A case for buying unprofitable stocks
By Deborah Adamson, CBS.MarketWatch.com
Last Update: 6:57 PM ET Apr 11, 2001
LOS ANGELES (CBS.MW) - Talk about coming back from the almost-dead.
Amazon.com (AMZN: news, msgs, alerts) blazed a hot trail this week after reporting better-than-expected first-quarter results. Shares of the Internet retailer rose nearly 60 percent in three days.
The stock's ascent came despite continued losses - a sign that investors may be giving more breathing room to companies still struggling to become profitable.
For its part, Amazon.com said it's on track to make money on an operating basis in the fourth quarter. See story.
Is buying a no-profit Internet company acceptable again? Didn't investors learn the hard way during the Internet bubble that earnings do count?
While most investment pundits would advise against buying the stock of a company that's not making money, there are special circumstances that warrant taking such a risk.
"The stock market is always about the future," said Pat Dorsey, director of stock analysis at Morningstar. It's not unusual that "companies with no earnings today could in two quarters or over a year begin to earn a lot of money."
The operative word is "could." Investors have to figure out how likely the scenario will come to pass and whether their conclusions justify taking a risk.
It's not unusual that "companies with no earnings today could in two quarters or over a year begin to earn a lot of money."
Pat Dorsey,Morningstar
They have to separate the America Onlines (before it became AOL Time Warner (AOL: news, msgs, alerts) ) from the failing EToys (ETYS: news, msgs, alerts) of the Internet world.
People who invested in AOL even before it became profitable saw their risk pay off while those who plunked their money into EToys, while waiting for it to be profitable, paid the price.
But making this distinction isn't easy. "It's such a crapshoot," Dorsey said.
Think like a venture capitalist
There are ways to separate potential winners from the pack. When looking at young, unprofitable companies, investors should think like venture capitalists, Dorsey said.
Venture capitalists don't expect to make money on many of their investments. They expect to hit upon a few winners that will generate astronomical returns to outweigh losses in some of the dogs they've bought, Dorsey explained.
Here are a few things investors ought to look for when evaluating an unprofitable stock:
Excellent management is a key qualification, Dorsey said. If you're analyzing a relatively young company that lacks a clear track record, look at what management did before joining the team.
Consider Juniper Networks (JNPR: news, msgs, alerts) , which became profitable in late 1999. Several of its senior executives came from Cisco (CSCO: news, msgs, alerts) , Dorsey said.
"If you're looking at a speculative stock, consider the quality of the management suite," Dorsey said.
The second thing to gauge in an unprofitable company is the barrier to entry in its business, Dorsey said. Is it easy for competitors to enter the same field?
Consider EToys. It was only a matter of time before bigger retail giants Toys 'R' Us (TOY: news, msgs, alerts) and Wal-Mart (WMT: news, msgs, alerts) muscled in with their online operations.
In contrast, EBay (EBAY: news, msgs, alerts) had a higher barrier, he said. Early in the game, the company set up a successful auction Web site, which Yahoo (YHOO: news, msgs, alerts) and Amazon.com tried to copy.
Third, look for evidence of "smart money" behind the scenes.
Find out who else is buying the stock you like. Bill Miller, manager of Legg Mason Value Fund (LMVTX: news, msgs, alerts) , made a mint after buying AOL in the mid-1990s before the company became profitable. Such savvy moves enabled him to beat the S&P 500 - a tough feat for fund managers -- in the last 10 years, Dorsey said.
What's Miller been buying recently? Amazon.com, Dorsey said. |
