FOOL ON THE HILL
The Cocktail-Party Test

Following the crowd and investing in fashionable companies is a recipe for disaster. Instead, says Whitney Tilson, seek out solid companies with strong balance sheets -- even if they are out of favor with Wall Street or not even on Wall Street's radar screen. This simple formula can be extremely rewarding, especially in tough economic times.

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By Whitney Tilson
July 10, 2001

Studies have shown that humans tend to seek the approval of others and want to be part of the crowd. It shouldn't be surprising, then, that when it comes to investing people are drawn to the best-known and most popular stocks. It's a trend that has risen over time as more and more inexperienced investors have been drawn into the market, and talking about stocks has become a national pastime.

So what's the matter with this? Nothing -- as long as you don't mind losing money. But if you do, then I suggest you habitually steer clear of the hottest stocks, in the hottest sectors, that are priced for perfection. To do so, try applying what I call the "Cocktail-Party Test."

Imagine that you meet a couple old friends at a cocktail party and, during the course of your conversation, you start swapping stock ideas. What would their reaction be if you shared your five largest holdings? Would they recognize the stocks and nod approvingly? If so, while you might be patting yourself on the back, you might have a problem. But if, on the other hand, a blank or disgusted look crosses their faces, you may have a portfolio that is better positioned for success.

Why? Because investing is, at its core, buying something for substantially less than it is worth. Doing so isn't easy. Despite its occasional absurdities, the market is remarkably efficient. Thus, it is rare -- though certainly not impossible -- to find a widely known, popular stock that is also significantly undervalued. (Before you email me to argue, I'm aware that for a number of years, ending only recently, one could simply buy the hottest stocks and laugh all the way to the bank. Those days have passed....)

Instead, I have found that the most mispriced stocks tend to fall into two categories: Either they're well-known but hated, or obscure and unknown. Warren Buffett seems to agree. At Berkshire Hathaway's 1999 annual meeting, he said: "If I had $10,000 to invest, I would probably focus on smaller companies because there would be a greater chance that something was overlooked in that arena."

The test in action
As I review the stocks mentioned in my 22 columns in the first half of this year -- I discussed 12 I wanted to investigate further and 17 I wanted to avoid -- I can see the cocktail-party test at work.

Can you imagine boasting to a friend about buying Imperial Parking (AMEX: IPK), Huttig Building Products (NYSE: HBP), and Handleman (NYSE: HDL)? How much easier it is to brag about owning Cisco (Nasdaq: CSCO), EMC (NYSE: EMC), and Nortel (NYSE: NT). Yet the former have increased by an average of 37% since I discussed them in late March, while the latter have crashed by an average of 43% since the end of February. (I've posted the data for all 29 stocks on the Fool on the Hill discussion board.)

Updated comments
Much has happened over the past six months, so I'd like to update my comments about many of these stocks.

I continue to own Imperial Parking and Huttig Building Products, and remain bullish on their prospects. I sold Criimi Mae when I became aware that it had a preferred security outstanding that could potentially cause unlimited dilution. Galileo was purchased by Cendant (NYSE: CD). I consider the remaining eight companies all solid and reasonably valued, though not cheap enough for me. I continue to recommend the website ValueInvestorsClub.com, which is open to guests for the time being, as a great source for investment ideas. The site has good write-ups of many companies, including Imperial Parking and Huttig.

I'm still leery of many of the stocks I have expressed reservations about in the past despite, in some cases, dramatic declines in their stock prices. Here are some specific comments:

  • In January, I wrote that Sunrise (Nasdaq: SNRS) "is a pretty good bet to go to zero." (I posted my reasoning on the Fool on the Hill discussion board.) The stock has since declined 72% from $2.96 to $0.84. Suffice it to say that my opinion remains unchanged.

  • A recent earnings warning showed that Manugistics (Nasdaq: MANU) is not immune to the slowdown affecting pretty much the entire tech sector. Despite the stock's tumble, it still trades at a ridiculous 96x this year's expected EPS of $0.24. As the momentum investors that were propping up this stock flee, I see it dropping like a rock.

  • Active Power (Nasdaq: ACPW) has cool technology and is growing revenues rapidly, but has yet to show any profits and still trades at a rich valuation. There also appears to be quite a bit of insider selling. These are the type of situations prudent investors should avoid, especially in this tough market.

  • Krispy Kreme (NYSE: KKD) has gone nuts since January, reporting strong earnings and splitting its shares two-for-one twice. This is a great case study for why I don't short stocks and don't recommend that anyone -- other than real pros -- do so either, as many people who shorted this stock have gotten killed. Do I regret avoiding it? No. Trading at 74x trailing earnings in January, it was a bad bet. The fact that the market has bid the stock up to even more preposterous levels (it now trades at 117x trailing earnings) doesn't mean it was a good buy in January. I still won't short it, however. I'm just staying away from it. While Krispy Kreme's doughnuts may be irresistible, its stock doesn't have to be as well.

  • IBM (NYSE: IBM) and GE (NYSE: GE) have shown surprising resilience in the face of the economic slowdown, but I still question whether their reported growth truly reflects the health of their underlying businesses. Shortly after my initial column panning them, the companies reported stronger-than-expected earnings and I subsequently removed the stocks from my "least-favorite list." I still wouldn't touch the stocks, but I'll keep them off the list for now.

  • With $2.1 billion in debt, a $5.7 billion market cap, and an unproven economic model, Amazon.com (Nasdaq: AMZN) is way too risky for me.

  • Siebel Systems (Nasdaq: SEBL) and Starbucks (Nasdaq: SBUX) are, in my opinion, as absurdly overvalued as Manugistics and Krispy Kreme. Good businesses, bad stocks.

  • I tried to guide investors away from Cisco, Oracle (Nasdaq: ORCL), EMC, Sun, Nortel, and Corning (NYSE: GLW) in October. Then they fell an average of 55%, so I repeated the message in February. They've fallen 36% since then, and I still wouldn't touch them! The story is different at each of these companies, but in general the underlying businesses all have big question marks -- yet not one of them is even remotely cheap.

Conclusion
Following the crowd and investing in what is fashionable is a recipe for disaster. Instead, look for solid companies with strong balance sheets that are either out of favor with Wall Street or, better yet, not even on Wall Street's radar screen.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Imperial Parking and Huttig Building Products at press time. He does not short stocks. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com.