Are you familiar with Fairfax Financial's CEO Prem Watsa? If you aren't, you really should be. Following Watsa's lead over the last twenty years could have helped you not only avoid several disasters but actually profit from them.
With the S&P 500 having nearly tripled from the March 2009 lows, now is a great time to pay attention to a man famous for spotting bubbles.
First a bit of a background on how Mr. Watsa gained my trust. It all goes back to the housing bubble and financial crisis that Watsa was miles ahead of the curve on. Incredibly, as far back as 2004, Watsa warned about the impending disaster in the housing market. And he didn't just warn about it, he positioned his company Fairfax to profit massively from it by owning credit default swaps on the most vulnerable financial institutions (like AIG).
It was contrarian moves like these that made him known as the Canadian Warren Buffett.
Here is a bit of what Watsa said in his 2005 letter to shareholders foreshadowing the impending bubble burst:
As we have mentioned ad nauseam, the risks in the U.S. are many and varied. They emanate from the fact that we have had the longest economic recovery with the shortest recession in living memory. Animal spirits are alive and well and downside risks have long been forgotten. Having lived through the telecom bubble recently and the oil bubble in the late 1970s and early 1980s (and perhaps again today), we see all the signs of a bubble in the housing market currently. It appears to us that buying a house is today viewed as a sure shot investment – perhaps just as housing prices are on their way down, maybe significantly.
The U.S. consumer is overextended, savings rates are below zero, credit spreads are at record lows and even emerging market countries are borrowing long term at very low spreads above treasuries. We continue to be fascinated – morbidly – by the recent Japanese experience. The Nikkei Dow dropped from 39,000 in 1989 to 7,600 15 years later while 10-year Japanese government bonds collapsed from 8.2% to 0.5%, totally contrary to normal historical investment experience. Japanese market capitalization dropped from 149% of GDP to 53% in 2002.
The U.S. market capitalization is still at about 120% of GDP, down from over 170% in 2000 but way above its 80-year average of 58% and even higher than its 1929 high of 87%!
What does all this mean? Well, for a few years now, we have said that we are protecting our shareholders' capital from a 1 in 50 year or 1 in 100 year event. By definition, this is a low probability event (like Hurricane Katrina) but we want to ensure that we survive this event if and when it happens.
This man predicted the 1 in 50 year meltdown that was the 2008 financial crisis four years ahead of time.
Today in his most recent letter to his shareholders, he predicts the threat of yet another bubble, this time in the technology sector.
In fact, he is kind enough to provide a specific list of stocks to avoid at all costs.
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Tech Bubble 2.0 -- Social Media Stocks
In the 2014 Fairfax annual report, Watsa included the following table that outlines specific social media and other technology stocks that have ridiculous valuations.
In the social media area Watsa thinks you should avoid the following:
Why? Because all of these stocks are extremely overvalued.
After doing a bit of my own analysis, I wholeheartedly agree with him. Let me show you how I evaluated two of them in particular.
By the end of 2013, Facebook (FB) had an astounding 1.23 billion users worldwide and this number is still growing. However, it is important to note the difference between a great business and a great investment opportunity.
This difference is determined by price.
Facebook has 2.575 billion shares outstanding (combined Class A and Class B) as of its last quarter end. With the current share price of $73 the company has a market capitalization of $188 billion.
In its last full fiscal year (2013) Facebook had net income of $1.5 billion. That means that the company is trading at a price to earnings ratio of 125 times. Or if you prefer an earnings yield view, that means that at the current share price you are earning $1.5 billion / $188 billion = 0.79%.
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That is not and I repeat is not 79%. That is less than one percent, as in 79 basis points.
Now, growth stocks should be valued very richly because rapid growth can quickly make an expensive share price seem reasonable. But the sheer staggering dollar valuation of Facebook really makes you wonder if it could ever live up to this valuation.
What really frightens me is what happens if the fad passes and the market falls out of love with Facebook? The share price could be cut in half and the price to earnings ratio would still be a staggering 60 times. Facebook's shares could be cut in half and then cut in half again and still be pretty expensive.
With 589 million shares outstanding and a current stock price of $44, Twitter has a market cap of more than $25 billion.
That means that when you buy a share of Twitter today at $43 you are saying that you think $25 billion is an attractive price at which to own a share of the Twitter business.
For $25 billion you get a company that lost $645 million last year. And that loss followed a loss in the year before that, and the year before that as well.
Like Facebook, Twitter is an above average company but a below average investment opportunity.
The chart below shows the rapid pace at which Twitter is gaining users.
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At some point this company will turn the corner and become profitable. But will it become profitable enough to live up to its ridiculous valuation? I personally doubt that. Here's why.
In 2013, Twitter had a revenue (not income) of $664 million. As I mentioned, Twitter has an enterprise value of $25 billion. That means that the company is trading at $25 billion / $664 million = 38 times revenue! 38 times earnings is expensive, 38 times revenue should make you leery of owning shares.
Again, I am not suggesting that Twitter won't become a profitable company.
I'm just saying that the valuation is extreme.
With the current valuation of $32 billion, Twitter needs to maintain consistent long term growth to justify the existing stock price.
At the moment there is no financial metric that supports Twitter's current valuation. These shares could drop 50% simply based on one disappointing quarter.
Prem Watsa has seen this movie before. Whether it's the bubble of the late 80s in Japanese stocks, the dot.com bubble of the late 90s, or the housing bubble of the last decade… listen to what he is saying. Do not expose your portfolio to these stocks.