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
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
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
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
In fact, he is kind enough to provide a specific list of
stocks to avoid at all costs.
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
- Twitter (
- Netflix (
- Facebook (
- LinkedIn (LKND)
- Yelp (
- Yandex (
- Tencent Holdings (
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
By the end of 2013,
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
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%.
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
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
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
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
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
While I've mentioned some stocks to avoid, my colleague
Dave Forest specializes in finding the opposite
. The goal: Find stocks good enough to buy, forget about and hold
"Forever." After six months and $1.3 milllion worth of research,
the team was successful. To learn more about the "Forever" stocks
that they uncovered -- including some names and ticker symbols --
This article was originally mentioned on
The Warren Buffett Of Canada Says Avoid These
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