FOOL ON THE HILL
What the Past Can Teach Us

It can be really annoying to read one of those "I told you so" articles once a stock price has dropped. But, there is a difference between these and articles that look at a fallen company and try to discern what an investor could have done to see the potential for a drop. In the market, companies can decay or improve fundamentally for a significant period of time before the stock responds. As such, when a drop occurs there is usually a valuable lesson -- if you can stomach it.

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By Bill Mann (TMF Otter)
November 24, 2000

I fully understand the anger that it causes. I even find myself responding cynically whenever I see an article in which the author writes "Well, it was obvious that something bad was going to happen because of X, Y, and Z." My first reaction is usually "Well, why didn't you bother to point out the risks before the stock actually cratered?" Sometimes the authors did, and sometimes they didn't.

Sometimes it seems like the only reason that a writer drafts an article is to make people feel stupid -- and you thought it was just you. Really, there are financial writers out there who have a certain superiority complex. I know, I know, it seems unbelievable.

There is a big difference between the "I told you so" or the "Anyone could have seen it coming" articles and the "Let's examine what went wrong" type of articles. The first two are largely worthless except as a view into the psyche of the insecure writer. The third type is generally useful and, as painful as it is to examine a stock that has turned down on you, in many cases these should be read with care. Unfortunately many investors, particularly now that the market has sunk its teeth into so many of us, are too high-strung to know the difference between the two.

The backward glance is very important. Perhaps the biggest clich� in investing is that "past performance is no guarantee of future returns." This is true. Past mistakes, however, unless they are examined in the open, are ripe for repetition. And the people who seek someone else to blame for their portfolio swoons are just the ones who will repeat them. Really, no one among us is capable of saving someone from himself but, as The Motley Fool is supposed to be educating investors, we also must look at some events and ask, "What did we miss?"

In the last two weeks, many of the next-generation networking stocks have dropped severely, some by more than 50%. Although people at the Fool had at various points said that this would happen, we had no idea when, or how hard these companies would fall. The first portion of this might be more important. Even if we looked at companies like Juniper Networks (Nasdaq: JNPR) and said, "Wow, based on any fundamental model I can think of, this company is really expensive," what we did not and could not say was "This company is going to drop in November. It has to. Optics stocks always drop in November."

Nor should we declare the game over for Juniper, Redback Networks (Nasdaq: RBAK), Broadcom (Nasdaq: BRCM), Avanex Corp (Nasdaq: AVNX), or any of the other companies that have been hit so hard, because they really haven't been hit very hard. Certainly, a 60% loss is tough to take, but it has come so fast in response to a rapid rise, that the companies even now are only back at where they began 2000. In the grand scheme of things, it could be argued convincingly that neither the rise nor the fall were based on company fundamentals. Rather, the market is just in the process of finding an equilibrium for companies with highly promising futures.

What's the lesson? In Tuesday's Rule Breaker report, Jeff Fischer pointed out that innovations people get excited about have always produced speculative binges followed by a dose of reality. The valuations of canals, railroads, airlines, car companies, computer manufacturers, and other innovators shot through the roof when their gee-whiz technologies first came on the scene, only to come back down as the realities of economics set in. Optical technologies are coming and coming fast. But, when a company is priced at 1600 times its present cash flow, its sales just cannot come fast enough.

Again, using Juniper's financials, let's look to see what was assumed when the company's stock was priced at $200 per share in September. At that time (we're using the 10-Q released in August, the most recent one available then), the company had cash flows of $61.3 million for the quarter ($82.1 million in cash from operations, minus $20.8 million in capital expenses). Annualized, this becomes $245.2 million, or $0.77 per share.

If I perform a simple cash flow model and discount at only 20%, I find that Juniper has to earn $184 per share in year 10 to justify its current share price, an annual increase in excess of 73%. Assuming that the company's cash flow margins stay the same (the Rule Maker's Cash King Margin), Juniper will have to grow its annual revenues from $452 million (Q2's revenues annualized) to $108 billion in the next decade. That means that, in the year 2010, Juniper will have to sell $15.32 worth of its equipment for every man, woman, and child in the world to justify its current market cap. There is no share price appreciation built into this expectation. That's about the size of General Electric's (NYSE: GE) current revenue base. Oh, and all of this assumes that the company does not issue a single additional share -- something that we should not assume.

Sure, it's possible, but that's a tough way to bet. This is what's tough about a company like Juniper, and that's why we need to use lessons when they come along. There can be no doubt that the company's products have enormous potential, and this is borne out by the fact that the company boasts current annual sales growth in excess of 800%. Any company with this type of growth should sport a high price-to-earnings ratio (or the imminently more useful price-to-free-cash-flow ratio). It has been said before that the great companies are often the ones that cause us to make our biggest mistakes.

Is a $200 per share investment in Juniper a mistake? I think so, but I don't have any special insight into Juniper's technology or its potential for continued technology development. I just know that investing should take into account both the potential for financial gain and the potential for financial loss. Ben Graham called investing the preservation and growth of invested capital. A majority of us, at some point, will be so taken by the potential for gain in a given stock that we will discount the potential for loss, or the potential for underperformance.

That lesson, for most, can only be taught in hindsight. Also, most of us (myself included) are going to stubbornly reject it until we discover it for ourselves. Yes, I'm looking back at something that just happened, and certainly Juniper could rebound. It could even, from a fundamental standpoint, provide market-beating returns for the next decade, even for shareholders who suddenly find themselves down more than 50%. But, those who buy a stock at an enormous multiple to cash flows (or even earnings) might be playing some seriously long odds.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards