Making the most of the bubble burst

Pratap Ravindran

In the 1800s, wily British fugitives discovered that rubbing a herring across their trail would divert the bloodhounds hot in pursuit. Later, in debate and detective mysteries, red herring described any clever device used to distract people from the main issue.

In the 1920s, equally clever American investment bankers began calling preliminary investment prospectus red herrings as a warning to investors that the documents were not complete or final.

These documents were distinguished by covers printed largely in red. Today, one Wall Street curmudgeon describes a red herring as ''the one shining example of truth in advertising in the securities industry.

'' In the spirit of truth in reporting, the founders of this publication felt Red Herring to be an appropriate name for a magazine dedicated to providing a first look at the companies and trends that are shaping the business of technology. - The Lore of Red Herring

MICHAEL C. Perkins is a founding editor of Red Herring which has a cult following among those who track the business of technology. He is also the author of The Red Herring Guide to the Digital Universe and the co-author of a Silicon Valley who-dun- it, A Cool Million.

And Anthony B. Perkins is the CEO and Editor-in-Chief of Red Herring magazine and Red Herring Online. He appears regularly on MSNBC's Hardball and is an online commentator for CNN, CNBC, BBC and Bloomberg television.

In short, they've been around the block. More than once.

In June, 1999, Anthony Perkins and Michael Perkins submitted the final manuscript of the first edition of their book, The Internet Bubble, to their publishers, HarperCollins, with the following concluding thesis:

''The bottom line to our analysis is very simple. With very few exceptions, every one of the 133 public Internet companies (in the US) is over-valued. Our advice to Internet investors is equally simple: If you hold any of these stocks, it is time to sell. Yes folks, if the Internet gala hasn't ended by the time this book hits the streets, it will probably end soon thereafter. So it's time to get out.''

The unambiguity of their recommendation notwithstanding, there weren't any takers. By the time The Internet Bubble hit the book stalls in November the same year, the market capitalisation of the Amazons and Yahoos continued to climb, literally by billions, and Internet IPOs were continuing without any noticeable loss of traction. Till April 14, 2000, when these Internet companies were hit by a 50 to 70 per cent cut in price.

And, by the time Michael Perkins and Anthony Perkins had completed the finishing touches to the second edition of the book, The Internet Bubble: The Inside Story on Why it Burst - and What You Can Do to Profit Now, on December 22, 2000, the total market capitalisation of the over 370 public Internet companies had crashed by 75 per cent - over a trillion dollars of capitalisation had evaporated in just under a year!

The second edition of The Internet Bubble (let's call it IB2, for short) is scheduled to hit the market shortly and is basically about what went wrong and what people can do to protect their interests while investing in technology stock.

What went wrong? Well, various things, according to the authors of IB2. Momentum investing, for instance. They point out that hot bull markets are full of momentum investing which is just another way of saying ''buy high and sell higher.''

Ultimately, momentum investors are looking for the greater fool who will pay more for the stock than they did. It's really a form of gambling.

This kind of gambling makes investors particularly susceptible to torpedo stocks - the overpriced, speculative issues whose prospects have been heavily hyped but are primed for a disastrous plunge that could ruin any portfolio. It's even worse when investors speculate on margin, investing with borrowed money.

And then there are the perils of over-confidence. Michael Perkins and Anthony Perkins cite a study done at the Johnson Graduate School of Management at Cornell University which found that investors, given one bit of financial data about a company - the expected rate of growth for return on equity - felt just as confident in their investing as those investors who had also been given the book value and the current rate of return on equity of a company.

Overconfident investors, the IB2 authors point out, tend to trade too much and bet too heavily on particular stocks or market sectors.

No study of the Internet bubble would be complete without reference to creative accounting. In this context, Michael Perkins and Anthony Perkins write:

''Complicating matters for amateur investors is that many Internet start-ups have used creative accounting methods to make their top-line revenue numbers look much stronger than they really are.

One common practice is the bartering or swapping of ads between online companies. With this deceptive practice, two online companies agree to run each other's ads for free, and then each company counts the other's ads as revenue.''

This may seem pretty elementary stuff for Indian finance professionals - but you've got to keep in mind the fact that US companies work in a much tighter regulatory environment and that it, therefore, takes a lot more chutzpah to pull off iffy accounting.

Further, you'll probably be surprised to learn that the manipulation of equity markets by insiders is not a uniquely Indian practice, however much you might like to imagine it is so.

According to the IB2 authors, ''instead of the greatest ever legal creation of wealth, the Internet financial bubble represented the greatest ever legal transfer of wealth -- from retail investors to insiders.''

The insiders being, of course, entrepreneurs, venture capital firms, investment banks and large institutional investors who had pulled out their capital long before the fall, leaving mom and pop investors holding the bag.

IB2 quotes Roger McNamee of Integral Capital Partners on certain ''rules to live by'' in the tech stock market. ''Our rules to live by,'' according to McNamee, ''represent the collective scar tissue of almost 18 years of investing in technology stocks.''

The rules are as follows:

*Information is a commodity, but insight is precious.

*Product cycles are the only cycles that matter.

*Favour products that are bought, not sold. If a company sells tens of millions of its products, it will not sell them all on the last day of the quarter. They will sell continuously through the quarter.

*In making investment decisions, do not rely on guidance from company management alone. Management is often the last to know what a company's problems are.

*Balance research insights with opportunism. Research determines what should be done, but the market determines what can be done today.

*A perfectly diversified technology stock portfolio is bound to under-perform the market. You want to diversify away the risk of execution problems without diversifying away the opportunities. Stick to two or three major investment themes, and use diversification within those themes to minimise risk.

*And finally, keep in mind that there is only one Microsoft. If you spend all your time looking for another Microsoft, you'll probably find it only after it is too late....

pratap@thehindu.co.in

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