In evaluating the investment performance of year 2000, many are looking back at the performance of the dot.com companies as a total disaster – one that investors should have seen coming and avoided. The NASDAQ, home of many dot.coms, lost 39.29 percent of its value in 2000. From its high on March 10, 2000 through the end of the year, the NASDAQ lost 51.07 percent. As of the end of February 2001, the average NASDAQ investor would need to advance 138.52 percent to regain the value held at last year’s peak, where as one trader remarked, unparalleled market excesses made the Dutch tulip bulb craze look like a value play.
Hindsight, of course, is 20/20. Ideally, investors would have bought the dot.com companies when their prices were low, waited until their prices were just about to peak, and sold them an instant before they peaked. Alas, such timing is not only uncommon, it is impossible for all investors to accomplish simultaneously.
So what is the lesson of the dot.com companies, many of which are now the dot.gone companies? The lesson is one that all investors need to keep in mind for all investments: The financial value of an asset depends ultimately on its ability to provide the promise of cash flows to the investor.
Investments at Their Most Basic
Suppose that someone promised you $10,000 to be received 10 years from today. What is that money worth to you today? Any first year finance student with a calculator will tell you that the money is worth the present value of the $10,000 using an appropriate cost of capital. Assuming a 10 percent cost of money, the value of that $10,000 today is $3855.43, which is what you’d expect to pay for that single payment on the market.
What can you do to make that $3855.43 higher? That, of course, is the question business people should ask themselves on a daily basis-our job, after all, is to maximize the value of the firm for its investors. We suggest to you that there are three answers to that question:
- You can decrease the length of time until you receive the $10,000. In business, this would be done by good project management, assuring that the construction of new assets is completed in a timely manner; and by shortening the collection cycle for sales.
- You can increase the amount of the $10,000. In business, we do this by maximizing the net present value of our investment choices, assuring that our marketing and sales departments are generating as much in sales as they can; that our prices are set at the profit maximizing price; and that our costs are lowered to the extent possible (usually the job of purchasing and production in most firms).
- You can lower the perceived risk of the project. By lowering the risk of the project, you lower the cost of capital for the project and therefore raise its present value. This activity is generally the province of the finance function in the firm.
If we mis-estimate any of those values, we will mis-value the asset. Believing that cash flows will come sooner than they do; or that they will be greater than they turn out to be; or that the risk of a project is lower than it in fact is; will cause us to overvalue the asset. With more and more people taking charge of their own finances, more investors than ever are making errors of judgment. The bullish 90’s created a strain of optimism impervious to rational requirements. Even though there are more ways than ever to research, monitor, and manage investments, whether through discount brokers, a flood of financial publications, constant television coverage or the Internet, people haven’t changed. Our errors remain remarkably constant.
What does that have to do with the dot.com companies?
Were those who invested in the dot.com companies guilty of ignoring the potential of earnings, as some have alleged? Put another way, did they assume that earnings were either unimportant in valuing dot.com companies or that the concept of dot.com was so important that earnings would be extraordinary, and therefore the price of dot.coms should be extraordinary?
At its heart, the market is composed of rational thinkers who evaluate companies based on the three factors listed above–namely, how much, when, and how risky will the cash flows from the company be. They are sophisticated investors who understand the risk and return structure of the market.
The percentage of these investors and analysts fell dramatically in 1998 and 1999. Rather than be left behind and derided as fossils, many analysts struggled to construct new valuation models to justify soaring prices for companies with negative earnings. Venture capitalists derided the idea of building a company to last, and virtually cut off the funding to any IPO not built-to-flip in six to twelve months. This group of people understood the importance of cash flows, but lost sight of that importance in the frenzy of the late 1990’s.
There is another group that has no understanding of underlying value. They believe they will be able to sell their stocks to a group of bigger fools, constantly willing to pay bigger prices for stocks that will ultimately become valueless.
It is those investors who failed to look at the underlying economics of investments like Amazon.com, as an example, and who bid the prices of those stocks to incredible heights given the rational expected payout for the companies. They believed that the payouts would be incredibly high, would come quickly, and would be nearly riskless. How else could they justify the fact that less than 20 percent of the top 133 flip IPO’s showed any profits as of mid-1999?
Had they put their assumptions on a spreadsheet, they would have found that the rates of growth they were projecting were stratospheric, that the amount of cash that Amazon.com needed to generate was unattainable and that, on balance, the stock was overbought.
However, there is no reason to do analysis if you believe that the market will bail you out – that you can get off the elevator just before the cable snaps and sends it crashing to the basement.
Where Were the Short Sellers?
It is true, of course, that the market has a correcting mechanism for those who believe that a stock is overvalued. It is the short sale – the ability to sell stock that you do not own with the expectation of buying it back later at a lower price.
In the case of the dot.coms, again hindsight being 20/20, there was a huge opportunity for short selling. However, there is, and was, a problem with short selling. The problem is that the short seller is uncertain as to when the market will awaken to its overbought condition. If it occurs quickly, as has happened, the profits from short selling are large.
If it takes a significant amount of time, the carrying costs of short selling can be large and the risks equally large. So what’s the lesson from the dot.coms? Investment texts have stated the underlying lesson of the dot.coms over a long period of time:
- Value the expected cash flows of a company.
- Understand and treasure its economics.
- No matter how bullish you are on any one company, don’t let it dominate your investment commitments.
Harry Markowitz received a Nobel Prize for his timeless essay on the provable advantages of diversification. Investors who diversify over the long run end up with more return per dollar of risk taken than the rest of us. That is the ultimate definition of winning the investment game. Such portfolios may not have the biggest one-year profits, but they will avoid the biggest one-year losses.
In the long run, those who believe they can sell stock to others at higher and higher prices will have to replenish their capital. They forget that a 50 percent loss must be followed by a 100 percent gain to get even, an event that significantly increases the length of time required to reach any given investment goal. (Recall the gambler’s lament, “I hope I break even today, I could sure use the money.”)
The precise length of time needed to break even depends on the risk premium the market offers. Assume the market offers a six percent risk premium; the investor will have to wait almost 12 years to become whole – a significant portion of his or her working life. Those who look at fundamental values will find that they miss out on the very high returns enjoyed by the fools who make money in the intermediate term.
They will also miss out on the risk those fools enjoy. Dot.gone.
Also, see related articles from past issues of the GBR…
Managing Earnings . . . or Cooking the Books?
