Tulipmaniacs or Visionaries?

Dateline: 11/16/98
Revised: 01/05/00

I originally posted this article here on November 16th, 1998. In the year and a bit since then, Internet stocks have continued to soar. My Canadian Internet Stock Average gained almost 350% for 1999. And we continue to read articles from bearishly inclined commentators on "bubble.com", a phenomenon that will soon be burst by a nasty pin prick - if not Y2K, then something else, maybe interest rates.

Nevertheless, my comments from late 1998 still apply. Analysts like Timothy and Carlton Lutz of the Cabot Market Letter boldly declare that there is an "investment revolution" going on. A contrast between Old World stocks, which are going nowhere, and New World stocks which are full of "vim and vigor".

This phenomenon has been noted by Patrick McKeough of The Successful Investor as well, though not in those terms. He argues that we are in a two tiered market where some stocks will do well and others poorly. "Rather than see the 1990s boom end in a traditional bear market," writes McKeough, "market leadership (will) simply narrow."

So are we in bubble.com? Or are we in a period of investment revolution? Read on!

Scenarios

Consider these scenarios:

The year is 1988 and you have the option to invest $10,000 in an up and coming company that is growing quickly. However, the shares are overvalued with a P/E of 500. Would you buy?

Let's go to 1990 and a similar opportunity presents itself. Again you have $10,000 to invest and the company's P/E ratio is 500. Do you buy?

The companies are Microsoft and Cisco systems. Neither of these companies were actually trading at such high multiples. Microsoft was trading at a "reasonable" 19.7 at the time. And Cisco was trading at 34.5 (which is too high for some traditionalists). But let's imagine they were trading at the extremely high multiple of 500 to make a point.

If you had bought $10,000 of Microsoft in 1988 at the inflated price of our example, it would have been be worth $29,334 ten years later. That is an annual compounded rate of return of just over 20%, not too shabby. It doesn't compare with the return had you bought Microsoft at its actual price, of course. (At its actual price, $10,000 invested in 1988 would have been worth $733,333.) But as I said, that's not the point.

With Cisco, the numbers are even more spectacular. $10,000 invested in Cisco at the inflated price of a 500 P/E ratio would be worth $74,356 ten years later. That's an annual compounded growth rate of 29%, a superior return by most any standard. (Again, if you had bought at the actual price, the return would be far greater - over a million dollars.)

The Dutch Tulip Mania of the 1600's

From 1634 to 1637 a maniacal frenzy seized Dutch investors. They went nuts over tulip bulbs. Over a period of three years the price of tulip bulbs skyrocketed 5900%. The Tulip Book of P. Cos, Dutch florist of the era, lists the weights and prices of bulbs he sold in 1637. The most costly was a Viceroy he sold for 4200 guilders. (4200 guilders today is worth $3402 Canadian.)

But that was hardly the most expensive bulb. In the most famous account of the era, Extraordinary Popular Delusions and the Madness of Crowds, author Charles Mackay tells us that the most precious bulb, the Semper Augustus, was considered cheap at 5500 florins. In The Great Reckoning, Davidson & Rees-Mogg report that at the height of the mania, November 1636, "single bulbs sold for prices equal to ten years' wages of the average worker".

One author of the day recounted a trade for a single Viceroy bulb (a cheap one - only 2500 florins) as follows: For that one bulb, the dealer received two lasts of wheat, four lasts of rye, four fat oxen, eight fat swine, twelve fat sheep, two hogsheads of wine, four tuns of beer, two tuns of butter, one thousand pounds of cheese, a complete bed, a suit of clothes, and a silver drinking cup. History House, in a whimsical discussion of this trade, converts the entire deal to cheese and notes that the 5500 florin Semper Augustus would have fetched 23 tons of la fromage de la bon gout. "That's a lot of cheese!" they declare. No kidding!

Of course, tulip bulbs are in the ground for much of the year and could only actually be supplied from July through November. So futures markets developed, aptly called windhandel or wind trading. The political cartoonists of the day had a field day with this foolishness, portraying tulip speculators as monkeys and asses. And then, the Wind Trade was becalmed. The price collapsed. In a space of two months many of Holland's wealthiest powerbrokers were bankrupted as prices dropped 93%.

That speculative binge became known as tulipmania or tulipomania. Others followed - the South Sea Bubble and the Mississippi Scheme among them. David Tice lists a number of them in a chart at his Prudent Bear Fund site, showing the duration of the mania, how much the price gain was, and how severely they collapsed. Bears and pessimists have cited these manias and their disastrous consequences repeatedly as a warning to stock market speculators.

Today many of these bearish folks are repeating the same dire warnings, some about the stock markets in general, most all of them about the Internet stocks in particular. Tulips and Bears has been advising people to short Internet stocks since May. Tice declares the current market to be "the biggest bubble in history". Steven Jon Kaplan, the writer of Gold Mining Outlook, is openly derisive of the stock market and predicts the Dow will fall to1500 in five years! He says "buying a stock with a high P/E is like driving an automobile at 120 miles per hour; you might get where you want to go quickly, but there is a significant chance that you will never arrive at your destination, since there is no margin for even minor hazards. "

How high are the valuations on today's Internet stocks? Here is a table with ten of them listing their closing prices on Nov. 16, 1998, their EPS and their P/E ratios.

As you can see, most of these ten companies hadn't even made a profit yet. Some were posting whopping losses per share. How can one explain such seeming madness? Are these investors tulipmaniacs caught up in a bubble about to burst? Read on.

The Visionaries

Suppose you were around as an investor in the 1950s when a new fangled invention was just starting to make its way into the marketplace. That invention was television. There were few broadcasting stations and even fewer production houses. The sets were expensive and had little tiny twelve inch black and white screens. Not even a quarter of all households had one. Would you have invested in an ABC or a CBS or an NBC? Would you have been able to predict the quantum leap television would make over the next fifty years to brilliant color, stereo sound, large screen flat panel displays? Would you have even been able to predict that eventually the average household would have not one, but two television sets? Would you have been able to predict that television signals from half way around the world could be beamed to your set by satellite? Or that you could access 500 channels?

I have been working in the television broadcasting industry for almost 25 years, and the changes that have happened in that time are nothing short of astounding. The job I currently have - as a satellite feed coordinator - did not exist five years ago. When I started in television, there were no home VCRs. Cable TV was a young industry. Many people still owned black and white television sets. There was no stereo sound. There was no closed captioning.

To have fully envisioned the future of television in the fifties would have taken a tremendous leap of faith. It would have taken visionary thinking. The same can be said for today's computer industry.

Business 2.0 bills itself as a magazine for the the new economy with new rules and new leaders. On their website an article charts the incredible growth of the Internet. The visionaries see this as just the beginning. Eventually the Internet will be like television. Every home will have at least one connection, and many will have two or more.

Not only that, Nicholas Negroponte, the founder and director of MIT's Media Lab, predicts a convergence between technologies. Television and the Internet will become as one. Indeed we already have an alliance between Microsoft and NBC. CBS has a strong presence online as does CNN. Each has its own online affilations. CBS is particularly strong in the business news area. The idea that the Internet will some day be as ubiquitous as television is not idle speculation. It is fast becoming a reality.

The station I work for, BCTV, has its complete nightly Newshour available online at the click of a button. Follow the link here and you'll see the most recent Newshour (yes, the entire hour including commercials!) on your computer. The image is small, it's true. But think of it as.... well, think of it as a twelve inch black and white screen back in the fifties! Wow! Does that change your perspective or what!

Those who are bullish on Internet stocks, like Andrew and Carlton Lutts of the Cabot Market Letter argued in late 1998 that revenues were exploding - Yahoo up 200% from the previous year, Amazon up 306% - and so were earnings. Earnings for Yahoo for the five quarters up to November 1998 were $0.01, $0.03, $0.04, $0.07 and $0.15 respectively. At those earnings, its P/E was 280. That's lower than the 500 P/E ratios we used in our examples of Microsoft and Cisco at the head of this article. Was Yahoo a bargain? The Luttses thought so. Its performance in 1999 bears out that they were right.

Amazon.com is often referred to as the Wal-Mart of the Internet. I could easily have included Wal-Mart along with Cisco and Microsoft in my example above and the results would have been equally staggering. Wouldn't you have liked to get in on Wal-Mart stock at the beginning?

The lead article in the November 1998 issue of Business 2.0 , entitled What's it Worth?, discusses the evaluation of Internet stocks in detail. I won't go over it here but leave you with this thought from Ann Winblad of Hummer Winblad Venture Partners who is quoted in the article. Comparing Amazon with Barnes & Noble, she says "Barnes & Noble has more revenue, more profit, and higher earnings than Amazon, but Amazon is just a better business".

Why? "B&N has $2 billion in leases, pays for inventory, moves it around to the stores, stacks it on the shelf, and has staff in over 1000 locations. Amazon has one location, one (main) warehouse, and collects all the money from customers in cash long before they pay for the merchandise".

But before you rush out and buy those Internet stocks, consider an article in the November 1998 Bloomberg Personal Finance magazine from Geoffrey Moore, author of The Gorilla Game and an acknowledged expert on high tech stocks. The important thing to look for says Moore is the Price to Sales ratio. If it is over 20, the stock is either a potential gorilla or it is a signal of market mania. He believes the Internet stocks that have captured the market's attention "can never be gorilllas" because they do not and cannot exert any proprietary architectural control over the Internet. But they can, he says, "become strong brands, and thus, like popular TV shows and magazines, they can become extremely valuable as media for advertising, subscriptions, and transaction processing". Exactly like television!.

In his best-selling book, The Seven Habits of Highly Successful People, Stephen Covey introduced the notion of a paradigm shift - a new way of looking at things. It involves a process of contemplation and then, all of a sudden, a light bulb flashes on. Aha! You say. Now that's an interesting new way of looking at things.

Where Kaplan likens buying stocks with high P/E ratios to getting into a car and buzzing down the highway at 120 MPH, an accident waiting to happen, a minor paradigm shift in thinking tells you that you could well be driving down the highway at 120 MPH in a Sherman tank and everyone had better get the hell out of the way!

Today's investor stands, not at the brink of disaster as the doom and gloomers would have it, but at the threshold of a new millenium. We have an opportunity to get in on the ground floor (actually the ground floor has been left behind - let's say the fifth floor) of an elevator about to ascend the Empire State Building. The question is "Are you afraid of heights?"

Thoughts on this? Why not post a message on our Bulletin Board! For a sobering contrary view, check out Steve Taub's article Suckers.con at Individual Investor Online.

Selected Links

Internet Stock Links - My collection of Canadian and U.S. Internet Stocks links.

Previous Internet Articles - a comprehensive listing of my previous articles on Canadian Internet stocks.

U.S. Internet Stock Links - Colleague Mike Griffis at the About.com Stocks site has this useful collection of Internet Stock links.

Internet Stock Index - ISDEX is the leading Internet Stock Index. Includes links to the sites and the stock reports.

The Internet Stock Report - Steve Harmon reports daily on the Internet scene.

Canadian High Tech Links - My collection of Net Links to Canadian High Tech sites. I'll be adding the links above to my collection soon.

Faster Growth, Lower Risk - Feature article in Bloomberg Personal Finance by Geoffrey Moore looks at evaluating Internet stocks.

Disclaimer: As with all my columns here, I should re-iterate a precaution. I am not a professional financial advisor. I am a financial journalist and editorialist. The views in these columns are my personal opinions. The author may hold interests in investments mentioned in this article.

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