Merlin, have you been posting under another name again? <GGG>
some Buckleyesque Briefing.com analysis relevant to some of the stocks discussed here...
tekboy/Ares@fashionvictim.com
Disconnected Stocks
[BRIEFING.COM - Robert V. Green] When a stock gets caught up in a wave of "fashion" it often
becomes "disconnected" from its underlying business prospects. Here are some thoughts on
"disconnected stocks."
Business Analysis
This is the traditional approach to investing.
Growth investing means finding a company whose revenues would grow (Cisco, Microsoft) in concert
with some basic fundamental trend. The bigger the trend, the greater overall growth potential for the
stock.
Value investing means finding a company whose stock valuation is depressed unreasonably, either in
relation to the individual company's problems, in relation to the company's competitors, or in relation to
other investments. The premise behind a value investment is that someday the value will be realized by
other investors.
In both of these cases, analyzing the business prospects for a company is the first step. The second step is
analyzing whether the stock price accurately reflects those prospects.
Investing in a company's because you believe its business future is good, is based the idea that the stock
price is related to the company's business.
But in the past few years, there are many stocks whose price is not related to their business prospects.
Briefing.com calls these "disconnected" stocks. The stocks become disconnected when "fashion" investors
descend upon them.
Fashion Investing
Fashion investing is the term we use for investors who jump after a stocks that become "hot" or have a
"buzz" about them. The concept is roughly akin to "following fashion."
This type of investing has become extremely popular. In fact, much of the action in stocks on any given
day can be attributed to fashionable investing, rather than business based investing.
Fashion investing requires no analysis of the company's underlying business prospects, current or future.
All it requires is a knowledge of what is fashionable, or soon to be fashionable.
One example is investors who buy stocks that are mentioned on a television spot, perhaps a highlight on
CNBC. There are many players who buy what is mentioned, as fast as possible, without any real
knowledge of the stock. By the time the piece is over, the position may actually have been sold.
Another example are investors who jump on "sympathy" plays. This happens when a particular type of
stock become "hot." Many investors look around for stocks in the same sector, or that fall into the same
"buzz." But rarely do they do any analysis of that stock's particular business prospects.
Another example is an investor who invests in a stock because they think it will soon become a player in a
fashionable space. Recently, there have been some stocks in the Application Service Provider (ASP)
space that have risen, in anticipation of the ASP space become the next hot sector. But since there aren't
really any ASPs that are actually "renting" software usage yet, at least for office enterprises, these are all
"fashion" plays.
Disconnected Stocks
The problem with fashionable investing is that it sometimes leads to a stock becoming "disconnected."
A disconnected stock is one whose trading pattern bears no relationship, at all, to the underlying
business trends of the company.
Trading in any stock always shows some degree of fluctuation due to shifting changes in investor
perception. But only disconnected stocks can double, triple, or quadruple over a couple of days on no
news.
Red Hat
One of the best examples of a disconnected stock is Red Hat (RHAT).
The future business prospects for Red Hat are pretty good, in our opinion. It is likely to be
profitable, and grow significantly bigger than its current $14.2 million in twelve month sales.
But any rational analysis of Red Hat's business ever growing into its $14 billion market capitalization leads
to the conclusion that Red Hat is overvalued.
If Red Hat grew sales tripled every year for four years, (something even Microsoft never did), they
would then have $1 billion in sales. Equivalent software companies with $1 billion in sales have price/sales
ratios between 3 (Peoplesoft) and 23 (Microsoft). Oracle has a Price/Sales of 12.
If Red Hat had $1 billion in sales, and was valued as Oracle is, the stock price would be $174! or 15%
lower than it is now. Four years from now.
Red Hat traded at half its current level just two weeks ago. Has Red Hat's prospects for the future
doubled in the last week? Or course not.
Linux Became Fashionable
The real explanation is that Red Hat became a disconnected stock. It began its run up a month ago (one
could argue it has been disconnected since its IPO) when Linux became fashionable.
As fashion investors chased the Linux trend, few did any kind of business analysis. Red Hat traded solely
on the demand of investors for a "hot" stock in "the next trend."
The Linux story was simply the "shoehorn" that brought investors into the stock. As the word spread
("Linux is the next big thing") fashion investors bought Red Hat, without ever doing any kind of business
analysis, or valuation analysis.
The increased price brought momentum investors. The increasing volume also brought investors who read
charts, technical analysis investors. Then the daytrading crowd came in to participate, and Red Hat
became disconnected quickly.
And when Red Hat eventually falls back under $100, it won't mean that investor sentiment about the
business future of Linux is less than it was. It will simply be an indication that RHAT is becoming
reconnected with the business of Red Hat.
Shorting Disconnected Stocks
When a stock becomes disconnected, it is only natural for fundamental investors to think it should now be
shorted.
This is often a poor idea. Unless you have a lot of patience.
Shorting an irrational stock on a rational premise is misguided. At least in the short term.
After all, why should rationality return to a stock anytime soon? Particularly if it wasn't really there to
begin with?
If a stock rises without any connection to its underlying business fundamentals, what is to make it fall to a
proper valuation based on its underlying business prospects?
Once a stock becomes disconnected, it is extremely hard to predict short term direction.
In fact, if there has been any single lesson of the last three years in the stock market it is this: overvalued
stocks can still go up!
But if you really want to capitalize on the insanity, and you believe that the stock will become related to
the business prospects of the question, shorting is how to do it.
But the best time to short a disconnected stock is when the volume dries up, not when the price drops.
When the volume finally drops down to 10% of its highest volume, it means that fashionality is leaving the
stock. There is almost always still a lot of price left in it. That price represents the reluctance of the guy
who wound up holding the "hot potato" as an investment.
We firmly believe that disconnected stocks always become reconnected with their long term business
prospects eventually. The only question is how long that takes and whether you are willing to wait it out.
Institutions Bow Out
When a stock becomes disconnected, institutions sell. Red Hat has almost no institutional ownership. This
is despite the fact that institutions had first crack at the stock through the IPO channels.
Just 520,000 shares are owned by institutional investors. That's 0.17 percent, less than two-tenths of one
percent. (Source: Vickers. Does not count shares purchased prior to the IPO).
The reason? Institutional investors make business analysis judgements. They don't chase fashion. If they
happen to be holding a stock when fashion puts the stock in the limelight, they sell.
Briefing.com's Attitude
In the end, you always have to sell your stock to someone.
That someone needs to believe that they will be able to sell their stock for a higher price later, to someone
else.
Therefore, whatever premise you use going into a stock, you should use the same premise going out of the
stock. Mixing premises is where most of the mistakes come from.
If you want to invest in a "hot" stock, make sure you know whether there is a relationship with the
business prospects of the company.
New Era of Networks (NEON), for example, is hot, but is backed by the belief that after the Y2K
deadline passes, NEON will be a big beneficiary. Ariel, (ADSP) is also a hot stock, but its action recently
has had nothing to do with its business prospects.
Missing Out on Disconnected Stocks
Obviously it is fun to own a stock before it becomes wildly disconnected. You make a lot of money
quickly.
But when you pass on a stock because you reject the future business prospects, or the current valuation,
and then the stock becomes fashionable, and quadruples, don't kick yourself.
First of all, just because a stock price moves opposite to your analysis does not mean the analysis was
wrong. Red Hat could go to $300 from here. But that won't mean it isn't overvalued at $200. When a
stock becomes disconnected, there are no rational guidelines for valuation.
Secondly, remember that it is virtually impossible to predict when a stock will become swept up in a wave
of fashion, and become disconnected.
If you want to play momentum or fashion trends, with the hope that it becomes disconnected, we have
only two pieces of advice. First, be sure to take profits. Forget about trying to get "the entire ride."
Second, wait until the action actually starts than try to get in ahead of time. (Briefing.com's InPlay page is
a good place to look for these moves.) Otherwise, you might sit around waiting forever.
While some other stock you don't own becomes disconnected, and triples in three days.
Comments can be emailed to the author, Robert V. Green, at rvgreen@briefing.com. |
