Interesting report from Credit Suisse First Boston Corp. available from Schwab's Analyst Center. CheckFree is listed as one of many e-commerce stocks.
Damn Lies and Statistics: Why so Volatile?
It's no secret that electronic commerce stocks are volatile.
For some investors, this volatility can make investing in EC
stocks like sitting helplessly in the passenger seat of a
Ferrari as Mario Andretti drives it through Monaco. About all
you can do is bring a pack of Rolaids, tighten your seatbelt
and hold on for dear life.
Just how volatile are EC stocks? According to the statistics,
about twice as volatile as the NASDAQ and almost three times
as volatile as the S&P 500. (See Exhibit 3)
While it's no secret that EC stocks are more volatile than
the market, the exact reasons for this volatility are not
immediately apparent. However, after closely watching these
stocks for long time (and suffering from a severe case of
motion sickness for our troubles), we think we've got a good
perspective on just what's driving this increased volatility.
All told, there are several factors driving this increased
volatility including:
High insider ownership: Most electronic commerce companies
are relatively young and are still run by their founders. In
such situations it is not uncommon to find that the founders
still hold a significant share of the equity. In fact, while
the companies in our EC Index have a total market value of $57
.5BN, over 27% or $15.6BN, of that equity is held by insiders
. Because insiders are subject to restrictions on when they
can buy and sell their company's stock, insider shares are
typically not considered part of the shares available to the
general public to buy and sell (otherwise known as "the float
"). Thus, the high degree of insider ownership in EC stocks
reduces the float and therefore makes the stocks more
sensitive to incremental changes in supply and demand, or in
other words, it makes them inherently more volatile.
Low institutional ownership: Conventional wisdom holds that
institutional ownership plays a role in limiting the
volatility of a company's stock price. That's because
institutions typically buy and hold stocks for a period of
time and thus do not constantly trade the stock each day.
Institutions also make fundamental investment decisions which
imply that they will purchase a stock if it falls below a
certain level (and sell it if it rises above a certain level
), thus giving the stock price some "fundamental support" and
preventing it from wild swings in valuation. This
conventional wisdom appears to be borne out within the EC
industry in a definite correlation between institutional ownership and
volatility. (See Exhibit 4)
High short interest: Short interest is the percentage of a
company's outstanding shares that are sold short.1 If a
substantial portion of a company's shares are sold short,
that reduces the float of the stock in the short term (
increasing volatility) and it makes it possible for the stock
to see very sharp price movements should the stock price
increase and "squeeze" the shorts. As it stands, about 3% of
the total capitalization in the EC space is sold short.
However, that total rises to about 9% if you subtract out insider shares and
institutional shares.
Retail supply vs. demand: If you subtract out the shares that
are either owned by insiders, owned by institutions or sold
short, what you end up with is roughly the shares that are
truly available for retail investors to purchase. In the case
of the EC Industry, subtracting out all these factors leaves
you with about 26% or $14.8BN of its market capitalization. (
See Exhibit 5) While that sounds like a lot of money, in the
grand scheme of things it's actually quite a pitiful sum.
After all, according to the Federal Reserve, retail investors
hold over $5.6TR in equities in total, which means that the
available EC stocks represent just 0.3% of their holdings.
Even a single company, Microsoft, has almost 8x as much stock
available for investors to purchase.2 Given the tremendous
amount of attention that Internet and electronic commerce
stocks have generated in the past few years, we don't think
it's a stretch to suggest that retail investors, if they could
, would devote more than 0.3% of their portfolios to this area
. About the only thing holding them back is the incredible
valuations in the sector, but even that does not seem to be
much of a deterrent of late. Such a structural imbalance of
supply and demand should not only lead to higher prices, but
should also lead to greater volatility due to decreased liquidity.
Finance Theory: All of the factors we have cited up to this
point are largely technical factors that in some way decrease
liquidity and raise price tension in the market, thereby
increasing volatility. While these technical factors play a
very important role, it should be pointed out that from a
theoretical perspective, EC stocks would be very volatile
even if they didn't suffer from these technical ills. That's
because most electronic commerce companies are high growth
companies and many of them are actually producing substantial
losses in the short term. What that means from a finance
theory perspective is that almost all of their current value
is based on cash flows that are many years in the future.
With so much of their value dependent on future cash flows,
even small changes in their expected cash flow growth rates
or long term rates of return should theoretically produce
significant changes in current valuation. Given that the
Internet is a rapidly evolving space where almost nothing is
certain, it's to be expected that investor expectations of
long term growth rates may change on an almost daily basis and thus, should
produce high levels of stock price volatility.
So there you have it. As far as we're concerned, there is a
series of solid reasons, both technical and theoretical,
which account for the relatively high levels of stock price
volatility in the EC industry. While this volatility makes
investing in EC stocks a high risk and somewhat stomach-
churning exercise, as the saying goes (and as the last three
months demonstrate), where there's no risk, there's no reward.
Investment Outlook
With three back-to-back months of record gains in the books,
the EC industry appears poised for a bit of a pause in the
month of February. That said, the deal calendar is quite full
and offerings such as Healtheon, Vignette, Intraware, iVillage
, pcOrder.com and others should keep interest in the Internet
, and the EC space in particular, quite high. The key to the
sector's health will no doubt be retail investors, who
increasingly dominate the trading of many names and whose
continued enthusiasms are critical to supporting the
industry's increasingly lofty valuations.
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