The Gods Must Be Crazy

“So, what do we do then?” asked a DR reader.

“Should we, like Buffett, simply not buy stocks that we can’t value? Isn’t that a bit naive, to simply not take any risks on companies or ideas that could realistically have a huge earnings stream? Consider Yahoo. From the very beginning this company was a potential blockbuster. Gross margins of 86% and almost zero capital cost.”

Lack of earnings history and high prices make the typical Internet stock inappropriate, if not abhorrent, to a value investor. But does this mean that value investors are doomed to miss out on all new tech opportunities?

To make a long story short, the answer is, “yes.”

In fact, Internet companies are not only out of reach of value investors — they are beyond the reach of any serious investor.

But the lure of great wealth, near the peak of a mania, is so strong that most people find it impossible to resist.

“The mark of a mania is when the general public senses that it has been left out of the cornucopia,” writes Gary North in a recent letter. “They begin to get frantic, looking for a way to get onto the one-way road to Easy Street. They follow the trends. They buy whatever has already gone up by three or five to one.”

It is not merely by mistake that these “investors” lose money…it is by design. That is the way the system works, in other words. For it to end up any other way would be an affront to the money gods…and a challenge to human nature.

An investor bidding on an Internet stock may feel that he is playing on a level field. And maybe it is level…like a marsh. You sink down a little further with each step you take, until there is no hope of ever getting out. All investors, though, get the same treatment.

Tech stocks are widely thought to represent the wave of the future. Jim Davidson has written that it is only by betting on these “New Economy” companies at a very early stage that one can hope to get rich by investing. Others have complained that if you try to apply “old-fashioned” investment approaches, you’ll find yourself sitting out the biggest wealth explosion of all time.

Of course, whatever dynamite there may be in the Internet revolution, it has yet to detonate. But it may someday. And the genome project may produce huge, almost miraculous benefits. Even so, could an investor put in money with a reasonable hope of a return?

Professor Hal Varian, dean of the School of Management, UC Berkeley, maintains that there are five stages in technology revolutions: experimentation, capitalization, management, hypercompetition and consolidation. “We are probably in stage two of the Internet revolution,” writes Gary North. “In previous revolutions, the hypercompetition can last a decade or more. Example: the reduction of the telegraph companies, 1855-61 — 88%. It happened again to the large electrical companies later in the century: 87%.”

“The odds are that the typical investor will not be heavily invested in the 10% to 15% of the Internet firms that survive. He will also have bought in late. Easy Street is always a dead-end road for most investors…”

So, if you were a serious investor, and you were able to calculate a reasonable price for a start-up company — that is, what the company would be worth if you expected it to succeed — you’d have to discount it by 85% or so.

However, it is almost impossible to figure out how much it should be worth. There are two many unknowns. Each opportunity requires much more intense study than an “investor” can give it.

That is why these deals are typically given to speculators to fund, not investors. Speculators usually specialize in a given area — say biotech — and get to know the area well. They are able to calculate the odds of success of a given project – roughly — and negotiate the terms of their involvement so they have a decent chance of making money. They know that most projects will fail. So they make sure that each investment they select has huge upside potential.

This is what Jim Davidson and his team are doing in the high tech area. It’s what Doug Casey has done for many years in the mining sector. But it is clearly not “investing” in the normal sense of the word.

The average investor has neither the information, the training, the expertise nor the temperament for real speculation. He is so far down the financial food chain – – below the promoters, founders, entrepreneurs, venture capitalists, brokers, touters and smooth-talkers — that he is almost certain to be swallowed whole. For not only has he no way of separating a good speculation from a bad one, his inability to do so almost guarantees that the deals he is offered will be bad.

Gresham’s Law operates in the world of Internet stocks, too. It is easier to create bad companies than good ones (they have fewer requirements). In a market that can’t tell the difference, Gresham’s Law predicts, the bad ones will push out the good ones. Soon the only ones available to the average investor will be bad ones.

That has already happened. Even good Internet stocks — assuming there were some — rose to such levels that they were bad for whoever bought them. Even experienced speculators — such as Julian Robertson — lost money on them. Can the average investor hope to do better?

Bill Bonner

On The Way To London May 15, 2000

*** Not much action on Wall Street. Dell announced its latest figures — which, as always, “were better than expected.”

*** But William Fleckenstein says that, “if you backed out non-operating income and then adjusted for taxes, you’ll find that Dell made 16.4 cents versus 16 cents last year.” This is a growth company? What justifies a P/E of 70?

*** The PPI figures — which shed some light on inflation at the wholesale level — came out, too. They were benign, showing the price of energy down by 4%. But the same day, the price of oil rose to nearly $30.

*** So the market didn’t have much to go on…and didn’t go very far. The Dow rose 63 points. The Nasdaq went up 29 points.

*** There were 1,593 stocks advancing; 1,325 declined. There were 82 stocks that hit new highs, while 75 hit new lows. I continue to report these numbers, but the clear pattern has disappeared.

*** Hanging over the entire affair is the threat of a rate increase by the Fed tomorrow. Greenspan is widely expected to raise rates by 50 basis points. A Reuters headline tells how even this is spun as good news: “Big Hike Seen Bringing Bigger Rally.” The logic of it is that a 50 bps increase will put the Greenspan Fed “ahead of the curve.” The bad news will be over. (Don’t count on it.)

*** The two largest IPOs in history are now both below their issue prices — AWE and Palm. Palm is 84% below its first day high of $165 — set on March 2.

*** Another big IPO — the Dutch Internet service World Online — fell from a flotation price of 43 euros on March 13 down to 16 euros on Friday. In a move that I predict will become more and more fashionable — shareholders are suing the issuers.

*** The hurdle is being raised. “It’s getting tougher and tougher for smaller companies,” said one analyst quoted by Reuters, to raise money. “There’s a lack of liquidity and demand for those deals; the market is really squeezing the smaller issuer.”

*** The cash dispensers didn’t work in Paris over the weekend. Y2K strikes? A hacker in the system? A high tech breakdown? Nope. Turns out, the digital economy is vulnerable in an unexpected way. Someone has to stock the machines with cash. And the union that represents the cash handlers went on strike.

*** Let’s see…what else is going on in the world? I’m sitting in the first class section of the Eurostar on the way to London. When I began making this trip a couple years ago, the cars were almost empty. Now they’re full. All businessmen.

*** The English newspapers are disappointing this morning. Not much happening in Britain, I guess. I’ve heard of people not getting enough slack, but here’s a story about someone who seems to have been cut too much. An unfortunate American went bungee jumping in Switzerland. He went right to the ground without even slowing up.

*** And here’s a story about a pair of gay guys who got some woman to have a baby for them. Turned out, she had twins…now they’ve got a pair of twin girls — Aspen and Saffron — who were baptized on Sunday.

*** There’s still time. This Wednesday The 15th Annual Premier Offshore Advantage Seminar begins in the Bahamas, and runs through Sunday (May 17-21). Enjoy the sunny Bahamas and learn about tax-deferred earnings and financial privacy. Only two days left, so if you’re going, you better make arrangements. Send Michael Whitstine an e-mail at mwhetstine@agora-inc.com right away.