Internet Mania – January 1999

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, 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.

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