January 11 1999
Dow Jones Average: 9617
S & P 500 Index: 1264
Internet Mania
We have witnessed many investment manias in our twenty plus years of
following the markets, but all pale in comparison to the internet mania
of 1998. There was the biotech fever of 1991-92, which drove the stock
values of many nascent biotech startups to levels approaching major
pharmaceutical companies. There was the personal computer craze of 1983,
featuring now forgotten computer makers such as Commodore, Franklin,
and Kaypro. There was the energy services boom of 1980-81, when mere
ownership of some oil rig parts conferred status as an energy company.
And we still recall the gambling stock bubble that accompanied the resurrection
of Atlantic City. Companies with nothing more than an option to buy
an acre of land in Atlantic City soared in value. Those past instances
where investors threw caution and rational thinking to the wind in the
pursuit of instant riches seem like minor happenings when compared to
the internet mania currently gripping investors. Perhaps the longest
bull market of all time created the excess funds to fuel the greatest
mania in U.S. stock market history.
Manias spring from an indisputable premise, a sense of mystery, and
a bullish investment climate. No one can dispute the pervasive influence
of the internet or its mysterious, almost magical qualities. And after
seventeen years of strong market conditions in the U.S., there are millions
of people willing to embrace the idea that stocks always go higher.
Americans feel that they are destined to make money in stocks, that
the market will make up for a chronically low savings rate and a flawed
social security system. Some will become wealthy as is is the case in
any gold rush, real estate boom, or investment mania. But the history
of manias strongly suggests that most people playing this game will
become significantly poorer.
One recent story illustrates the lottery mentality running rampant
in the market these days. A small company named Skymall, that sells
goods through catalogs on airplanes, was trading for two dollars per
share in October, 1998. The company was decidedly unsuccessful as a
business and did not warrant a price much above two dollars per share.
But soon after Christmas the president of the company made an appearance
on CNBC, the 24 hour a day investment channel. These "appearances" usually
cost the participants tens of thousands of dollars and are nothing more
than promotion for the company and air time fillers for CNBC. The president
of Skymall said that the company's internet sales were surging, albeit
from a miniscule base. All the traders who spend their days with one
eye on CNBC and the other on their on-line trading screens jumped into
the stock sending it to 35 dollars per share. Meanwhile the president
of Skymall called outside counsel for an opinion on whether it would
be legal for him to sell his shares. After receiving an affirmative
response to his question, he sold 675,000 shares for 35 dollars per
share, before the close of trading on that same day. Even though he
received his Christmas present a few days late it was a tidy sum, nearly
24 million dollars. As with most of the internet mania stocks things
soon cooled down and Skymall fell back 20 points or so to the mid-teens.
If Skymall was an isolated example it would hardly be worth a mention,
but it is all too typical of the excesses afflicting the market. The
mob of internet traders must have their daily fix of exploding stock
prices. Every moribund retailer that has been unable to move products
through typical retail channels is being pressured by stockholders,
investment bankers, and traders to find salvation in internet retailing,
to say the magic words, "we have a new internet site". Most of these
companies will sell little more over the internet than they currently
sell through other channels, and some may even go out of business faster
as they spend to establish internet sites. When a trend begins to encompass
and feature hundreds of low quality companies, it is a sure sign that
the trend has become a mania.
Even though experienced investors know that manias end badly, with
huge, sudden losses for the speculators, it is impossible to predict
when a mania will end. The desire to be part of the action overwhelms
all reason and warning signs. Selling by corporate insiders, negative
earnings, weak cash flow, and preposterous enterprise values are all
ignored in the rush to get on board. At the moment AOL has a value higher
than Disney, Yahoo is approaching the market value of General Motors,
Amazon.com shares are worth more than all but a few of the largest retailers,
and E.Trade has a higher value than AG Edwards. As a group internet
related companies are worth hundreds of billions of dollars on the stock
exchange, while producing little in the way of earnings to back up that
value. We do not know when the fever will break, but when it does it
will seriously damage investor psychology.
Current Strategy
Investors worldwide revere Alan Greenspan, chairman of the Federal
Reserve Board. He is given credit for the strong U.S. economy and the
prosperity that has flowed from the unparalleled stock market gains.
People hang on his every word and pray for his good health. What investors
fail to realize is that through their own actions they have taken much
of the control over events away from government officials, including
Alan Greenspan. The irony is that while investors believe that Alan
Greenspan is leading them to the promised land, they are actually forcing
his decisions at every turn. Greenspan was about to raise interest rates
in July, 1998, but by October he was cutting rates 3/4 of one percent.
His abrupt change of mind was in response to worldwide investor panic.
It was not part of some master economic plan he has for continued prosperity.
We doubt that a minor shift in interest rates ended the worst economic
crisis in sixty years. There is widespread agreement that South America
is headed into recession, Europe is weakening after a robust 1998, Japan
is still faltering, and the rest of Asia has stabilized at depressed
economic levels. Alan Greenspan has said that America can not remain
an island of prosperity and we quite agree. Half the companies in the
Dow Jones average have already announced dismal earnings due largely
to problems overseas. Stocks are usually priced with some small margin
of safety for the buyer to allow for inherent economic risks. There
is no margin for error built into current stock prices, in fact most
stocks are overvalued even if everything goes perfectly. While this
situation is not rational, we are clearly not living in rational times.
We continue to seek out those stocks that are priced at levels that
do allow a margin of safety. Finding companies that have a reliable
earnings stream and a reasonable stock price is difficult, but not impossible.
We do not buy stocks that have simply fallen in price, because their
earnings stream may be in question. The overall economic environment
also weighs on our thinking, as serious dislocations can impact even
the strongest companies. While investing is undeniably risky, our greatest
satisfaction comes from identifying those situations where the potential
rewards far outweigh the risks.
