Bad Business

“The man to watch if you are an investor,” wrote Lynn Carpenter, “is not Greenspan. It’s Arthur Levitt.”

Levitt runs the SEC. And it was the SEC that forced MicroStrategy to recompose its earnings. This led, in turn, to a big drop in revenues and a change not merely in the number on the bottom line — but its character as well. Indeed, the change was so dramatic it can only be likened to a sex change operation: the 15 cents a share of profit reported by MicroStrategy turned into a 43-51 cent loss.

Thus, investors felt betrayed. The stock they had courted and married turned out to something much different from what they expected.

At least five law firms saw cause for legal action. They have engaged the company in class-action suits, though the legal proceedings are likely be marked by very little action and no class whatsoever.

And at least one investor was so distraught that he said he could no longer live with himself. As reported above, he wrote on a message board that he didn’t know “one could lose like this.” “How could I have been so stupid?” he must have asked himself. And yet, up until Monday, stupidity had paid off quite well. He had leveraged his investment of $129,000 so that when the stock dropped he was wiped out. And yet, had it not been for the SEC, MicroStrategy probably would have risen along with everything else yesterday. Instead of thinking about suicide, this investor would still be thinking himself a genius and might have made, leveraged, about $25,000 before the bell rang on Tuesday afternoon.

Eventually, (as I keep saying…) this too will pass. That is, there will be a lot of MicroStrategies that fall from grace for one reason or another. And, alas, there will also be a lot of shareholders who are surprised by how much money one can lose.

There will also be a lot of hyena law firms ready to take up the opportunity to rip pieces of flesh from whatever carcasses they can find. In addition to the obvious shareholder class-action suits, they are likely to find another group of willing litigants. These are not investors — but the people who have gotten stock options.

So far, the SEC has been remarkably quiet about the use of stock options in place of cash. But the practice has become so widespread that it is bound to cause trouble.

When a company sells shares to the public, it is required to make disclosures. Those disclosures tell investors that almost anything can go wrong, and probably will. The story the company can tell is regulated by the SEC, which supposedly tries to protect investors from misrepresentations and fraud.

But when a company gives out options, there is no regulatory system in place. People who take the options are on their own.

An article, whose provenance has been lost, records an Internet entrepreneur using options to get his hair cut. “Fit me in today,” he told the stylist, “and I’ll give you 10 shares of my company.”

“I’ve given net options to our PR firm, our graphics firm and our consultants,” said the entrepreneur. “All kinds of people want to get jobs with me. They all know the option price will go up.”

The company in question had not yet reached the IPO stage. At this stage, typically “friends and family” as well as “qualified early-stage investors” are given shares. Where does the hairdresser fit in?

In effect, the shares have been sold for services rendered to unqualified investors with no disclosures and none of the regulatory procedures that companies usually have to endure. The shares were used in place of cash.

As mentioned yesterday, one out of every four Internet companies will run out of cash this year. Three-quarters of them are running at negative cash flow. They need to use the shares as a currency — a replacement for cash.

Last year, two companies announced plans to give away shares to people who signed up for their online services. In another case, Red Hat, gave away shares to its pool of 4,000 or so online shareware developers. And still another: Harris Interactive is giving its poll respondents pre-IPO shares just for continuing to cooperate.

Shares are given to suppliers, customers, employees, people who bring in new employees, landlords — everyone.

Not only is this cheap, or “bad,” currency driving out good currency — it is also destroying wealth. Options lure resources towards activities that don’t really make sense…and will never really make money.

People who could be gainfully employed driving cabs or flipping burgers are instead starting up Internet companies. Then they pay for valuable commercial space with stock options.

If the options go bad…it will then be clear that time and space were wasted…and money was lost. People will find that the whole transaction made them poorer, not richer.

So far, no landlords have gone to court in Santa Clara county alleging that the options they were given were misrepresented. But so far, most of the optioned stocks have been doing well.

But, there’s always…

More to come.

Your correspondent in the middle of a field in Germany,

Bill Bonner

Bonn, Germany March 22, 2000

*** The titanic struggle between a timid, aging Fed chairman and a frenzied crowd of investors continued yesterday. Greenspan raised rates a trifling quarter of a point. And the mob went even crazier.

*** The Dow rose 227 points — led by GE, which announced higher earnings. The S&P rose to a new high, now trading at an average P/E of 36.

*** But the real excitement was in the center of lunacy — the Internets. The HHH was up 8%. Many stocks were up 10%. The Nasdaq 100 rose 188 points.

*** Where does this leave us? Hmmm…could we have begun a new bull cycle…not just in the techs and Nets, but in the Dow, too? Or is this just a bear market rally…while we wait for the Nasdaq to crack?

*** Advancing stocks beat declining ones 1,788 to 1,151. But new lows exceeded new highs 46 to 41.

** Well, I don’t know. But I am comforted by the realization that these things are not supposed to make sense. In that regard, the market is doing what it is supposed to do and what I have predicted it would do all along — it isn’t making sense.

*** So let’s let the dust settle…and see what happens today. And enjoy the spectacle from the safety of the sidelines.

*** “Get in now or get left behind,” says the e-mail ad I got from Michael Murphy yesterday. I think I’ll just get left behind, thank you. Because no matter what the markets do at this stage — they’re too risky, too pricey and too absurd for a value investor (except for the beaten-down, pariah stocks such as Fleetwood, Ford and GM — which I’ve mentioned from time to time.)

*** Even gold rose yesterday. Perhaps gold investors alone noticed that the trade deficit hit a new record too yesterday — at $28 billion for the last month. Or maybe it was the news that the money supply seems to be on an upward swing again.

*** “I never thought one could lose like this,” said one investor on the Yahoo/MicroStrategy message board. He went on to announce that he was going to kill himself. He had lost all of his money — $129,000 — when MicroStrategy tanked on Monday. More below…

*** MicroStrategy, you may recall, is the company mentioned here on several occasions over the last couple of weeks. It is a company whose founder and chairman, Michael Saylor, believes passionately in the future of the Internet to do good. Certainly, it has been good to him. Maybe not so good for the investors who bought his shares.

*** The collapse of the Iridium satellite communications system has left two Norwegians crossing the North Pole on skis…and one Frenchman rowing across the Pacific… without regular phone service. Evidently these were the only three people on the planet willing to pay Iridium’s high telephone rates.

*** “There are only two kinds of candidates,” wrote a correspondent, referring to the presidential race, “those who sell out and those who drop out.”

*** Earlier this month, the originator of sociobiology, Bill Hamilton, died. He was a professor at Oxford who noticed that genes seemed to have a will and survival strategy of their own — apart from the human vessels that carried them. This led him to explore the concept of altruism and to the discovery of “Hamilton’s rule” — which makes sense, from a genetic point of view, of the willingness of people to die to defend their families and tribal groups.

He also wondered why the sexes exist and came up with a hypothesis — that sex was a way of constantly mixing and remixing genes to avoid giving harmful parasites a fixed, static target.

Hamilton only had to give one lecture a year at Oxford. But he was so absent-minded that he would often forget. He may also have forgotten to get the appropriate shots before embarking on a trip into the Congo earlier this month. He died of a tropical disease while researching the origins of the HIV virus in chimpanzees.