Social media stocks up 90%. Here's how to play them

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Facebook stock has poked its head above issue price and rumblings about a Twitter Inc. initial public offering are reaching a crescendo. Investor disgust at the Facebook offering has faded and the recent strong performance in the social media sector has investors asking whether insanely high profitability levels justify taking a position in this sector. The answer is yes, but not at any price.

Social media stocks have been red hot to date in 2013. An equal-weighted index of industry heavyweights Facebook Inc., LinkedIn Corp., Groupon Inc., Zynga Inc. and Yelp Inc. has jumped 88.4 per cent so far in 2013, eclipsing the broader S&P 500's 18.1 per cent return by a huge margin.

Stung by the Facebook IPO debacle, many investors remain justifiably skittish about social media stocks. But even these "once-burned" market participants may succumb to the upcoming hype ahead of the rumoured multibillion-dollar stock issue by Twitter.

Twitter management has repeatedly denied that an IPO is imminent. But, as USA Today discovered, the company recently posted a help wanted ad for a financial reporting manager to prepare public financial documents. Private companies like Twitter, if it needs to be said, don't have to prepare public documents, so the day when the company starts trading on the stock market is likely near.

Conventional valuation metrics such as price-to-earnings are of little use to investors considering a social media stock. The LinkedIn stock price, for example, has more than doubled this year, despite a trailing price earnings ratio above 600 times. Facebook, another strong performer, is trading well above its IPO multiple at 168 times trailing earnings.

The rapid profit growth of social media companies justified the extraordinary multiples, at least in part. LinkedIn continues to grow earnings at a 40-per-cent clip and Facebook is expected to show a 50-per-cent year-over-year improvement in profit for 2013.

Ridiculously high gross margins also support the lofty P/E ratios – successful companies in the sector virtually print money. Facebook, despite heavy investment in its mobile advertising platform, has a gross profit margin of 74 per cent. LinkedIn is even better at 87 per cent. Perhaps more importantly, profitability will rise still further as these companies grow because costs are largely fixed.

Investors looking to benefit from growth in the social media sector should be patient and take a diversified approach. If the Twitter deal is announced, the hysteria emanating from both the underwriting syndicate and media will be extreme, potentially driving existing stocks in the sector to new heights.

The risk, where Twitter is concerned, is that investors' famously mediocre short-term memory has them revisiting the same mistakes made during the Facebook deal. An extreme valuation for Twitter at issue – investors willing to buy at any price – would be a sign that the rally in social media stocks is overheated and poised to disappoint.

In the end, aggressive traders may want to play the pre-Twitter hype while longer-term investors should wait to see how the deal goes – however long they need to wait. The play is not without risk, so a diversified approach through the Global X Social Media ETF (SOCL) or similar vehicle is recommended.

Social media is a revolution and unlike Pets.com and other famous duds from the dot-bomb era, many social media companies are generating high profits on legitimate growth. They are worthy of investor attention, but caution and timing will be key.