FOOL ON THE HILL
An Investment OpinionBy
Risk vs. Return Bill Mann (TMF Otter)
December 17, 1999
During rampaging bull markets, it's pretty easy to forget that one of the core reasons why certain companies fluctuate wildly is the uncertainty of their ability to make future profits. Currently it seems that any company with a wild business plan that includes a dotcom in its name has the tendency to sway 10% to 20% per day. And the investors who are backing the right horse when one of these companies makes such a move upward can feel really good about having anticipated the potential for growth.
But why do some companies move like squirrels running across the street, while others have about as much volatility as a vat of pudding? The answer is that some companies, such as the electric utilities, have revenue bases and even profit margins that are the closest thing one can get to a guarantee in private industry, while others have market factors that one could most charitably describe as "fluid."
What is it that makes VA Linux <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: LNUX)") else Response.Write("(Nasdaq: LNUX)") end if %> swing more in a day than a Duke Energy <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DUK)") else Response.Write("(NYSE: DUK)") end if %> has moved in a decade? The answer lies in the stability of their revenue bases. Duke Energy, the monopoly investor-owned electric utility for Western North and South Carolina, has a market capitalization of approximately $18 billion on 1999 sales of $19.8 billion and revenues of $1.9 billion. VA Linux on the other hand, has a market cap of $8 billion on sales of $30 million and a loss of $23 million.
On a comparative basis, it looks more like this. VA Linux has 44% of the market capitalization of Duke Power, but only 0.1% of the sales. On an earnings basis, the two cannot be compared because VA Linux has never made an operating profit. For every dollar of annual revenues at Duke Power, the investor is paying $0.88. For each dollar of revenue at VA Linux, investors pay $40.29. Doesn't seem very smart, when you look at it this way.
But in actuality, it IS smart, if it is done rationally. The prudent investor can hold either one of these companies and be perfectly justified in doing so. The reason is that an investor holding Duke Power should be expecting very different things than an investor holding VA Linux.
I can hear the cynics on either side of the fence right now. In the high momentum camp they're cackling, "Yeah, Duke Energy holders should expect their stock to be in exactly the same place a year from now," while the utility type investors are crowing about the heartburn the momentum investors will suffer through with such a volatile stock. And guess what, they're both right, and both wrong.
They're both right because they have accurately picked the exact thing that they themselves would hate about holding the other stock: be it boredom and stagnation or a roller coaster ride. They're both wrong because they are applying their own goals to the portfolios of others. Foolish investing is all about keeping within yourself. If you cannot take the risk of the Internet company stocks, you could hardly do better than a solid, consistent company like Duke Energy (even if the name assaults my Tarheel sensibilities). The company has a dividend yield of 4.58%, better than a checking account, and has appreciated at a rate of 5% per year. Best of all, Duke Power is the company with the lowest beta of any in America, 0.09.
[Beta is the measure of volatility of any stock. It is measured against the Standard & Poor's 500 Index. Simply, in the case of Duke Power, for every 1% up or down that the S&P 500 moves, on average DUK will move 0.09%. VA Linux has not traded long enough to have a measurable beta, but Yahoo! <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: YHOO)") else Response.Write("(Nasdaq: YHOO)") end if %>, for example, has a beta of 3.3]
Beta is, in my mind, a poor gauge for stock performance because it is entirely dependent on history and gives no indication whatsoever of the fundamentals of a company. But beta is a fine gauge of Newton's Law as it applies to the stock market: That which is in motion tends to stay in motion. No investor would be well served over the long run by investing in low-beta stocks that decrease in value because their business model is poor. But nor would a person who intends to take on a higher level of risk. Duke Power is a great, well-run company, with dynamic management, but it's not the vehicle that is going to make any individual investor rich.
The investor looking to achieve market-beating returns for the long term would be well advised to look elsewhere for the company (or companies) to get him or her to that goal. For the investor who wants to take on minimal risk and derive some income from investments, one probably could not ask for a better company to hold than Duke Power, for although it won't shoot the lights out, neither will it collapse when the rest of the market swoons, either.
So a company like VA Linux comes along, has a barn-burning IPO, shows the potential to deliver absolutely phenomenal return on investment, and is the toast of Wall Street, or some portions thereof. The Foolish investor should just plow money into this company, right?
With regrets to Lee Corso, not so fast, my friend.
VA Linux is the type of company that is apt to be too risky and too volatile for the tastes of most investors. It does not have the operating history (if one can call it that) of an eBay <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: EBAY)") else Response.Write("(Nasdaq: EBAY)") end if %>, but it is more than likely to see its share of 50%, 60%, or even 70% drops in its time; just as eBay sailed up to $234, got chopped back to $70, and then recovered to its current level in the $150s. With every company the investor is buying a portion of expected future earnings. The Duke Powers of the world have some security in their rate of growth and profit margins. VA Linux has no such guardrail, and if it fails to achieve a fairly high level of growth, it's going to get clobbered.
But there are a number of very intelligent people out there who have a great deal of confidence in VA Linux and its business model: investors, analysts, insiders. I would not be calling these people stupid by saying that their investment vehicle of choice comes with a high level of risk. They KNOW this. At least they should.
The people truly at risk are the ones who invest but do not see the flip side of the potential payoff. The investors out there who believe that their dotcom company of choice has somehow already succeeded by virtue of its high stock price. This is not the case. Share prices are not self-fulfilling prophesies. They are expectations. The higher the share price in comparison to current sales, the higher the expectations. There is no getting around this simple truth. And for the investors who do choose the wrong company, the punishment will be severe, whether they were cognizant of the risk they were taking or not. By all means, if you have the stomach for it, you should be willing to take the risk on a company whose prospects you believe in. But do it Foolishly, with eyes open, and you'll improve your chance of long-term success.
Fool on!
Bill Mann (TMF Otter on the boards)
Related Links:
Rule Maker, 12/17/99: Investing IN Something -Duke Power 10-Q from Free Edgar -VA Linux S-1 from Free Edgar
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