The New York Times ran an extremely compelling article this past weekend about a group of investors who made massive purchases of the stock of Audible
But these folks believed in the power of Audible, and as such, they bought in ways that violated some of the cardinal rules of investing: They concentrated their holdings in one stock, invested money they couldn't afford to lose, went on margin, and risked everything on a company that had completely burned all of its previous shareholders. Audible's stock fell by almost 99% since its IPO in 1999. The stock dipped below a buck per stub in October of 2000, and it spent almost all of the next three years down in the pennies. In February 2003, Audible got kicked off the Nasdaq.
In the meantime, Audible has turned its game around. It burned through nearly $50 million in its first eight years of existence, only turning in its first quarterly profit in 2003. It also turned free-cash-flow positive at about the same time, which means that, as of now, the company is self-funding.
But Audible has minimal financial leverage. Its spoken-word audio download business continues to grow, with its top-line revenues approaching $30 million in the last 12 months. (Of course, that means that Audible trades at more than 18 times sales, but ahem!)
The bottom line for investors: Shares that in March 2003 were trading as low as $0.63 (reverse split-adjusted) now change hands at more than $25.
The response to this type of article is almost inevitable. In fact, if you go to the Audible message board at Yahoo!, you can already see the result: Some unconscionable hypester is touting the "next Audible." The fact is that penny stocks -- nay, penny companies -- almost never turn around. Audible beat the odds, as have other rebounds like iVillage
Almost all of the other companies, once relegated to penny stock purgatory, from Iridium to Metricom, iXL to iTurf, never come back. What made Audible different? And, more interesting to me, were these true believers, for whom Audible invariably made up a vast majority of their investing resources, rational in their decisions? Was their story one that individual investors should emulate in any way?
I think Gary Rivlin did a great job with the Times article, but it does include certain arm-waving elements that need to be addressed. First and foremost, no company is a statistic. It's all well and good to say 95 out of 100 of the companies sent to the pink sheets wind up dead. It's another thing to recognize that the five that make it likely have some common traits. People make plenty of good money investing in turnarounds -- but Warren Buffett is exactly right when he says that most turnarounds don't actually ever turn around. The headline of the article calls it "roulette," but I'm not quite so sure that framing what happened here entirely as a game of chance is the way to go.
Penny stock investing, like shorting, is something that most investors are patently unequipped to handle, because the risk, volatility, and instance of loss is almost certain to be substantially higher. But there's a reason that my inbox (along with millions of others) is overflowing with bald-faced touts for garbage-quality companies: because they are an effective way to pump up a share price. These companies, if they can even be called companies, are not high-risk, high-return, as the article suggests is pro forma. High risk can also mean ungodly loss. Sometimes such loss is assured. Look, I don't think you could have ever, at any point, called companies like Leucadia, Wal-Mart
I've never seen the first bit of hyping related to Audible, and I've had the pleasure of sitting right next to Rex Moore as he went through the thought process to buy and hold onto this company, many percent of gains ago, for many of the same reasons that the folks in the Times article espoused.
But we shouldn't mince words here: What these gentlemen in the Times story did was extraordinarily risky, both in the structure of their own portfolios (generally, they were close to 100% Audible), and in the vehicle they chose for such concentration. Even into 2004, Audible had to sell more than $2 million in shares into the market to fund its operations -- though it hasn't had to cram down its existing shareholders by some ridiculous percentage in the way that Sirius
You can have a company with a differentiated and incredibly sticky product, quarter-after-quarter revenue growth, high gross margins, and a high degree of operating leverage, and the company can still turn out to be a failure. Krispy Kreme
In investing, such bet-the-farm situations are best avoided. Even if you've done hundreds of hours of painstaking research, even if your research tells you that the company has a can't-miss business, you're still risking nearly unrecoverable losses in the case that a can't-miss somehow does miss. And when you're talking about penny stocks, they often miss. Without knowing for sure, I get the feeling that Rivlin purposely focused on folks who stood the farthest out on the ledge, and that there were other people for whom Audible has grown to be a big position as it has surged.
My hat's off to the guys in this article, as well as to Rex Moore. A look at the website the gentlemen maintained while the company was unlisted shows that they were, by and large, well-versed in what the company did, how it was doing, even what color pants the CEO was wearing that day. They made a bet, and a calculated one. And still, you can see signs of the True Believer Syndrome in the quotes in Rivlin's article, particularly as one investor discussed "rallying around the company" in light of Nasdaq's decision to delist it in 2003, a decision that some described as "unfair." But you can't simply say that these folks were lucky. They found a company, unappreciated on Wall Street, thrown on the slagheap of irrelevance, and they bought it, and held. They could've done the same thing with an old bag of garbage like Commerce One. They didn't. They picked this one, and they were right.
Is this a model for others to follow? Again, it's easy to make generalities and say "absolutely not." But it's also just as undeniable that many of the great investors make large bets when they're absolutely sure that their facts are right and in their favor. In such situations, aggressiveness is warranted.
With the vast majority of companies -- not just penny stocks, companies -- such aggression certainly is not warranted. The risk of the proverbial bus, the dislocative technology, the SEC investigation, or even the long-term underperformance is simply too great. This isn't a model, but it is a really good story.
- Bill Mann's "Won't, May, Should, Could, Will"...
- or his "Never Lose Money"...
- or see Whitney Tilson's "Focus Investing."
Bill Mann holds shares in Denny's, another successful turnaround. Bill contributed a stock idea in the current edition of Hidden Gems. A free trial is yours for the askin'.