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Until recently, internet stocks and value investing were considered mutually exclusive domains. Internet stocks were ridiculously overpriced by any traditional valuation metric, and so value investors ignored the sector and left the frenzied buying to momentum investors and those who believed that the internet would change the world overnight. As the dotcom bubble burst and prices came crashing down, those formerly bullish investors swung like a pendulum from "buy now or you'll regret it" to "buy now and you'll regret it". But savvy investors who believe that the pendulum will eventually swing back are starting to look for opportunities in the sector, and with many stocks 80-90% off their highs, even value investors are starting to find bargains. The purpose of this essay is to investigate one technique for finding such investment opportunities. It may surprise you to hear that there are several dozen internet stocks which have a market capitalization below the amount of cash and short-term investments they have (and in some cases, even less than the cash minus outstanding debt). What this means is that the companies themselves, as business enterprises, are being assigned a negative value by the market. For example, the share of stock that you can buy for $1 represents fractional ownership of the company plus more than $1 in cash. This is highly counterintuitive, so I decided it would be worthwhile to develop a screen to find such companies, as a springboard to additional research. The initial screen, of internet companies with cash on hand in excess of market cap, turned up a list of 51 companies. Of course, these aren't all necessarily good investments (and in fact, the majority of them are not). In many cases there is a valid reason for the share price to be so low, such as fundamental problems with the company's operations, and such problems won't show up in a quantitative screen. But even when such problems exist, should the enterprise itself be worthless? Sometimes, yes. While the answer depends on a large variety of factors (just as any stock evaluation does), the most important one is, how close is the company to profitability? A company with $2 a share in cash and no debt can be a bad investment even if the stock price is below $2 a share. As a shareholder, you unfortunately don't have the option of taking the $2 in cash, but instead must trust the company to use it wisely. If the company is tremendously unprofitable and will be for the foreseeable future, the cash will not last very long. With this in mind, I whittled the initial list down to only those which were close enough to profitability that it appeared relatively unlikely they would soon face a cash crunch. Quantitatively, I filtered out any companies with a burn rate of more than 20% a year; in other words, those which will run out of money in five years if their profitability picture doesn't improve and if they don't get a cash infusion. 7 companies on the list were expected (per analysts' consensus estimates) to be profitable by next year, and another 15 were expected to lose sufficiently little to be able to meet this 20% burn rate requirement. The accompanying spreadsheet breaks the full list of "negative enterprise value internet stocks" into four groups:
By this rationale, subsequent research should be focused on companies in the first group and (to a lesser extent) the second group. Each group is sorted by discount (a measure of the amount by which cash exceeds market cap), implying that the best bargains would tend to appear near the top of the list. Here are the companies that made the top list (profitability expected by analysts next year):
It is important to point out here that the numbers on which the calculations are based are only approximations, for the following reasons:
Despite these factors, this investigation is still a useful one, because the screening activity is only the first half of the research process. Once a strong list of candidates has been compiled, more detailed company-specific research still needs to be done. It is vital to fully research any company you're considering for purchase, to confirm that the cash will really last as long as the company-reported numbers make it appear, to identify any other issues with the company that might justify its low stock price, and to analyze the company qualitatively to uncover everything that the quantitative screen wasn't able to reveal. As a second caveat, be aware that these investments are very risky. These are companies that other investors are betting will fail, which is why their stock prices have fallen so far. Additionally, cheap stocks often have trouble digging themselves out of the hole. Many of these companies have had significant rounds of layoffs, some have lost key management, and some are facing shareholder lawsuits. Furthermore, these companies receive little or no analyst coverage, are shunned by institutional investors, and run the risk of being delisted. Benjamin Graham famously said that the market is a voting machine in the short term and a weighing machine in the long term... by this analogy, what I'm saying is that you shouldn't expect these stocks to get votes from other investors; buy only if you believe the company is "heavy". If you're a true value investor this shouldn't be a problem, because you're accustomed to disagreeing with the popular opinion. One other note: if you're considering buying any of these stocks, I encourage you to also read Tomments 5, which describes another important way in which price can affect value, potentially making a "bargain" stock not a bargain at all. As I mentioned, this screen should be utilized as any screen should: not by itself, but as step one in a two-step process, to be followed by a more detailed investigation of the candidate stocks on a one-by-one basis. I have not performed the second step of the process, meaning that I don't know enough about any of the stocks listed to give them thumbs up or thumbs down. (Regardless, it is our policy at InvestorGuide.com never to specifically recommend stocks, but instead to help our readers develop the ability to make such decisions themselves.) I encourage you to choose some stocks from these lists that sound interesting to you, investigate each, select a few that you think will do the best, and watch them in the coming months to see how your predictions fared. Spreadsheet: http://www.tomments.com/tomments10data.xls Related Links: The stock screens were performed and the data were compiled using these two InvestorGuide tools: http://www.investorguide.com/research.html http://www.investorguide.com/stockscreening.html Disclaimer: Neither Tom Murcko nor WebFinance Inc. (d/b/a InvestorGuide.com) is a registered Investment Adviser or a Broker/Dealer. Readers are advised that the report is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy. The data, opinions and analyses included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty, expressed or implied, is made as to their accuracy, correctness or completeness. Readers are urged to consult with their own independent financial advisors with respect to any investment. All information contained in this report should be independently verified with the companies mentioned. In addition, we receive no compensation of any kind from any companies mentioned in this report and accompanying spreadsheet, and do not currently have a long or short position in any of them. Send feedback |
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