Get Ready for the Next Bubble

Step into the Wayback Machine, Mr. Peabody
VentureWire reported that newly formed Demand Media had, in less than six months, breezed through $120 million worth of capital on its way to creating a library of highly trafficked websites that say, well, nothing.

According to a profile of the firm at private equity tracker Redherring.com, the sites Demand owns -- such as mobilephone.com -- offer little more than a search engine and related links. Demand Media runs 150,000 of these bare-bones digital rest stops, which generate 25 million visits monthly. Money is made when accidental Web tourists divert their travels to click on ads before arriving at their intended destinations.

Clearly the clicks are worth something. But $220 million? That's what private equity firm 3i seems to think; it led a new financing round, in which investors poured another $100 million into the firm.

Pop!
Am I the only one who thinks this deal is eerily reminiscent of the dark days of 2000? Back then, VCs rushed to put money to work as they set aside serious evaluations of business quality. Otherwise, they would have seen through the lunacy of selling pet food online.

Perhaps the best explanation here is the simplest: There's too much money in the private equity market, which has led to less selectivity and larger investments. You already know when this happened last -- a sock puppet with a microphone became a cultural icon.

Beat the bubble
Perhaps I'm being paranoid. I hope so. But I don't want you throwing your hard-earned money at an empty vessel. In fact, now might be a great time to revisit your speculative stocks and make sure they're still headed in the right direction.

How do you do that? Make sure your fast movers are still moving fast when it comes to sales and cash from operations. Such firms are inherently more effective than their peers at generating the capital needed to grow and produce meaningful returns for shareholders. Consider this list:

Company

3-year sales CAGR

3-year cash flow CAGR

Avg. annual return

Mittal Steel (NYSE: MT  )

81.4%

206.2%

88.9%

Armor Holdings (NYSE: AH  )

79.9%

49.7%

48.9%

TASER Industries (Nasdaq: TASR  )

64.0%

178.3%

46.7%

Psychiatric Solutions (Nasdaq: PSYS  )

79.8%

116.4%

69.0%

Caremark Rx (NYSE: CMX  )

63.7%

49.3%

31.3%

Sunrise Senior Living (NYSE: SRZ  )

62.0%

101.2%

29.9%

InterDigital Comm. (Nasdaq: IDCC  )

60.9%

156.5%

27.6%

Source: Capital IQ

The lesson? Good stories, like making money from inadvertent Internet clicks, can spark a lot of investor interest, but proven financial performance in the way of increasing sales and cash flow matters much, much more.

Break the rules, not your portfolio
Let cash-rich venture capitalists throw money at questionable business models that depend on the generosity of accidental Web tourists; you'll do better by being more discerning with your growth-stock selections. That's how David Gardner and his team do it at Motley Fool Rule Breakers. We're looking for businesses that are realizing broad economic gains by reshaping their industries.

If that sounds like a strategy you'd like to learn more about, consider trying Rule Breakers free for 30 days. Four stocks in the portfolio have more than doubled over the past two years, and many others that are trading at deep discounts to their potential, including a new pick from yours truly. Interested? Just click here for more information.

Fool contributor Tim Beyers only breaks the rules in his portfolio. Wimp. Tim didn't own shares in any of the companies or funds mentioned in this story at the time of publication. Get the skinny on all of the stocks in Tim's portfolio by checking his Fool profile. Taser is a Motley Fool Rule Breakers pick. Mittal Steel is an Inside Value selection. InterDigital is a Stock Advisor choice. The Motley Fool's disclosure policy is a rebel with a cause.


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