Oh brave new world that hath such concept stocks in it!
Sure, Shakespeare’s heroine Miranda said “people,” not “concept stocks,” in “The Tempest.” But she was only living on a magical island, not trading in a magical stock market.
And what an enchanted time it has been for concept stocks–those levitating on little more than a wing and a business plan. However, in previous speculative booms like this, investors have ultimately gotten wind that something was rotten in the state of concept-stock valuations. VerticalNet, which runs business-to-business commerce sites on the Internet, has a paranormal stock-market value equal to 326 times its annual sales as of Feb. 15. (The median for the broader market: two times sales.)
And on just any old average day, the stock of General Magic–which now makes voice-enabled software for use on the Internet, in cars and elsewhere, after an earlier concept failed–swings in a range that adds up to more than 15 percent of its closing price (compared with less than 5 percent for stocks in general).
The magic behind these highflying stock prices? Investors believe their business concepts, and future prospects, are thrilling. No past earnings could justify such great expectations.
Concept stocks have been highfliers before, particularly in 1969 and 1972. In those instances, speculation on such ethereal concepts preceded significant market downturns. Of course, nobody rings a bell and says the stock-market party is over, and such stocks can continue soaring in the meantime.
So while concept stocks are extremely risky, in this market it just doesn’t pay to fight against them, says John C. Bogle Jr., president of Bogle Investment Management. “The more overpriced a stock is, the more overpriced it can become,” he says. “There is no sensible metric for valuing” such stocks.
That’s why Bogle, like some other adapt-or-die investors, is making sure he has at least a little exposure to them. He doesn’t want too much exposure, just enough that he isn’t left out of the revelry–maybe half to two-thirds the weighting that they would have in an index of stocks he is trying to beat. He does this even though he concedes: “It’s contrary to most of the stuff I was taught about investing.”
Concept stocks are alluring: Who can resist the quest for the next Microsoft (which, back in the ’80s, was itself a concept play)?
Despite the allure, concept stocks lost money for years, working about as well as Dad’s magic tricks at a birthday party. Since 1980, if you only bought concept stocks as defined by Bogle, you would have lost money, cumulatively, for nearly 20 years.
But since late 1998, it is as if Dad reached into a hat and actually pulled out a real rabbit. Concept stocks have risen sharply, wiping out the losses of the prior 18 1/2 years, and even started making money on a cumulative basis. The return on concept stocks in the 15 months through the end of 1999 was 247 percent. In the same period, the Standard & Poor’s 500 Index gained 40.1 percent.
Concepts are “castles in the air” by definition, so how does Bogle quantify concept stocks? He looks for three characteristics. First, the stocks have extremely high price-to-sales ratios. Price-to-earnings ratios won’t work because these companies so often are losing money.
Like height in the National Basketball Association, the definition of a tall price-to-sales ratio has expanded over the years. In the 1980s, concept stocks tended to sell for about three or four times revenue. In the early and middle 1990s, as interest rates dropped and earnings accelerated, such stocks sold for around 10 times revenue. Today, concept stocks sell for a price-to-sales average of 50 times–on average. The median of more than 2,800 stocks tracked by Bogle Investment management is two times sales.
Second, Bogle looks for frenetic investor activity. Currently, shares of the concept stocks tagged by Bogle trade hands twice in a year for every share outstanding. In comparison, the median stock has about half of its shares outstanding trade during the course of a year, up from 12 percent in the early 1980s.
Third, concept stocks are volatile on most days. The universe of stocks Bogle looks at includes nearly all U.S. stocks “liquid” enough to trade $60 million to $70 million in stock a year. Concept stocks had price swings of nearly 10 percent on an average day.
Bogle adds up these three rankings for the stocks he follows, and he arbitrarily designates the 10 percent of stocks with the highest scores to be concept stocks.
It is a fun group, and most of them are indeed growing very rapidly, though whether that growth justifies their lofty stock prices is a question that stodgy investors will continue to raise.
Consider Geoworks, which makes servers for distributing wireless data to disparate devices, and also sells ads distributed to consumers.
Think about it: Electronic commerce and wireless combined, what a concept! The stock, which was trading at about $33 in mid-February, about 67 times annual sales of 50 cents a share, and shares are trading at an annual rate of more than five times its shares outstanding. (On Tuesday, the stock was trading in the neighborhood of $48 a share.)
And then there is ZixIt, which makes digital encryption technology that may be used in e-mail and other applications. ZixIt is, in a sense, a perfect concept stock, because the company has no sales at all, pending its product introductions. (It sold a previous business tagging vehicles to raise funds for the new business.)
The concept stocks that Bogle Investment owns tend to rank a bit lower as concept stocks–and sometimes even are profitable. The firm owns Amkor Technology, which sells semiconductor packaging and test services. At $47.1875 in mid-February, it sells for about 39 times expected First Call/Thomson Financial consensus earnings of $1.22 per share in 2000. (The stock was in the range of $59 on Tuesday.) Another concept stock Bogle owns is Allaire, which sells software for Web development. At a mid-February price of $122.375, it sported a price-earnings ratio of 382 times First Call consensus earnings of 32 cents a share in 2000. (Tuesday’s price was in the neighborhood of $180.)
“We don’t want to have full market exposure; we think these companies in many respects are outrageously overvalued,” Bogle says of concept stocks. Still, he is making sure he has some exposure to these stocks, since they are hot now, and you never know when their run is going to end.
But make no mistake: It will end, and when it does, don’t expect it to be pretty. The Internet is “a concept with substance,” says Chuck Hill, director of Research at earnings tracker First Call/Thomson Financial. But inevitably, concept stocks get overinflated, he says.
