FOOL ON THE HILL
Faith in the Market

The stock market has been an institution for so long that we forget just how amazing a mechanism it is. Imagine any other market where people routinely pay $50 for something everyone knows to be worth $2 today! The American markets have earned our trust, but investors who are overcome by greed at the expense of logic may find themselves misplacing that trust -- and paying for it.

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By Bill Mann (TMF Otter)
March 1, 2002

Editor's Note: Bill Mann's on a short break after the birth of his daughter. Today we're offering up a classic column of his that originally ran in July 2001.

What is the over-arching word that comes to your mind when you think of the stock market? The optimistic among us might choose "opportunity," while the pessimistic would select something like "gamble." The realistic among us might even latch upon "volatility" or "dynamism."

I choose "faith."

Faith is the glue that keeps any market together. Faith is what causes someone to pay $50 for the rights to what is now an earnings flow of only $2 -- or, even more to the point, paying the same amount for a company that is losing money. When you buy a stock, you are essentially telling both the company and the market itself "Yes! I'm ready to believe you!" And in general, that's a good thing.

Have you ever thought about what you are buying when you purchase a stock? Sure, you're paying for a portion of the company, but in almost all cases you are paying well above the actual book value of the company and its assets. (Book value is the total asset base of a company minus its total liabilities.) You are also generally paying a premium to a company's current earnings or cash flow. What you are purchasing, in actuality, is a proportionate amount of all of the company's future earnings.

Many times the company only returns a portion of that money to you, in the form of a dividend. Companies that are growing quickly tend to pay no dividends at all. And yet, here we are, trusting that management can take money that might otherwise have been returned to us, and reinvest it profitably back into the company.

There is no contract with companies that they will pay you a dividend. With the exception of certain types of trusts -- real estate investment trusts, or REITs, for example -- companies actually have no requirement at all to do so. So we are paying a premium for the right to money generated from operations, but even if a company performs admirably, we often have no expectation of actually receiving it. That's faith.

In an unhealthy market, however, faith is easily exploited -- and thus destroyed.

There are forces that prey upon faith in our market. Last year, I profiled four penny stocks in a piece called "Following the Stupid Money." Needless to say, I got an earful from shareholders of the companies I discussed, all of whom were convinced that they had found a sure path to riches. It was a path to something, for sure, but not riches.

These were unlisted stocks, which means that the level of oversight on them is slight. Three of these companies, InvestAmerica (OTCBB: INVT),  Microaccel (OTCBB: MROA), and Centraxx (OTCBB: CNXX) had no operations and were still valued by the market at $148, $212, and $188 million, respectively. One of them had grand plans for a broadband network, another a microprocessor "technology," and the third intended to launch a wireless tracking technology.

Today the combined market value of these three companies is a shade under $10 million. One company is bankrupt. Only InvestAmerica has any revenues -- a total of $1.2 million for 2000 -- but it racked up massive losses in the process. Its revenues for the first quarter of 2001 totaled $52,000. The company's balance sheet looks like it has been hit by a truck.

These companies originally came to my attention because each of them paid a promoter to release a "research report" on their prospects. Why would revenueless companies feel the need to do such a thing? I've no idea, but I do know two things. First, these research reports, along with all the boiler room and stock message board hype activities, prey upon the very faith that causes us to trust the market. Second, they tend to work. This, I hope, is an enduring lesson to those shareholders who react to any type of stock hype: Your greed has been used against you. Faith, when untempered by logic, is not a force that is easy to harness.

Still, the United States' equity markets rightly deserve the faith investors worldwide grant them. That the U.S. is the destination market of choice for much of the world's risk capital -- almost 50% of the world's public company market capitalization is based in the United States -- is a credit not only to the sheer quality of American companies, but the faith that can be placed on the vitality of the market itself.

The American market simply has no equal when it comes to protecting the rights of minority shareholders. By and large, the participants who are in the position to manipulate the market do not. To undermine wider faith in it is to slay the golden goose. From accounting practices to our legal system to the Securities and Exchange Commission, the pillars of our market are strong. When a person or a company undermines that faith, we expect the penalty to be severe.

I'm here to tell you that your faith in the market is well-placed. That some people will continue to test the old adage that "no one ever went broke underestimating the American public" reminds us that faith and greed are powerful. This is not, however, an issue to be hung on the market. It is impossible to completely protect people from themselves.

The market and its mechanisms work. We do not have to concern ourselves with the chance of having our investments confiscated by companies without legal recourse, and it is reasonable to believe that what we read in financial reports is largely accurate. The fact that we can put our resources at risk on businesses and not have to worry so much about the particular mechanism is remarkable.

But investors nevertheless must constantly guard against giving that trust to people and entities that do not deserve it. They're out there, trying to separate you from your money with promises of an easy score and "can't miss" investments, right now.

When they succeed, we are all hurt.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann blesses the rains down in Africa. To see his stock holdings, view his profile. The Motley Fool is investors writing for investors.