Monday, January 31, 2011

Shades of the Dot-Com Bubble

This recent Barron's article on Salesforce.com (CRM) makes the following point:

- The stock trades at 300 times earnings
- There's been a sharp rise in expenses
- Shares outstanding has been growing
- Earnings look less than inspiring when looked at using generally accepted accounting principles (GAAP)

It's always difficult to predict when a speculative stock's valuation will normalize.

Once you get the kind of valuation CRM has more often than not the time it takes to correct is measured in years, not months. A clearly overvalued stock will often just get more overvalued before those willing to play the greater fool game are done with it. So, on the surface, it would seem there's plenty of time to play the speculative game. Many actually try to time (some succeed, most don't, but either way the winner is the "croupier") getting out before the other speculators head for the door.

For me, stuff like this has always fell into the category of AVOID.

Here's why.

Occasionally, this kind of stock will actually even justify what seemed like an inflated valuation. In that specific case, the investor took a huge risk over time by buying at an inflated multiple, in the long run turned out to be right, and ended up breaking even. Sometimes, an exceptional situation like Apple (AAPL)* comes along. Most of the time, if you play in the inflated multiple arena you need to get the trading right or you lose. In any case, if you pay something like a 100x earnings multiple for a stock, huge risks of permanent capital loss are being taken compared to the potential rewards. It's a game where the odds are against the participants but if you can control for those losses it may work out.

For me, there's too much risk of permanent loss of capital. When you avoid the big losses in investing, the gains take care of themselves. It's a simple mathematical truth that percentage gains and losses have an asymmetrical impact on wealth:
  • Lose 60% on a stock and an investor needs to make 150% on the next one to break even
  • Lose 70% on a stock and an investor needs to make 233% on the next one to break even
It all goes downhill quickly from there. Also, it's wise to keep in mind the adverse affects caused by loss aversion.

In contrast, if you buy a durable business at a fair multiple of earnings, the core economics will determine your long-term outcome. No timing or trading skills required. A good business with durable economics bought below intrinsic value and a stock that happens to go down from the price paid is not a problem for the long-term investor. The core economics will still drive your returns over the long run even if what you see on the quote screen looks a little ugly.

In fact, as a long-term owner, the cheap stock will just serve to juice returns via buybacks.

Adam

Long position in AAPL established at lower than recent prices. No position in CRM.

* Apple's stock, even with all the appreciation, is actually still not that expensive: Roughly 12-15x.  At times during the past decade Apple may have seemed somewhat expensive (though nothing like Salesforce.com) but, with the clarity of hindsight, was certainly not. Those who can predict what Apple has been able to accomplish beforehand deserve big returns.
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