AsinineValuations.com
by Bill Valentine, CFA
The original name of this article was "CaveatEmptor.com"--but
it seemed to fall short. After thinking about the mania
surrounding "web" stocks, I decided that "buyer beware" was
less reflective of my thoughts than something that captures the
"what-the-hell-are-these-people-thinking?" flavor of this current
mania. Recently, several new stocks of Internet companies
have come to market (in an IPO) only to see their prices
double, triple, or quadruple faster than you could say, "Hey,
they don't have any earnings!" As someone who's devoted their
life to the stock market, and as a hack financial historian, I'm
afraid I have to join the ranks of those in the professional
investment community trying to discourage rampant,
speculative trading in web stocks. Lest my intention and
perspective be misunderstood, please realize that the train
wreck building in these stocks doesn't affect my portfolio or
investment results one bit. Additionally, you won't find a bigger
fan of the Internet than this investment manager. The problem
is not web stocks per se; it's why people are buying them, how
much they're paying for them, and what will inevitably happen
to them.
What's going on?
Over the past two months, a number of visible Internet web site
companies have come to market. Most of them operate a high
profile, commerce-based web site. Very typically, the shares
double on the first day of trading on the back of enormous
trading volume. Subsequent days find the shares trading all
over the place, often up or down 30 to 50% in a day. After a
month, many of these companies have traded three to four
times their total outstanding shares (meaning, hypothetically,
that all the company shares have traded hands three to four
times). By virtue of the amount of turnover these shares
experience, it's clear that the owners of these shares are
speculators, not investors. Shares are being bought, and
then dumped a couple of days later. So who's responsible for
all this frothy speculation? Those darn institutions? Nope. The
vast majority of these trades are placed by individuals (often
through the Internet via E*Trade and the like). In a world where
institutions typically own around 40% of most stocks,
institutions own only 5-10% of these web stocks.
This is not the first Internet
stock mania in history (say what?)
Before there was an Internet, this current mania played itself
out under different names. Speculative mania goes back as far
as time. They are part imbalance in supply-and-demand, and
part hysteria. They're characterized by the antithesis of the law
of elasticity (In economics, the demand for a good falls as its
price rises. In a mania, the higher the price of a stock goes,
the more a stock is in demand). Past manias existed around
the issuance of shares in the South Sea trading company,
railroad stocks in the U.S. in the 1800s, and most recently,
biotechnology companies in the early 1980's. [In 1980 any IPO
with the words "molecular," "gene," "zyme," or "bio" in the
company name was treated as benevolent. These days, all a
company has to do is call itself "(anything).com" and the
market treats it like it prints money]. Every one of these
manias has ended the same way. Prices eventually collapse
as the hype fades and reality sets in.
Valuation, Schmaluation
In a mania, the valuation of a company is ignored. Stock prices
do not reflect any fundamental economic basis. The prices of
the web stocks relative to their sales, earnings, and book
values are so outrageously high that they're meaningless.
Warren Buffet once said that if he were teaching an
investment class, the final exam would be an essay question:
"How do you value an Internet company?" He said he'd fail
anyone who turned in an answer. For an investment to be
successful, it must be attractive on an absolute AND a relative
basis. For example, I love Ford Explorers. I've owned a couple
over the last few years and couldn't be happier. Does that
mean I would pay $150,000 to own one? I think not. At
$150,000, the concept of owning the Explorer is still attractive
("the absolute"), but I don't get $150,000's worth of value out of
it ("the relative"). Buying shares without regard to valuation is to
ignore the relative.
How this comes home to roost
In the stock market, eventually all stocks gravitate to the
fundamentals of the companies on which they are issued.
That's why relative valuation is important. If a stock trades at an
above-average level of Price-to-Earnings, Price-to-Sales, or
Price-to-Book, the values in the denominator must grow at an
extraordinary pace--or the stock must fall. It's one or the other.
In the case of many of the web IPOs, there is no reasonable
way for the sales, earnings, or book values to catch up to what
would be a reasonable valuation. Thus, the stock price will have
to collapse to make up the difference. Expect it to eventually
happen. Some of the holders of these stocks won't be around
long enough to see that happen. I'm referring to those self
styled bandits that buy and sell the stock in a short period in a
speculative ploy to capture short-term profits. These are
gamblers, pure and simple. Many are novices that are putting
their family's net worth at risk. The same people that won't take
$100 to Las Vegas are buying and selling hundred-share
blocks of these stocks every day. The problem is that most will
end up loosing over time. Here's how that works. Every stock
trade has a zero-sum economic outcome (i.e. for every dollar
gained, there's a dollar lost). At any given time, half the trades
take money away from a participant. For some, it will be that
loss that forces them out. A whole different thing happens on
the "winning" side of the trades. The "winners" are not only not
forced out, they develop a false sense of aptitude based on
their winning trade. This serves to impair their judgement.
Eventually, they will lose also, and because they didn't walk
away from the proverbial table when they were up, the only way
out is to be forced out when they lose. So if the losers
eventually have to cut out (due to inadequate capital), and all
winners eventually become losers, who wins in this zero-sum
game? The brokers (be they electronic or otherwise). The sad
fact is that the Internet is responsible for a growing
socioeconomic dysfunction akin to the devastation caused by
gambling. If you think it's any different than a gambling problem
for some of these folks, I suggest you look into the subject.
Yeah, but which Internet stock should I buy?
Still not scared away from Internet stocks? Well, back to my
earlier point, I'm not anti Internet stocks. If you want to
participate in the Internet, a safer alternative to the web site
companies is to buy the large companies who aren't solely
relying on future revenue from web traffic. Companies such as
Cisco (who provides the network equipment for the Net) and
MCI WorldCom (who own most of the pipeline that is the Net)
have been very successful stocks for me. If, however, you still
have your heart set on owning a highflying web stock, you
might consider three rules to keep you from the
crash-and-burn:
1.Wait until 6 months after the IPO before buying and then
only when the stock starts trading near where it was
issued, or after a major sell-off, which ever comes first.
2.Buy-and-hold the stock. If the stock doubles, sell half.
Set a downside limit that forces you to get out before
most of your investment disappears.
3.Limit the percent of your portfolio in web stocks to a
reasonable percentage (5%-20%), in spite of the
temptation to own more.
As with all stocks, get to know your company…it is, after all,
your company. It's easy to forget that stock shares represent
ownership in a company. Alternatively, you can skip the
sector, choose from thousands of other stocks, sleep at night,
and still make a fortune.
Bill Valentine, CFA, is the founder of Valentine Ventures, LLC, an investment
management firm for individuals. His expertise is in using investment
strategies to build diversified portfolios of global stocks and bonds.
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