Hacker Finances: Stocks Versus Mutual Funds, Part III

www.wallstreetsurvivor.com

I’ve made every mistake in the book picking stocks. I’ve bought too soon, sold too soon, bought for the wrong reasons, bought losers, sold too late, sold for the wrong reasons, and for sure, I’ve made still more mistakes that I am too embarrassed to admit. But I’ll admit them anyway in case you are inclined to make the same mistake. My shame is your gain. Let’s start with the most shameful, just to get it out of the way.

(sidebar, if you’re new to Hacker Finances, start here: Hacker Finances: Introduction)

In 1995, Greg, my software engineer friend, joined a startup called Worldtalk Corporation. Worldtalk made a system that converted e-mail formats among the common formats at the time. When Worldtalk went public, I wanted to support Greg and cheer him on, so I bought some shares.

Mistake Number 1: Don’t buy stock in a company just because your friend works there. Worldtalk lasted a couple of years, I think. The stock waned, sagged and schlepped to a significant loss before they were acquired.

There was a time in the mid-90s just before the Internet Bubble, when ‘client-server’ was all the rage. Today, it’s called ‘Web Server’ and ‘API’. But at the time, it was novel as an architecture. Remote Procedure Calls were a thing and shared services seemed like they couldn’t fail to become huge. I had read about Gupta Technologies’ Initial Public Offering in the San Jose Mercury News and I bought some so I could get the first ticket on that rocket ship. All I knew about them was that they were a client-server company, but what more did I need to know? For starters, it would have helped if I’d known that they would miss revenue targets right out of the gate, quarter after quarter. I didn’t know. The stock languished, and never exceeded the IPO price. I held on for a year or so and finally bailed with a -82% beating.

Mistake Number 2: Don’t buy a stock at the IPO. Yes, there are companies that never dropped below the IPO price, like MSFT and CSCO. But usually, they go down before they go up. Facebook is an example of this. Here is a chart showing the first 2 years of FB:

The stock dropped from day 1 and did not return to the IPO price for more than 1–1/2 years. And you may have noticed in Stocks Versus Mutual Funds Part II that TEAM had the same behavior. It was still trading below its IPO price, 6 months on.

When a company has an IPO, give it a few quarters before getting in so that all the polish that the bankers applied pre-IPO rubs off and you can see how they are really performing. Give the insiders who have been waiting to cash out time to sell their shares. Give the employees who’ve got vested options time to sell theirs. And give the company time to generate some financial returns so you can see how their sales are growing, what their gross margins look like, where they are spending their money and importantly, how believable their leadership are about how they will manage and grow the company. You can’t really get a feel for all of that until several quarters have elapsed.

In the late 90s, it seemed that everyone was buying stock. Day traders populated Silicon Valley coffee shops the way that founders do today, and the stock market just went up. Venture capitalists and bankers were in a feeding frenzy: find a founding team with any kind of Internet idea, fund them, take them public, then lather, rinse and repeat as fast as possible. The general public’s appetite for newly public companies became insatiable. This chart shows the average first-day returns of IPOs from 1990–2016.

www.quandl.com

That substantial blip in 1998–1999 is the bubble. The more companies that IPO’d with stellar first days, the more retail investors like you and I wanted in. The grand champion, none other than our aforementioned VA Linux, had an IPO price of $30/share and closed the first day at $239.25, a 698% first day gain. It’s hard to see those types of numbers week after week and not become preoccupied with wanting a piece of the action. The more we retail investors wanted in, the bigger those returns became. It was a perfect bubble recipe.

Those bankers and VCs made obscene amounts of money, primarily on retail investors like us.

The Internet Bubble pushed the NASDAQ to $5,048 in 2000, a level it did not return to until 2015. That means if you’d bought a NASDAQ Exchange Traded Fund at the intra-day peak of 5,132.52 on March 10, 2000 and held, you would not have gotten back to even-money for 15 years.

It was during that time that I bought the most sketchy of companies. Copper Mountain Networks, TheGlobe.com, and other flame outs I can’t even remember just took cash out of my bank account and tossed it into the wind. And boy, was it windy.

Mistake Number 3: Don’t buy a stock just because everyone else is.

After selling GPTA, I took the paltry remains and looked around for some place to make a bet. Really, I was just gambling. It turns out that Amazon.com had just gone public. I’d seen them succeed selling books, and just before they went public, they started selling music CDs. Buying online was obviously going to be a thing, so it was clear they had plenty of room to grow and they were the early leader. So I bought a few shares.

I felt really smart for a couple of years. I mean, look at this chart:

Amazon became the lead horse in the Internet Bubble. It split 3 times in 2 years [3] before the Big Pop and I had 12x the shares I’d bought. It was so heady, you may recall, that a now infamous Henry Blodgett [2] predicted Amazon, $240 at the time of his prediction, would hit $400/share in a year. It made that leap in 3 weeks, topping out at $430.

Then the bubble burst, and I watched as AMZN plunged along with everything else. It bottomed in September of 2001, then gradually made a modest comeback. I finally decided to sell in 2003 because Amazon was still showing no profit, and taking on huge amounts of debt in order to grow their business. I made 5x on my small investment, but I lost faith. That was expensive. Since the time I sold, AMZN is up another 14x. That’s multiplied. 5x times 14x is a 70x gain that I walked away from.

Mistake Number 4: Selling too soon. This one is tough, because you do need to pay attention and be ready to act if it starts looking like an investment has run its course. At the time I sold AMZN, I was still bruised and bloody from watching my Bubble stocks blow away, and I wanted a win so I could start to heal a little. So I took the profit. But now, I obviously wish I hadn’t.

Enough self-flagellation. From all this experience, I’ve developed a few rules for how and when to get into a stock. I’d call these the right reasons:

Only invest in businesses that you understand. Some businesses are simple, some aren’t. But if you don’t understand it, you can’t make sound judgments about the company’s performance or the feasibility of their product approach and competitive position. In addition to understanding their business, you need to understand their market. Is it a new market or service that they are creating, or is it an existing market that they are executing better than the incumbents? Is that market growing? If so how big can it get? Without that understanding, you can’t really have a sense for how big your investment can grow and you can’t really know when things are not going to get better for them and get out. We Hackers therefore will most likely stick to technology companies. That’s a pretty solid advantage since technology companies are growing faster than any other market segment. Five of the top ten companies by market capitalization are technology companies, and new ones are coming up regularly. So there are opportunities.

Next, look for companies that you and your friends and family actually use. Actually using them means you probably have an implicit understanding of their business and their competitive advantages. Chipotle was one I should have bought. I actually did buy Yelp!, because I use it all the time and Yelp! ratings affect the sales of the businesses listed. That means Yelp! has leverage to sell advertising to businesses listed on it, which will drive Yelp! revenue. This appears to be true as their revenue has a compound growth rate 50% for 5 years. Google became the de-facto search engine more than 10 years ago and their growth not only outpaced their rivals, but accelerated. I kept seeing more and more friends and coworkers using it, so I bought shares in 2006. One that I’ve been watching for similar reasons is Ulta Salon, Cosmetics and Fragrance, Inc. It’s not a tech company, but I have teenage daughters and that is where they get their makeup and beauty products. And where all their friends get it. And I’ve seen more and more stores opening in the area. ULTA, the stock, is growing at 39% annualized over the last 5 years, and I’m taking a serious look at it. Here’s the Google Finance beauty shot:

Notice not only the strong sales growth, but that the operating and net earnings % remain constant. Each new store adds incrementally to profit. That illustrates controlled, strong growth and a well run enterprise.

Another key to picking good stocks is company leadership. What is the ethos of the CEO and his or her staff? I’d watched Netflix for quite a few years and considered investing. But I didn’t pull the trigger until after I’d read ‘Netflix Culture: Freedom & Responsibility’[1], a slide-share that hit the front page of Hacker News. I was sure that there was a lot in there that was wrong. But what caught my attention was that Hastings had made operational innovation a pervasive directive in the company. He seemed to tell employees, regardless of their department, that as long as what they wanted to do was supported by data, they’d try it. Moreover, ideas that were implemented were also instrumented so they could be monitored to empirically prove whether they were effective. I was impressed. I got my buying opportunity when Netflix announced they were separating the DVD business from the streaming business. The market didn’t buy it at first and the stock price dropped from a high of $293 in 2011 (prior to their 7:1 split) to a low of about $64. There was no doubt in my mind that the world’s video entertainment needs were going to be delivered online, so I had no concerns about the market. And Hastings had convinced me he could execute. I bought close to that interim bottom and have held on since, watching them flourish on their way to becoming the Earth’s TV station.

Company leadership matters and finding CEOs who have the intelligence and tenacity to drive growth and compete are always good bets. Can you say Musk, Bezos, Jobs and Hastings all in the same sentence?

To recap:

Don’t buy a stock because:

• Your friend works there
• Everyone else is buying it
• It just went public

Don’t sell a stock:

• Too soon.

Buy a stock because:

• You understand the business they are in
• You, or your friends and family, or businesses you know use it
• You understand the ethos of the company leadership and it resonates with you.

[1] http://www.slideshare.net/reed2001/culture-1798664

[2] https://en.wikipedia.org/wiki/Henry_Blodget

[3] Stock splits do nothing to change the value of a company or stock, but during the Internet Bubble, it was a way for bankers to keep making money off of the companies they took public. Splits double or triple the number of shares available while reducing the share price by the same ratio so that the market cap is not changed. All shareholders get the additional shares added to their account, and the price reduced so that the value of their shares is unchanged. Most companies that have been around for a long time have split. Famously, one company that eschews it, Berkshire Hathaway, has been hugely successful for decades, but sees stock splits as an artificial and misleading attribute. BRK.A had an IPO estimated at $19. It’s currently trading at $237,199. That means that today, you need nearly a quarter million dollars to purchase 1 share of stock. The stock has never been split.