The Stock's Fallen 50%... Should I Buy?[Fool on the Hill] June 27, 2000

An Investment Opinion

The Stock's Fallen 50%... Should I Buy?

By Warren Gump (TMF Gump)
June 27, 2000

Summary: Many stocks, particularly those in the technology/Internet space, have fallen precipitously from their highs. Analyzing such things as a company's market, potential profitability, and barriers of entry can help determine if the company is a worthy investment.

In a world where stock prices have been extraordinarily volatile, finding stocks in technology-focused companies that are 50%, 70%, or 90% off their 52-week highs is easy. You need look no farther than Yahoo! (Nasdaq: YHOO), (NYSE: AMZN), or (Nasdaq: DSCM), respectively. As in a clearance sale at your favorite discount clothing store, however, you need to be careful about the merchandise you select. Some of the stuff might represent a tremendous bargain, but a lot of it will be junk that no one will ever want to use again (let's optimistically assume that we can use parachute pants as an example).

The investor's challenge when sifting through these companies is determining which will become profitable enterprises that will justify a valuation higher than what the market is charging today. That's no small task. At the beginning of the year, Yahoo!'s stock price implied that the company was going to create enough value to justify a $135 billion market capitalization. Today, the company's price tag is only $65 billion. Where will it be five years from now? Is it on its way down another 50% or prepared to soar above any valuation it's seen in the past?

The right answer, which no one knows at this point, depends on how the markets and company develop over the next few years. While the range of possible outcomes is varied, trying to figure out Yahoo!'s future is in many ways easier than doing so for many other start-ups. Yahoo! has several years of historical financials, providing perspective on the growth and profitability that has been achieved. Many of technology stocks recently put on the market don't even have a year's history. And even with this limited data, you don't have any sense of the company's profitability opportunities since they are still posting substantial losses.

Here are a few things I consider when evaluating whether to invest in emerging technology stocks. You should notice that "How much has the stock fallen from its previous high" is not on the list. The answer to that question tells you absolutely nothing about a stock's future.

1. Can the business create and sustain profitability? We all invest in companies to make money. If the companies themselves don't have the ability to do this, what's the purpose of investing? I know that it's exciting to see high revenue growth rates and market share gains, but almost anyone can do that at a loss. The key is being able to achieve these objectives while making money.

High gross margins and relatively fixed infrastructure costs (leading to operating leverage) are indicators of businesses with a higher likelihood of success. Most businesses will start out operating at a loss before achieving certain economies of scale. A sales jump at a company with high margins and relatively fixed costs will lead to a much bigger improvement in profitability than one with low margins.

2. How big will the market be? Will participating in this market open up opportunities to move into other business lines? It's helpful to get some sense of the size of the market that a company is addressing. A $10 billion market cap company focusing solely on a market that will ultimately produce $100 million in revenue is probably overvalued. On the other hand, a $2 billion company that has reasonable chances of being an important player in a $50 billion market could be attractive.

Looking at the current market opportunities of a company is important, because investors will be focused on that issue. At the same time, you need to look out and see where solid positioning in one market might ultimately lead. The wireless market was attractive five years ago if you simply looked at the opportunity to link people with voice communications. When you add in the possibility of the wireless Internet and other data transmission, however, it becomes exponentially more attractive. If a company can leverage a strong position in one market into another market, its future opportunities can be much greater than they initially appear.

3. Are there substantial barriers to entry or sustainable competitive advantages? Try to evaluate whether a company will be able to maintain its lead in the marketplace. Does it have patents, an infrastructure, or long-term relationships with key customers that make it harder for rivals to penetrate the market? Are substitute products available (or likely to be developed) that will affect these advantages? Those companies that have advantages that can't be duplicated or substituted should be better positioned for success than competitors.

4. How profitable will the business be? After considering the first three questions, try to evaluate the level of profitability that can be achieved by the company. I purposely ask this question after evaluating barriers to entry and sustainable competitive advantages. If an industry doesn't have these attributes, the entry of new competitors will turn what could be a great business into one that is only marginally profitable, if that.

5. Does the business have the resources to make it to profitability? If a business is currently operating at a loss, but is involved in an industry that should be attractive, I want to make sure that it has the financial wherewithal to make it to profitability. Ideally, this would mean no debt and a big cash hoard. Since that is an extremely high threshold, I'm willing to settle for a company associated with strong financial partners that would be willing to lend or invest additional money when needed to achieve success.

6. Are positive or negative surprises more likely? Recognize that predictions are just best guesses about what will happen in the future. The numbers and assumptions you have when looking at industries will rarely be exactly right. Evaluate the assumptions and try to figure out whether surprises are more likely to be positive or negative. Will the markets be larger or smaller than your estimate? Will competition be more or less intense than expected? If negative surprises are more likely, the company probably isn't as attractive as it appears.

7. Never expect to time the market correctly and get in at the stock's bottom. It would be great if this could happen with regularity, but the truth of the matter is that it can't. The only thing you can do is invest in a company when you think there is a reasonably good chance that the present value of its future earnings is greater than its stock price.

If you're conservative, you can add a "margin of safety." This simply means reducing your estimate of the present value of earnings by a certain percentage to compensate for possible mistakes. For example, if you think that a stock is worth $50, you could add a 20% margin of safety by being willing to pay no more than $40 [$50 * (1- 20%)]. Adding a margin of safety doesn't ensure that you won't lose money, but it gives you a little extra cushion.

These seven questions are in no way a comprehensive list of things to consider when investing in a fallen stock. If you have other criteria or questions to ask before investing in a fallen stock, why don't you head over to our Fool on the Hill discussion board to share your knowledge with everyone in Fooldom.