime (for lifelong investors) will pretty much always be the winners we sold too soon.

    You can lose 100% on the downside. You can miss 4000% on the upside (as I did with Dell Computer from the early 1990s forward. . . sold for an apparently happy 25% gain).

    Great work, Joe.

  • Report this Comment On October 04, 2013, at 11:36 PM, bcellars wrote:

    Nice article, and nice to hear you admit to repeatedly 'missing the boat' on great investment opportunities.

    So, is it now 'better late than never'? And are you buying shares now, at the current price?

    I likewise 'missed the boat', but I didn't use the product or have an HR department that I knew loved it. I now understand the potential a little better, and I say, "Better late than later." I've decided to buy a little and hope it drops a bunch so i can buy more. If it doesn't drop, oh well, at least I've got a few dollars on board for the ride.

  • Report this Comment On October 05, 2013, at 4:12 PM, TMFGreedandFear wrote:

    Excellent look back Joe. I think we can all learn from your lesson. I appreciate you taking the time to put your thoughts down so we can all benefit!

  • Report this Comment On October 05, 2013, at 6:25 PM, talotu wrote:

    One of the moves I regret was dropping my Inside Value subscription in mid-2009...

    I too have continually missed the CMG boat despite being a pretty dedicated customer but it taught me just enough to be willing to listen to TomG when he started talking about LNKD a year ago.

  • Report this Comment On October 06, 2013, at 10:12 AM, TMFSoccer wrote:

    I continue to hear professionals say, "I am only now realizing how much I can use LinkedIn and how connected and networked I've become." With Facebook everyone saw it coming. LinkedIn seems to be sneaking up on people.

  • Report this Comment On October 07, 2013, at 1:15 PM, TurbulentTime wrote:

    Motley Fool has missed Tesla Motors by a thousand miles since the beginning of its as a publicly traded company. I started my position since $34-55, added more at $108 when Motley Fool said at that time, Tesla Motors was way over-valued. I have been owning Amazon shares since 2001 at $7-9, added more a few times between $20 - 100 and Motley Fool always suggested that Amazon was way over-valued.

    I don't know. I missed the wonderful boat of Priceline though, having bought at under $10 a share for 500 shares, but sold at $25 - 27 a share. Now, it is over $1,000 a share.

    However, I do win wonderfully big on Tesla Motors against the short-sellers and Amazon against all nay-sayers of Moltey Fools.

  • Report this Comment On October 07, 2013, at 1:19 PM, TurbulentTime wrote:

    Not to mention, my investment in Starbucks has been paying off handsomely, although a little slow compared to other companies that I still own.

  • Report this Comment On October 07, 2013, at 1:25 PM, TurbulentTime wrote:

    In successful investing, the lesson is that Starbucks was disruptive, new-era business model with no competition. A lot of folk were criticizing that Starbucks coffee were expensive and even if Starbucks coffee would be successful, it would draw competition.

    Same with Tesla Motors, many criticize that Model S are expensive and would not appeal to the mass, these folks are thinking themselves since they canot afford a Model S for now, but does Tesla Motors only plan to sell one model, which is the Model S?

    And, many argue that even if Tesla Motors will be successful, it will draw competition. Well, look at Starbucks and Amazon, do they not draw competition? But, even the closest competitors can't figure out how to fight these first-movers and industry-disruptors! Peet's Coffee is still largely confined in California, for example. McDonald's McCafe is still not up to the level of Starbucks in terms of presence in big American cities.

  • Report this Comment On October 07, 2013, at 2:47 PM, talotu wrote:

    @TurburlentTime The reason I invested in TSLA was because of a Fool recommendation on one of the paid services (when it was in the 30's) so you're incorrect when you say that they "missed" TSLA.

  • Report this Comment On October 11, 2013, at 3:03 PM, robertcatesby wrote:

    I like the fact that you can be honest about not calling the stock right, but let's be honest - if it was a logical process, many people involved in the stock recommendations/analysis industry simply wouldn't be needed. Sometimes a stock is based more on emotive factors than it should be. LinkedIn is a classic example of this : based on the fact that many people in your circle have started to use it, you presume the whole world will. Of course your HR department love it - they can recruit without paying recruitment fees. And linkedin can carry on growing as new people join the workforce - in certain industries. But this is a small sphere ! You're not going to get the majority of the workforce who do a normal job, will never get headhunted and do not want to spend time building a work network joining Linkedin. And that, Joe is the majority of the labour force. The examples you mentioned - Apple, Amazon, Chipotle were emotive buys. But with far more potential for the masses. If someone had told you the future value when you bought you'd have laughed - but if they'd sat you down and explained market size and p/e ratio you'd have seen it made some sort of sense. The Linkedin bubble is due to the emotions of buyers who are greater fools for believing that the world is exactly the same as them. The market potential simply isn't big enough to justify a valuation of even half what it is now. All that said, I'm not ready to short it just yet - there are plenty of fools around that will keep the price high for now. I agree it has potential to be around as a site in years to come. But it will be on a much more sensible ratio than it is now.

  • Report this Comment On October 11, 2013, at 3:05 PM, BentMike wrote:

    As a longtime free user of LinkedIn, they have significantly degraded it for me by reducing my access to the profiles of people with whom I have not "friended."

    Oh, that's right it isn't, or wasn't, "friending" a la Facebook. it WAS a network of professional associates. That quality network idea has been lost entirely.

    I now get regular dunning to become a paid premium member.

    I am not as happy as I once was. Foolish me, I bought early. Then there was an inexplicable jump up in share trading value, but not literal value. I have let the position go.

    That may have been a mistake made with no real understanding of how LinkedIn was monetizing the HR side its participants, I admit it.

    Now that it has less value to me personally, I am reluctant to take it on again. It may be valued fairly at this point. I am reconsidering, but not convinced.

  • Report this Comment On October 21, 2013, at 9:32 AM, Jacob9009 wrote:

    I completely agree with Joe Magyer, in fact there is a huge opportunity for linkedIn to grow, and investment in its stocks can be very beneficial in the longer run, this article claims that Sell side of linkedIn is expecting its EPS to grow at a 3-year CAGR of 45%, higher than that of Facebook. which concludes the linkedIn to be a better investment.

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