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Dot-Social and Dot-Cloud Bubbles

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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 quickly 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 Craigslist.

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 percent 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.

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, Colo. 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.