Last Updated January 1999

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You could, of course, jump on the internet bandwagon. Recently, any stock with a "dot-com" in its name has traded like it has a license to print money. Does this make sense? Not really. See why in Lunacy.com.

On the other hand, you might consider rebalancing your entire portfolio. That could be a good idea, but be sure you base your decisions on the right information. Investing Alchemy has a common example of the wrong information.

What are you doing? Drop us an e-mail.

Lunacy.com

"Since time immemorial, all the great manias start out as no brainers and end up being played by those with no brains."

-- Barton Biggs

 

F YOU'VE EVER TAKEN AN introductory economics course, you've probably encountered talk about "efficient markets" and "rational investors". Examples are usually trotted out to show that investors, acting rationally, quickly incorporate financial information, so securities are always priced efficiently. Technicians hate this stuff since they make their living attempting to take advantage of supply and demand imbalances.

Well, the technicians can rest easily. A key ingredient of the "efficient market hypothesis" just doesn't exist -- investors aren't always (or even frequently) rational. Need proof? Just consider the so-called "internet stocks".

Amazon.com, Inktomi, eBay, and Egghead.com among others, have been on fire. They don't have any earnings and for the most part, don't even promise any in the next year. What they and other "internet" stocks have in common is an incredible valuation and trading volume. What's up with this?

Contrary to what you might think, they aren't just being bought by day-trading geeks. No, folks who should know better are also banging their drums. The story is, these dot-coms could be the next Microsoft. While skeptics question their viability, they're establishing themselves as pioneers in their respective fields.

Valuing Vapor

Fair enough, several of these could be big hits or even one of Peter Lynch's "four baggers". But how do you value them? In fact, what's to value?

There's no earnings, so P/E ratios become in Barron's words, "Price/Fantasy" ratios. Most internet stocks have a relatively limited history, so there's very little to use for traditional fundamental valuation. At best they're being valued by money spent or bytes uploaded. This is rational?

Adding to this goofiness is the fact that the companies you can come the closest to valuing are the ones that have the least ability to prosper. For example, Amazon and Egghead are retailers. Amazon sells books and CDs while Egghead sells software. Presumably what makes them so special is their ability to do this more efficiently by eliminating bricks and mortar as well as the retail salesforce.

That's true enough, but they're still selling products -- products verging on commodities. Because of this, their potential profit -- whenever it's earned -- is limited to the difference between what they pay for their products and what they sell them for. Sure they've eliminated the middle man, but it's only that margin they're offering investors. Is it worth paying up for? Is that rational?

In essence, the Amazons and Eggheads of the world are traditional businesses utilizing the web. Even if you never logged onto the internet, you could still buy books, CDs, software, and the like. On the other hand, without the web, businesses like Yahoo or eBay wouldn't exist. Only enterprises like these are true internet businesses.

But you still can't value them. There's no earnings, there's no book value, it's even hard to find the cash flow. Sure, one or two of them may be the next Microsoft, but by the same token they may be offering this decade's Betamax or 8-track tape. Is it rational to pay $200 a share for that?

The Efficient Market

Investors seem to think so. Despite the lack of meaningful valuation, these stocks jump 8, 10, or 20 points each day. For every seller, there's more than one willing buyer -- and this is reflected in the price.

That's right, the market does efficiently price them based on supply and demand. It isn't that the market is ineffecient, it's just that investors that are running up the prices are irrational. What else would you call paying several hundred dollars a share for a company that has yet to earn its first profit? You may as well be at a crap table in Vegas with all the other "rational investors".

But you know, before this internet mania wears off, the federal government ought to consider changing the name of Social Security to SocialSecurity.com. It wouldn't matter that it doesn't have a product or will never turn a profit. No, "rational" investors would fall all over themselves to pour money into it. The President wouldn't have to fret about saving Social Security and maybe -- just maybe -- our taxes wouldn't get squandered. Now that's a rational idea!

Investing Alchemy

"You should study the past if you would divine the future."

-- Confucius

 

LITTLE KNOWLEDGE CAN be dangerous. Technology speeds the flow of information, making this an even greater problem. As a case in point, just think about what many investors (maybe even you!) are doing right now -- rebalancing their portfolios.

Now in and of itself, this isn't bad, but it's often doing the right thing for the wrong reason. Why? Well just stop and think about it. Many investors rebalance their portfolios at the start of the year because information about the previous year just became available. That's right, they're rejiggering their investments for the coming year based on what happened in the previous one.

Shortly after the close of the year, The Wall Street Journal, Morningstar, and other services make year-end performance numbers available for all types of investment vehicles. Armed with this information, investors sell holdings that lagged and pile into the previous year's winners. They're trying to divine the future by studying the past, but they're missing the point.

The Mistaken Assumption

The chart appearing below illustrates this fact. It shows the returns for the best and worst asset classes for the years 1987 - 1994. The data is taken from Morningstar's universe of variable annuities and serves as a proxy for mutual fund classes and equity categories.

International bonds were the top performer in 1987. With stocks coming off their crash year, you might have been inclined to give international bonds a try. Bad choice -- international bonds turned in the worst performance in 1988. If you stuck with them, you'd also have had the worst return in 1989 when aggressive growth had the best. If you switched to that category, you would again receive the worst performance in 1990 while international bonds moved back to the top. That would probably tempt you to get back into international bonds, or anything but aggressive growth. Bad decision again, as aggressive growth led the pack in 1991.

You get the picture. Shifting out of the prior year's poor performers into the best just doesn't work. The fact is, conditions change. The economic and market factors that determined the order of performance in the previous year are probably different now. They're what's important, not recent performance.

History is important, but in a much broader context. Rather than simply looking at the prior twelve months' performance, it's more informative to take note of what economic and market conditions were in place. When they converge again, you can expect similar market performance. By studying these factors, you're in a much better position to make a forward looking decision based on the current conditions. That's exactly what we try to do in the True Facts. No, economics isn't exciting, but then again, neither is chronic underperformance.