Personal Capital: Capital at risk
By R. Scott Raynovich
Redherring.com, November 30, 2000
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It's not a pleasant time in the market... or is it?
If you're looking to turn a quick buck as a day-trader, it's a terrible time in the market (unless you're adept at selling stocks short). But for a real, long-term technology investor, things are getting interesting.
Remember back in the early 1990s, when not every investor was a technology investor? Back then you could pick up Cisco Systems (Nasdaq: CSCO) with a price-to-earnings ratio of 30. Well, it would be nice to see such values again -- and the more the bubble deflates, the closer we get.
This year's massive, painful, and volatile correction in many young technology companies is a by-product of Wall Street's rush to take companies public. The massive assembly line of IPOs churned out over the last two years flooded the market with young, inexperienced, and unprofitable companies, and a lot of inexperienced investors gobbled them up. Many of these companies were completely incompetent or had terrible business models. Others were simply not ready for the public markets.
This column was started on the premise that the market was turning into a risky public venture market. That type of environment demands a closer, more analytical look at specific vertical technology fields. As clumps of technology companies in specific markets go public earlier in their life cycle, investing gets more risky, but the potential for huge returns is also still there.
THE PUBLIC VC MARKET
Years ago, an emerging market would have dozens of players funded by the venture community. These companies would fight tooth and nail for market share and profitability -- in the private market. Then, after several years of creative destruction in the market, Wall Street would consider taking them public.
In the last two years, we saw an elimination of the later stages of the IPO process. Wall Street stripped out the requirement for profitability -- or in many cases, even the requirement for revenue -- and took the companies straight to the market. You had dozens of companies going public in the same market, with no prior weeding out in the private market.
In my mind, this all culminated in July of this year, when Corvis (Nasdaq: CORV), a promising optical networking technology company founded by former Ciena (Nasdaq: CIEN) founder David Huber, went public without any revenues and certainly no promises of profit on the near horizon. The IPO was really a $1 billion venture capital round, funded out of the wallets of public investors, at a valuation that would make any real venture capitalist cringe. Wall Street quickly bid Corvis up to a $37 billion market cap within a week.
Corvis's market cap is now $9 billion, as the stock has fallen more than 75 percent in just four months. This IPO, more than any others, is a symbol of the extremes tested by Wall Street. After the recent correction, the market has become more selective. Will we return to only taking profitable companies public? Probably not. But reckless and greedy IPOs with irrational valuations have been put on hold.
In the venture market, risky and turbulent company life cycles are the norm -- a company, as it evolves, goes through fits and starts, customer wins and losses, and an evolution in management and culture. If the companies blow up, or need help, the VCs and other investors become involved. But such investors are accustomed to large amounts of risk, and they build portfolios that are hedged against such risk with a "one in ten" philosophy of funding enough companies to hit at least one grand slam out of every ten investments. The average investor cannot afford to assume that much risk.
WHAT NOW?
In the first leg of the correction in April, we adjusted our attitude toward this new wild-west public market with the new new rules. One of the rules was that an unprofitable company (and certainly one without revenues) should never be valued over $10 billion. Another was that if an investor is not able to diversify the portfolio and play several companies in the same technology spaces, you're better off sticking with bonds or mutual funds.
What you have seen in the market this year is the negative aspect of that risk -- young, fast-growing but inexperienced companies can collapse back to earth just as fast as they sailed into orbit -- all it takes is one sticky quarter. Take Cacheflow (Nasdaq: CFLO), one of the companies I've written about, as a recent example. Its quarter was deemed a disappointment. A rocket ship up, and a lead balloon down. Surprising? Not really. Painful? Sometimes. But necessary for the evolution of emerging markets. The company still has the same potential, but Wall Street's hacked it down for its short-term bobble.
So, what now? Largely, what we are seeing now is an across-the-board valuation reality check. When Wall Street gets gloomy, it dwells on risk and becomes increasingly pessimistic. Remember that the market is very shortsighted. You should keep your eye on a two- to three-year time frame.
Can the Nasdaq go to 2000? Possibly. Will it go to zero? Definitely not. The market should begin the healing process by the first quarter of next year. Of course, it would help the process along if the country avoided a civil war and picked a new president. And history says that the probability of the Nasdaq rising to new highs within the next five years is extremely high, barring a complete collapse of the U.S. economy.
FOLLOW THE LEADER
Many of the companies closely followed by Personal Capital were picked because they were emerging as leaders in developing technology markets, and they were also leading hot trends. For example, BEA Systems (Nasdaq: BEAS) was gaining momentum in the componentized Web application space. Companies such as Extreme Networks (Nasdaq: EXTR), Sycamore Networks (Nasdaq: SCMR), Ciena, Juniper Networks (Nasdaq: JNPR), and Redback Networks (Nasdaq: RBAK) are leading the charge in next-generation networking gear.
JDS Uniphase (Nasdaq: JDSU) and SDL (Nasdaq: SDLI) are gorillas in the optic components space, and their valuations are finally reaching attractive proportions. Micromuse (Nasdaq: MUSE) maintains its lead in the field of telecommunications network management.
Another sector to watch is communications chip makers. Many of these companies, such as Xilinx (Nasdaq: XLNX) and Broadcom (Nasdaq: BRCM), were the first to get slaughtered in the correction, and they are thus likely to be the first to recover. Xilinx, which has seen its profits grow at a rate in excess of 80 percent and is now trading at a P/E ratio of 21, looks downright cheap.
With the IPO pipeline shutting down, these companies I mentioned, most of which are already profitable, will get stronger as the upstarts will need more time to raise capital and catch up. That's why we should now get back to the basics of technology investing, and look for the profitable leaders in the public space to extend their leads.
redherring.com
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