Tuesday, April 6, 1999
Shooting for the Stars
In today's highflying market, where multibillion dollar Internet companies somewhat regularly see their market capitalization increase 20%-50% in a day, hunting for traditional value-oriented stocks has lost much of its appeal. Why dig around for "undervalued" stocks when almost any Internet stock will provide rapid price appreciation and immediate gratification? I'm going to show you a couple of examples where falling for the hype of two red-hot companies provided the quick fix of a drug hit, but the longer-term relationship between stockholders and the company became unsatisfactory.
Internet stocks are certainly the rage of the day. While many of the more established players continue to show rapid price appreciation, the IPOs of new entrants seem to have rocket boosters driving their price higher. Just last week Priceline.com (Nasdaq: PCLN) sold shares for the first time and saw its stock rise from its offering price of $16 to a closing price of $69. (Day traders attempting to take advantage of a first day spike were left unhappy too... the first trade in the stock where anybody could buy or sell was $81 a share and it fell from there.) Since then, the price has sputtered around, with today's closing price being $79.
While Internet stocks are providing a lot of quick gains, remember that the true measure of success in the stock market is performance over an extended period of time. Grabbing 300% in a month means nothing if the stock you are investing in tumbles 75% or more over the next three years. Over the entire holding period, what was at one time a plump gain turns into an absolute return of zero (or worse). Incorporating the opportunity cost of other investments, the return can be a substantial loss.
Of course, you might not think such a situation could happen to the Internet stocks. They are riding a wave into a new frontier where valuation doesn't matter. The opportunities are so vast that these companies won't fail -- just look at the growth opportunities. Well, why don't you tell that to the long-term holders of Secure Computing (Nasdaq: SCUR). This company was a steamin' Internet IPO in November 1995. After opening at $39 1/2 on its first day of trading, the network security product maker's stock price more than tripled from its $16 offering price when it closed at $48 1/4. Over the next month, the stock continued to rise, reaching a pinnacle of $64 1/2 in mid-December. An investor who bought shares in the open market on the first day of trading would have obtained a one-month gain of nearly 60%. You can imagine the bragging that occurred on the cocktail circuit.
Fast forwarding more than three years ahead, an investor in Secure Computing would not likely be chatting about that investment, since the stock is now trading for less than $5 per share. No splits or dividends account for this fall. The company's stock has simply plunged over 90% as it failed to live up to optimistic prospects. Throughout the period, the company posted nice revenue growth, as sales grew from $28 million to $61 million between 1995 and 1998. Unfortunately, profits never materialized and investors ran away from the stock. The once extremely successful investment fell into the abyss of unmentioned investment mistakes.
Another Internet high flyer that came crashing down to earth was Netscape Communications, the browser and portal company. This company was actually a top-dog and first mover in an emerging field, as it created the Web browser market. Adjusting for a subsequent stock split, Netscape was offered to the public in August 1995 at $14 a share. After its first day, the shares closed at $29 1/8, a 108% rise. Throughout the next four months, the stock continued to defy naysayers, hitting $87 in December 1995. Yes, that's a jump of another 199% from the first day's closing price.
From that level, Netscape began a long fall resembling a yo-yo losing momentum. Because of stiff competition from Microsoft and other stumbles, Netscape plunged as low as $14 7/8 in early 1998. Two and a half years after this "hot" offering, the stock was down more than 80% from its peak. If you had gotten into the stock "early," at the close of its first day of trading, your loss would still have been a substantial 49%. The investment picture for Netscape shareholders brightened considerably in late 1998 with a takeover offer from America Online (NYSE: AOL). In its last week of trading before the merger closed this March, the stock finally topped the $87 level again. That was a long, hard three-year ride for investors to endure just to get back to break-even.
After the tremendous gains the stock market has bestowed on recent Internet offerings, it is hard not to want to join in the excitement. I personally have to admit to allocating a small portion of my portfolio to Internet-associated stocks that defy traditional fundamental valuation metrics. Those stocks have shown gangbuster performance, easily overshadowing the mundane returns from a good portion of my primarily value-oriented portfolio. Nonetheless, I don't believe it would be a smart idea to jump on many of the direct Internet players at this point. Too many other people are playing that game, driving prices to levels that discount bright futures decades ahead.
Undoubtedly, one or two of the emerging Internet stocks will be the next America Online, surging several hundred-fold over a seven year period. Most of them, however, will end up with only decent or struggling businesses, marred by changing marketplaces, increased competition, and/or management blunders. Like Secure Computing, these bright stars of today will turn into the investment black holes of the future.
While the temptation to put a substantial portion of your portfolio into what now appear to be the "new stars" is strong, as a long-term investor you should be cautious and diligent. Make sure that you understand the business model and the prospects for the company. Consider competitive threats. Think of all the new entrants that will try to gain market share by offering better prices or better service. What kind of impact would that have on the potential investment? Can the company's management team withstand these challenges? After giving consideration to these factors, place your money only in companies that you expect to generate more earnings (or better yet, free cash flow) than you are investing.
In the short-term, higher and higher stock prices aren't necessarily indicators of value creation as investor sentiment and high hopes sometime override rationality. Over longer periods of time, however, aberrational pricing usually isn't sustained as prospects and opportunities become better defined. Many of what today look like dynamic growth opportunities trading at unheard of multiples of revenues will flounder and create substantial losses. At the same time, some less-well-known companies with regular 10%-25% earnings growth at surprisingly low earnings multiples will turn out to be the true stars for investors.
Call Your Boss a Fool.
|Recent Fool on the Hill Headlines|
|Fool on the Hill Archives »|