FOOL ON THE HILL: An Investment Opinion
The $190 Billion Haircut

One of the hardest things that market and business analysts have to do is to make a call of a company being "overvalued." The reaction is never good, and the writer more often than not is judged upon the short-term performance of the stock. But a fundamental determination of valuation and short-term stock movements are two very different things. The heavy hit taken by Nortel and the optical networking companies this week provides a good example.

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By Bill Mann (TMF Otter)
October 27, 2000

After the large-cap optical fiber companies got a collective $190 billion haircut on Wednesday, Thursday was not much better.

On the back of an earnings report by Nortel Networks (NYSE: NT) that only included optical networking revenue increases of 90%, Nortel tanked badly, and pulled vendors, competitors, and comparable companies down with it. The following companies were down 10% or more over the two days: Juniper Networks (Nasdaq: JNPR), JDS Uniphase (Nasdaq: JDSU), Avanex (Nasdaq: AVNX), Applied Micro Circuits (Nasdaq: AMCC), Broadcom (Nasdaq: BRCM), Emulex (Nasdaq: EMLX), SDL (Nasdaq: SDLI), and Ciena (Nasdaq: CIEN).

Several other large-cap optical networking companies have been hit hard as well. What's interesting is not so much that these companies have taken short-term beatings, though. Optical networking companies, for all of their wonderful potential, fantastic growth rates, and powerful customer rosters, had defied the malaise that hit every other sector of communications and high tech over the last six months.

More importantly, with the exception of a few voices, the financial community was almost completely quiet about the fact that some of these companies have been priced to beyond perfection.

To a great extent, I understand this. Seriously. It is never that gratifying to stand up and claim that the high-flying sector du jour is sailing just a bit too high. The resulting vitriol that inevitably comes our way from these types of calls can be quite demoralizing. In most cases, the vituperative is also misguided -- one pundit's opinion is a useless indicator for the long-term direction of a company.

Regardless, the company will eventually trade at its intrinsic value, regardless of what path it takes to get there.

For this very reason, you rarely see writers come out against the hottest stocks solely on valuation. It also gives me some understanding of the pressure felt by Wall Street analysts to maintain high ratings on companies they cover. Up the rating on a stock, and the investing world bathes your feet with rose water; cut a rating, and prepare to endure death by 1,000 cuts, administered by a mob. There is nothing so ugly as euphoria attacking reason. We saw it with the Internet stocks in 1999, the B2B stocks this year, and now we see it with optical networks.

Throwing a "valuation" call out there also dooms one to play market timer. I recently spent some time speaking with Whitney Tilson, a guest columnist for The Motley Fool, to discuss one of the companies in the optical networking arena: Juniper.

At the time (just prior to its blowout earnings report), it was trading at 1,600 times trailing cash flows, a level that is nothing short of insane. However, the reality is that Juniper's customers are absolutely crazy about its products, and it is the only company that has, in a meaningful fashion, taken market share away from Cisco Systems (Nasdaq: CSCO) in one of its core areas of competency. In other words, Juniper's got some horses.

I still could not get my head around the company's valuation to cash flow. Whitney simplified it for me by making a very concise observation: If a company can be valued at 1,600 times cash flows, there really is nothing stopping it from going up to 3,200 times cash flows.

This is the dilemma equity commentators face. If you base an argument on a fundamental inability for a company to justify a valuation, you almost have to time the call correctly. Yet, who amongst fundamental investors really bothers with trying to time a market gone mad anyway? Those who would benefit the most from this commentary, by and large, don't want to hear it -- if our inboxes are any indication.

And that's too bad. Because it did not take a genius to see that the optical networking stocks were going to fall. It would take a savant to know when they would fall, but not if. Telecommunications companies, their major customers, are suffering and pinching pennies. A vendor can execute flawlessly, but will still see salad days if its customer base has no ability to buy.

I am not that savant. In fact, ask me if the fall of these stocks is done, or overdone, and I'd say "no." This does not mean that the companies are going to fall tomorrow, and the next day, and the day after that. They could, in fact, rise back up into the upper nosebleed territory right away.

What's so amazing is the number of people who were otherworldly bullish on Nortel on Tuesday, and looking for an exit point, blood, or both on Wednesday. That's no way to manage a portfolio. Nortel's earnings were lighter than expected, but for those who bought in recently, just what were their expectations?

Therein lies the dilemma. It often seems that there is no price that is too high for someone who is truly bullish on the prospects of a company. However, there is a point of rationality, one where almost any performance for a company has already been priced into the stock.

If you cannot figure out why your companies that miss estimates seem to get waxed, while the ones that beat expectations do not rise, there's a good chance that people who most recently bought paid a premium that includes the outperformance.

From a business perspective, Nortel isn't disappearing anytime soon. It is in the sweet spot of the next generation networks, just like the other companies listed at the outset of this article. Nevertheless, if you're thinking of jumping in now to take advantage of the beginning of this revolution, understand that you'll be paying as if it has already happened.

If you wonder why people didn't say this before these stocks dropped, well, they did. You just didn't want to listen.