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Why I Underestimated LinkedIn

By Joe Magyer - Oct 3, 2013 at 6:00PM

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A Foolish value hound opens up on how he blew it with 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 (LNKD.DL). 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.

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