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Fool on the Hill: Market Implosion? Just Add Gorillas
By Bill Mann
A year ago, even after many sectors of the stock market had plummeted, there was a joie de
vivre that surrounded some technology companies. While dot-coms and other former
darlings were tanking, other companies were getting along swimmingly.
Many of those technology companies were, and are, known as "Gorillas"
-- companies that dominate their market and have characteristics, such as
"high switching costs," "proprietary open architectures," and others, that
stand as barriers to entry by erstwhile competitors. (The term "gorilla"
comes from a 1998 book called The Gorilla Game by Geoffrey Moore,
Paul Johnson, and Tom Kippola. It's a great book that offers a simple
framework for thinking about high-technology markets.)
Such companies as Cisco (Nasdaq: CSCO - news), Microsoft
(Nasdaq: MSFT - news), Qualcomm (Nasdaq: QCOM - news), and
Brocade (Nasdaq: BRCD - news) were able to command massive
multiples for their stocks because they had so much protection of their
markets and so much potential for continued growth. Hundreds of
thousands of investors bought into the idea that gorilla status lowered
these companies' investment risk -- to what seem now to be hideous
consequences.
It is pretty telling that Johnson, in a speech a year ago at Sun Valley, Idaho, mentioned that he had sold all of his Cisco,
Microsoft, and several other big companies, because he realized things could not get much better for them. This turned out to
be a good move. Unfortunately, Johnson was also buying up Sycamore (Nasdaq: SCMR - news), which has since fared
disastrously in the telecommunications meltdown and has lost some 97% of its value in the past year.
I have no problem with "Gorilla Gaming." It teaches a highly useful way of looking at companies rank-and-file investors may be
unable to otherwise understand. The issue with Gorilla Gaming as practiced by many is this: One should never expect to be able
to run down a list of "tells" and come up with a good list of investment candidates.
"Uh, Bill, what about the Fool's Rule Maker and Rule Breaker strategies?"
Again: One should NEVER expect to be able to run down a list of "tells" and come up with a list of good investment
candidates, particularly when using a strategy as highly publicized as Gorilla Gaming -- or our own strategies. The corporate
environment does not operate within a black box, so to expect that you can operate within one and beat the market is perilous
thinking. There are too many external factors a list of criteria can't account for, and if many of the people using such lists are
already unqualified to understand the companies they are putting through quantitative or qualitative tests, it's a risky
combination. What, for example, happens when a tornado meets a cliff?
Well, we know now, don't we? Competitive advantage doesn't mean squat when the market disintegrates. Brocade has
suffered both a decline in market vitality and a severe multiple compression, and the result for investors is a loss from its peak of
over 90%. At a current annualized earnings rate of $0.20 per share, with its October 2000 price-to-earnings (P/E ) ratio of
333, Brocade would be priced at $66 per share rather than the current $15.70.
The cause for such enormous multiples over the last few years -- at one point Brocade traded at a P/E of 1,700 -- was the
combination of growing companies and investor inability to see a time when things would be different. Investing is rarely so
simple.
Occasionally, greed trumps rationality
The interesting thing about "Gorilla Gaming" was that there was minimal outlet for valuation. If a company were a Gorilla, an
argument could be made at almost any price. I look at this as the same way I look at the "one-dollar premise," which compares
the level of retained earnings to the level of increase in stock price and says the two should increase at the same rate: It is a
self-fulfilling prophecy.
What happened in the late 1990s, as we now know, was that many investors simply counted on other investors to pay more for
companies than they themselves did. The black box models out there are generally porous enough that candidates for
"gorilladom" or "whateverdom" were treated as if they had already reached the Promised Land. Blodget, Meeker, and Cohen
became stars largely for simply telling people what they wanted to hear. SOMEONE was willing to buy Corvis (Nasdaq:
CORV - news) at a valuation of $28 billion, even though it had no revenues.
And yet there was always some set of criteria that would show that it, and other companies, was a good buy. That it made no
sense was beside the point, because so many investors were so far outside of their own knowledge base that they had no
indication whatsoever that the business was deteriorating. (Heck, even investors inside their own circle of competence were
blindsided.)
Investors assign "Gorilla" status to any old company
The book's seven-step process, even when applied perfectly, should not be used as a definitive determinant of a good
investment. The Motley Fool has had this simple fact rubbed into our face for some time now, as we watched our investment in
Yahoo! (Nasdaq: YHOO - news), a quintessential Rule Maker, completely disintegrate as the company was defrocked for the
sin of having only one true revenue source, and a bad one at that.
These intellectual exercises become even more dangerous when applied badly. How many "Rule Breaker" arguments were
there for Metricom, or even Iridium? Rule Breakers, not really. Viable businesses, definitively not. It becomes dangerous when
an investor uses some synthetic status -- again, I don't want to pick exclusively on "gorillas," because I think they, along with
Rule Breakers and Makers, reveal some excellent insights about companies -- to determine the investibility of a company. It
can be doubly so when these models are misapplied.
Reliance on a status begets overconcentration
How many investors out there remained focused upon "tech" when the tech world was blowing up? How many gurus for high
technology got their starts in the end of the 1990s, using models to show how the rate of growth for certain companies would
continue unabated? It's tough for a gorilla to keep its status when the whole damn jungle's on fire.
When you're looking for a host of companies with "open proprietary architecture," a retail company is necessarily going to be
excluded, regardless of whether it is a superior investment or not. I've made the point quite often in the past few months: The
telecommunications carriers have racked up $600 billion in debt building out networks over the last five years. How is owning
eight different companies, all dependent upon the economic viability of carriers, going to help you if the entire sector blows up?
There are very few sectors that have been unaffected by the economic meltdown, and yet those who concentrated in
technology are certainly more likely to be unpleasantly surprised at the lack of economic diversification among their holdings.
The solution is simple. Use these methods, and consider the Gorilla and other frameworks -- they are especially wonderful for
helping investors understand certain companies and industries -- but use them as a starting point only.
Dig deep into company financials. Read trade journals, white papers, and anything else you can get your hands on about the
company and its market. Think. Think hard about the assumptions that are being made to justify the multiples being assigned a
company.
And be willing to question everything -- especially when some methodology is telling you that you have found something that
"can't miss." Hundreds of billions of dollars of investment capital have vanished in the past two years on companies that couldn't
miss, and did.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann may be the only native North Carolinian who is excited that hockey season starts today. At time of publishing,
Bill had beneficial interest in Cisco. The Motley Fool is investors writing for investors.
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