FOOL ON THE HILL
An Investment Opinion
The 84% annual growth rate the Nasdaq Composite achieved in 1999 just was not sustainable. We knew that. The companies that were rewarded the most within that universe had to eventually be reeled in by the immutable laws of finance. We knew that, too. And companies with no earnings and no prospect of earnings in the near future simply cannot retain enormous market capitalizations. I'm pretty sure we knew that, too.
And yet, here we are, wondering what in the world has gone wrong, why the technology companies, the Internet companies, the telecommunications sector, B2B, whatever the hot stocks du jour were yesterday, are all getting pummeled. I submit that they are not really getting hit very hard. Sure, I know, the Nasdaq is down for the year, well into correction territory, and the bears are a-roarin' about the end of the bubble. But let's take our heads out of the microwave and use some common sense as we see our "sure things," our gravy trains, start to look awfully mortal.
I used the term microwave because that is the appliance that most reminds me of the recent market activity. How does a microwave work? I'm glad you asked. A microwave transforms the standard current of electricity into high voltage, which creates waves of electromagnetic cooking energy. In effect, it speeds up current, and uses it to create a superheated energy field. If you've ever used a microwave, you know that these energy fields, while incredibly efficient at cooking things, are not really that good at distributing heat throughout the food you are cooking. So everyone has seen microwaved things that are practically charred in some parts, and still frozen in others. But, regardless of these inefficiencies, the microwave is really fast. Defrost for two hours? Nah, just nuke it for a few minutes.
The market has taken on similar characteristics. Companies that even a few years ago would have never been taken public are now coming out in droves, and immediately being driven up into the stratosphere. Where four years ago people who wanted to buy an Internet company had the choice between America Online (NYSE: AOL) and Netscape, there are now hundreds of companies to choose from, most of which have never made a penny in profit.
Now, many of these companies that were brought public without any real view into how they could be profitable in the future are getting waxed by investors. Pundits call the problem one of over-supply, but the fact is quite a bit more sinister -- most of these companies should have never been brought public in the first place. They were in fact brought public for the benefit of the insiders, and perhaps even more startling, for the investment bankers who brought them there, flipped the shares during the initial stock run, and moved on to the next pile of dreck to pass along to an insatiable public.
The point is this: Some of the companies that are down right now are not coming back up. Ever. They're not in a dip. You're not buying it on sale. They are poor investments being valued accurately by the market. Or, if not accurately, appropriately. But we've been so conditioned to "buy on the dips" that perhaps we are a bit blind to the company that is going down for really good reasons.
I'll give you an example. I was watching CNBC yesterday morning, for what ever reason, and I noticed that the same stock came scrolling by on the ticker VPHM 48�VPHM 45�VPHM 45�VPHM 46 �, and so on. I noticed two things. First, the company's price was steadily dropping like a stone. In five minutes it went from $52 down to $30, touching every number in between. Every once in a while you'd see a bounce, like it would go 25, 25, 45, 25, and so on.
I knew nothing about the company, didn't even know what VPHM stood for, but I figured that something was up. So I checked the news, and there it was: Viropharma (Nasdaq: VPHM), a company that had a drug they hoped to gain Food and Drug Administration (FDA) approval for treatment of colds and viral meningitis, had disappointing Phase III trials, with insufficient evidence that the drug had meaningful effect. The result was a stock that dropped from $72 down to $23 yesterday (and dropped another 27% today).
This is a stock that has dropped for good reason. The company's major source of potential income is now seriously in question. This is not a stock "on sale," this is a company in crisis. Particularly in pharmaceuticals, these things happen -- drugs are by composition unknown quantities until they have actually received FDA approval (or approval from the drug administration in other countries), and millions of dollars of research and development, not to mention revenue potential can, and often does, evaporate.
This is an extreme example, but there are hundreds, if not thousands of companies out there that are coming under severe market pressure right now. I have spoken before about the difference between systematic risk and unsystematic risk. Systematic risk means that a stock is going down just because the overall market is going down. Unsystematic risk means that there is something particular to that company that is causing it to go down. Many of the forgotten stars of yesterday (I mean, again, in microwave time) suffered from unsystematic risks rearing up and biting them. Remember VISX (Nasdaq: VISX)? VISX did not go down because the market was bad. Neither has Excite@Home (Nasdaq: ATHM). Nor has Drkoop.com (Nasdaq: KOOP), CDNow (Nasdaq: CDNW), Celera (NYSE: CRA) or even Knight-Trimark (Nasdaq: NITE).
These companies have not dropped in value for reasons external to their businesses. They dropped due to questions about their ability to be profitable. Sure, there's some momentum piled on for good measure in some instances, but still the prudent, the Foolish investor must ask himself: Are the questions valid? Some will be borne out to have been so, others will overcome these risks and be very profitable. (Of these, I believe that Knight-Trimark and Celera have been most needlessly punished, personally). But the point is that anyone could look at these companies, explore their business models, and decide what the most obvious potential risks are. And, as shareholders, or as potential shareholders, you should.
And if you believe that the potential for benefit is higher than the potential for risk, you are correct in buying, or even buying more. Buying on the dips then can give you exceptional returns, since you are in fact buying a good company at a cheaper price -- the value proposition. But of the companies listed above, some of them will not survive their risks, and are bad investments even at lower prices. For these companies, the only dips will be the people who own them as they crash to the ground.
Buy on the dips, but make sure that it's a dip. That's prudent marshaling of your investment money.
Bill Mann, TMFOtter on the Fool Discussion Boards