Facebook (FB 0.56%) and Alibaba (BABA 0.45%) both initially seem like undervalued growth stocks in this frothy market.
Facebook's family of apps -- including its namesake platform, Instagram, and WhatsApp -- reach 3.3 billion people every month, but its stock trades at just 20 times forward earnings. Alibaba serves 779 million shoppers in China annually and controls over 40% of the country's cloud market, but its stock trades at just 21 times forward earnings.
Those valuations are low relative to their projected growth rates. Analysts expect Facebook's revenue and earnings to rise 25% and 13%, respectively, this year. They expect Alibaba's revenue and earnings to jump 51% and 37%, respectively, in fiscal 2021, which ends next month.
Image source: Getty Images.
Yet investors don't seem eager to buy either stock. Over the past 12 months, Facebook's stock has risen about 30% as Alibaba's stock has climbed just over 20% -- but both stocks underperformed the Nasdaq's near-50% gain.
Both stocks also generated weaker returns than many of their peers in the social networking and Chinese tech markets. Let's see why Facebook and Alibaba failed to excite the bulls, and if that trend will reverse and make one of these tech giants a better long-term investment.
Beware the regulatory challenges
Facebook and Alibaba both face intense regulatory headwinds. Facebook faces antitrust probes in the U.S. and Europe, it's clashing with regulators in Canada and Australia over proposed payments for posted news stories, and the deadly Capitol riot in January sparked serious concerns about the platform's role in spreading misinformation and hate speech.
Last December, the Federal Trade Commission (FTC) sued Facebook over its "illegal monopolization" of the social networking market and proposed forcing it to divest Instagram and WhatsApp. Facebook could also be held legally accountable for the actions of all its users if proposed changes to Section 230 of the Communications Decency Act are passed.
Image source: Facebook.
Alibaba faces regulatory pressure in both China and the U.S. China's antitrust regulators launched an antitrust probe into its e-commerce business last December to target its exclusive deals with merchants and promotional prices for new users. Those regulators also halted the IPO of Alibaba's fintech affiliate Ant Group, which it owns a 33% stake in, due to additional antitrust concerns.
Alibaba's Taobao remains on a piracy blacklist in the U.S., and it narrowly avoided a proposed stock delisting in January over its alleged ties to the Chinese military. A newly passed law will also require Alibaba and other Chinese firms to comply with tighter auditing standards over the next three years or be booted from U.S. exchanges.
The markets hate uncertainty
These regulatory headwinds haven't throttled Facebook and Alibaba's near-term growth yet, but the uncertain impact of those regulations have kept many investors at bay.
If Facebook is forced to spin off Instagram, it would lose its main defense against higher-growth niche players like Snap's (SNAP +0.54%) Snapchat, Pinterest (PINS +1.80%), and ByteDance's TikTok. And if it's held liable for the illegal behavior of its users, its legal expenses could soar and crush its margins.
Apple (AAPL 1.06%) also plans to allow its users to opt out of targeted ads in its apps in its upcoming iOS 14 update. Facebook warns that the change could reduce its Audience Network ad revenue by more than 50%, and is reportedly planning to sue Apple to halt the update.
If Alibaba ends its exclusive deals with merchants and promotions for new users, it could lose its advantage against its two biggest e-commerce rivals, JD.com (JD 0.86%) and Pinduoduo (PDD 3.33%). It generates all of its profits from its core commerce business, and a slowdown in that profit engine would curb its ability to expand its unprofitable cloud, digital media, and innovation initiatives businesses.
All that uncertainty has caused Facebook and Alibaba to significantly underperform their industry peers over the past 12 months:
Source: YCharts
Which stock faces fewer headwinds?
I'm not a fan of either stock right now. I sold my shares of Facebook last month due to ethical and fundamental concerns about its business. I also recently declared I would never invest in Alibaba, due to its regulatory challenges, growing dependence on lower-margin retail businesses, and the Chinese government's usage of its AI-powered surveillance technologies.
But if those issues don't bother you, I believe Alibaba is a more compelling investment than Facebook right now. Alibaba's core commerce business is still growing, its cloud segment's profitability is gradually improving, and its ecosystem continues to expand with fresh investments and acquisitions. It also seems to face milder regulatory and competitive headwinds than Facebook.
Meanwhile, Facebook seems to be losing control of the platform it created. Its AI algorithms and outsourced censors aren't curbing the spread of misinformation on its platform, and its constant need to boost engagement rates between its users is fueling that self-consuming blaze. As Facebook clumsily tries to put out those flames, other smaller social networks -- like Snap and Pinterest -- could pull away more of its users as the regulators tighten the screws.
