A few months ago we wrote about the social networking/ online gaming stocks pointing out how excessive valuations and unproven business models in the group would prevent stock prices from rising anytime soon.

One of the few areas of the market where we have said that valuations were already too excessive was in the social networking space.  This was brought to a head in the past few weeks with the IPO (Initial Public Offering) of shares in Facebook, the fastest growing and largest of the social networkers, with over 900 million users worldwide.  Given the huge interest and high valuations of prior public offerings in this area (Zynga, Linked In), it was expected by many that the Facebook IPO would be a major success.  But the underwriters increased the size of the offering by over 25% in the final week and then moved the price range from $28-35 up to $34-38 and then priced the deal right at the high end of that range.  Add to that the substantial amount of selling from insiders and early investors on the deal as well as the poor management of the first day of trading by NASDAQ, the issue traded above the offering price for only the first few hours and, one week later, had dropped more than 20% below that initial level.   However, the fact that a company with less than $4 billion in revenue and under $1 billion in annual profits could not sustain a market valuation of over $100 billion made investors like us who have avoided the space for some time feel like logic had finally returned to the market.  Particularly since we also found out after the deal that Morgan Stanley and some of the other dealers involved had recently downgraded growth for Facebook as their migration to mobile users is going more slowly and costing more money.  We continue to avoid the group in general.

With Facebook now trading 50% below its issue price (while Zynga and Groupon shares have also collapsed to new lows) is it time yet to start looking at the stocks?  With nearly one billion users and a business model that does generate revenue, cash flow and earnings, Facebook clearly has some value.  If we use Google as a comparison and apply similar valuations and then add back cash then we get a fair value for Facebook of around US$15 per share.  This assumes they can continue to grow at double-digit rates and that they can effectively migrate their users onto wireless platforms as well.  We may not be quite there yet, but we are getting very close to a buy level for this stock.

Further on technology stocks, while we have done well with our investments in the key smart phone players, Google (Android operating system) and Apple, as well as the key semi-conductor companies supplying the industry (Qualcomm and Broadcomm) we definitely cannot say the same thing for Research in Motion (RIM), manufacturer of the Blackberry, which continues to lose global market share.  We don’t expect any turnaround soon in their market share position (recent travels to Europe, Northern Africa and the Middle East showed us that Samsung has definitely become the device of choice in those regions).  So why continue to own RIM?  Bottom line is that the value of the company is worth substantially more than the current stock price, even assuming only moderate success with the Blackberry10 and the new operating system.  The value of the cash on the balance sheet, fixed government contracts, the enterprise operating system, the patents acquired in the past few years and the 80 million existing subscribers could easily value the company at $15-20 per share, with the only caveat being that this needs to be recognized at some point over the next year, given that the company is no longer generating positive cash flow at this level of revenue.  We believe that RIM would make an attractive acquisition for a variety of technology companies who all have the wherewithal to make such a purchase, including IBM, Google, Samsung, Microsoft, Dell and even Facebook.

For the first time in 34 years, US oil production has risen for three consecutive years. Since reaching a low in 2008, output has in­creased by 1.2 million barrels per day and America’s reliance on import­ed oil has fallen to 66% of consumption from 75%.  America’s 21st century energy boom is the result of aggressive de­velopment of unconventional U.S. oil plays such as the Bakken Shale in North Dakota and the Eagle Ford Shale in south Texas. Horizon­tal drilling and hydraulic fracturing, innovations that improve the flow of oil through shale rock, have enabled producers to unlock billions of barrels of new oil reserves. Although this upsurge in domestic US oil production is a tremendous boon to the US economy, non-OPEC oil production outside North America is expected to fall in 2012 because of production outages and project delays.  This has moderated the impact of the supply growth in the U.S. this year and allowed oil prices to rise.  Also, although US oil demand has declined because of the slug­gish economy, China and other emerging markets continue to experi­ence strong demand growth. Chinese oil imports hit an all-time high in early 2012.   The increase in global oil demand continues to exceed the growth in non-OPEC production, keeping the balance in global oil markets tight. Crude oil prices have already pulled back enough to reflect the slowdown in the global economy.  We look for the price of WTI crude oil, the US benchmark, to average between $90 and $100 per bar­rel in coming years.  That makes the Energy indices in both Canada and the U.S. look attractive at today’s prices using historical valuation levels. 

However, we will have to pay attention to production growth in oil going forward.  If the U.S. was able to reverse a 34-year downturn in production using new drilling techniques, and these techniques are starting to be implemented all over the world, then the supply picture could easily get distorted in the coming decade with crude oil prices falling.  While not an immediate expectation, we have learned a lesson from the natural gas market, which was the first to be impacted by the shale oil projects in North America.  Natural gas prices have fallen by over 75% over the past five years and remain over-supplied.  Just a reminder that markets are rarely static and we always have to be aware of any changes in supply-demand characteristics and how they will impact these markets.

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