Omaha & Bubbles

Courtesy of Vitaliy Katsenelson

I have to confess, I am tired of writing “structured” articles, the ones where I have to limit my thoughts to 800 words.  So with this email I am taking a break. This is an unstructured stream of thought, in no particular sequence.

China bubble today vs. Japan bubble in 80s

I am back from San Francisco, where I had the great pleasure of attending and speaking at FAME Symposium, diligently put together by students at San Francisco University.  One of the other speakers was a famous international investor, Charles De Vaulx.  During a break Charles and I were discussing the Chinese bubble today vs. the Japanese bubble of the  late ’80s.  This conversation got me thinking.  In Japan the bubble was the most prominent in commercial real estate and to a lesser degree in residential real estate.  The house-price-to-income ratio (just take the average house price and divide by average income) in Tokyo at the height of the bubble was 9, while in China in 2010, in the big cities this number was much greater (Beijing 15, Shanghai 13), and in fact the ratio for the whole of China was over 8.  The commercial real estate bubble might have been greater in Japan; it is hard to tell.  I remember reading that at the peak of the Japanese bubble the Imperial Palace was worth more than a state of California.  But from different reports I’ve seen, China has plenty of empty skyscrapers.

But China also has a couple more bubbles, in industrial overcapacity and overinvestment in infrastructure.  Japan did not have an infrastructure bubble, for several reasons: first, it was a more developed country than China.  Second, the government played a much smaller role in the economy – Japan did not have a command-control economy, and it did not try to build for social/political stability reasons.  Japan had your garden variety real estate bubble: easy credit, inadequate banking laws, etc…

Also, and this point is hard to quantify, but the quality of Japanese construction is better than in China.  There are many reasons for that: less corruption, no five-year plans (i.e., output-per-capita targets), and the Japanese put a higher value on human life.  I remember reading an interview, just a few years ago (before the high-speed-train crash in China) with a Japanese high-speed-train executive.  At the time the Chinese were showcasing their high-speed-train system and rubbing in Japanese faces the fact that their trains traveled at higher speeds.  The Japanese executive said something along these lines: “Our systems are very similar, since the Chinese stole our high-speed railroad designs.  We could run our trains at faster speeds, but we just don’t think it’s safe.”  Japan has a population of 130 million people, which is shrinking.  China has over a billion people and its population is growing.

The quality of Chinese construction is horrible; you read stories of glass and masonry falling off of buildings, and the latest story was of a girl swallowed by capsized pavement.   So they’ll have to do a lot more rebuilding in the future, and thus their return on capital, which was already very low, will actually be even lower.

Japanese economy, despite Government debt to GDP doubling, has been stuck in a rut for over two decades.   Just saying…

Dot-Social and dot-cloud bubbles

At the FAME Symposium I was asked if we are in the midst of another bubble – the social and cloud bubble.  I said that if one really wants to make some money quick he should start a company and call it “SocialCloud”.  I read a lot of articles defending Facebook paying one billion dollars for a company with less than a dozen employees, with an app that has terrific photo filters and 30 million users, but with no revenue and no network.  Once you take a picture, Instagram gives you the ability to post it to a half a dozen places, including Facebook and Twitter.  But Facebook will be paying for this acquisition with funny money – it has a $100 billion market cap on three or four billion of revenues.

The Instagram acquisition by Facebook has likely injected a lot of fertilizer into the angel investing bubble. I am sure there are a lot of startups out there that will be raising money from angel investors dreaming of selling themselves to the Facebooks and Googles of the world for billions of dollars.

I looked at recent IPOs, and their valuations appear bubbly.   Yelp – a terrific company (more on it in a bit) – has a market capitalization of $1.3 billion, and analysts expect its revenues in 2012 to hit $180 million.  Angie’s list – a website I recently used, since we were remodeling the house – has a valuation that is as silly as Yelp’s, except that its website is a slight improvement over Craig’s List.

I know the enormous appeal Facebook has to advertisers. Never before could advertisers target their customers with such precision.  Facebook knows your address, your age, where you went to school, the music you like, whether you are married or recently engaged, where you travel, etc… All this information we volunteer when we fill out our user profile. I get it, it is incredible.  I’ve yet to meet a person who doesn’t think Facebook will do well on its IPO.  But what if Facebook struggles to monetize its enormous user base?  There are only so many ads it can put up on a page before they start impacting the user experience.  The counterargument here is that since these ads are so finely targeted, they are more expensive and thus Facebook will not need as many.

What if people will simply get tired of the social thing?  Social networking may turn out to be a fad, or at least the amount of time we spend it on it may decline a lot.  I know large employers are blocking access to Facebook left and right; it is a huge productivity drain.

Zynga is another stock that looks bubbly (though less bubbly then when I looked at it a few weeks ago, the stock is down 40% or so).  Social games could be another passing fad.  At the conference I described a company that we recently purchased that may benefit tremendously from social games, but for them it is an added bonus (an option), while for Zynga social games are everything.  I don’t know if I am right on these stocks or not – maybe their businesses will go at a much faster rate than I expect.  But I can definitely sense that the second we mention the words social or cloud our objectivity in judging businesses dissipates.  This doesn’t just apply to dot-clouds or dot-socials, it applies to boring, real companies feeling the pressure to be in the space, who are paying insane valuations for dot-social and dot-cloud businesses (Centurylink buying Savvis at 10x EBITDA comes to mind).  Since we own plenty of real companies, my concern is that they’ll overpay for their dot-stuff.

Yelp

The last time I was in San Francisco, a portable GPS was a very expensive novelty.  That was early 2006.  My best friend and I were on a road trip, driving from Denver to San Francisco and back.  We had a GPS attachment connected through a USB port to a laptop and used Microsoft mapping software.  All phones were dumb (even Blackberry, the smartest phone at the time, was dumber than a brick compared to today’s iPhone).

This time around armed with iPhone, I was surprised how good the Yelp app was.  Though they are trying to expand beyond it, Yelp is a social app where users review and rate restaurants.  It is crowd sourcing at its best.  All I had to do was type “sushi,” select the distance from my current location that I was willing to travel, and Yelp showed me all sushi restaurants around me and their ratings.  In the absence of any other data points, you start heavily relying on Yelp’s ratings, especially since many restaurants have several hundred reviews.  The feature in the app that I found astonishingly innovative was the “monocle.”  You click on the “monocle” button, point your iPhone in any direction, as if you were taking a picture, and it shows you the restaurants and their ratings in that direction.

Apps like Yelp’s will have a significant impact on restaurants.  They facilitate the word-of-mouth restaurant recommendations between friends and extend them to strangers. They’ll also likely expedite the failure rate of restaurants.  Restaurants with high reviews will get more customers, and the ones with poor reviews will die a quicker death. 

Deadline to register for VALUEx Vail is May 1^st. 

I am very excited about one of our “dessert speakers,” Jon Markman, who’ll speak about Jessie Livermore, one of the most successful (until he failed) and interesting traders ever, who lived in the first half of the last century.  No one knows more about Jessie Livermore than Jon, as he annotated one of my favorite books,Reminiscences of a Stock Operator.  Here is what I wrote about it a few years ago: “Jon’s skillful annotation takes you behind the scenes of Livermore story and provides important insights into characters and the backdrop of that very interesting time period.  Jon’s annotations are almost like a book within a book.”

Omaha!

It is Omaha time again!  This year Value Investor Congress, which I’ll be attending, has been moved to Omaha.  Congress is Sunday (May 6^th) through Monday.
May 4^th – Friday

May 5^th – Saturday

May 6^th – Sunday

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.