If they’re not focused on the established and well-entrenched companies, the bulk of investors are hot on the latest dot-com or another flavor of the month. You know what I’m talking about.
This is the kind of company you read about in the headlines and
118 the big tech score
hear discussed on television. The CEO’s face appears everywhere you turn, and everybody seems to be talking about him or her.
This kind of sensation can be tempting. After all, would a com- pany anointed by the media and analysts everywhere be risky? You bet. It can be very risky. If you can get in on the IPO, great. If not, you’re taking a big risk. Once a company is on the general radar, especially at such magnitude, it’s often trading at hundreds of times beyond next year’s consensus revenue. When a stock is val-
C O M P O U N D A N N U A L R E T U R N
Also sometimes called the compound annual growth rate(CAGR), compound annual return is the interest rate required for an initial investment to reach a certain critical mass in a specified time period, as a result of both interest on the initial amount and interest on the interest that accumulates.
For example, suppose someone told you that an invest- ment would double your money in six years. For $100 to become $200 in six years, you’d need an annual interest rate, or CAGR, of about 12.25 percent (see Figure 9.1). For the money to double in three years, the CAGR would have to be about 26 percent:
● At 26 percent return, $100 would grow to $126 in one year.
● In the second year, the interest would be applied to $126.
26 percent of $126 is $32.76. Adding the $32.76 in interest to the $126 principal means you would have $158.76 at the end of the second year.
● In the third year, the 26 percent interest would be applied to your $158.76, which brings the total up to slightly over $200.
The key thing to realize is that compounding means earn- ing interest on interest. If you had earned 26 percent each year on only the original $100, then you would have three years of $26 returns and wind up with a total of $178 (the orig- inal $100 plus 3 times the $26).
ued at 250 times next year’s revenue estimate, even if it’s growing at 100 percent annually, it will be extremely difficult for it to do well over the next few years, despite the hype.
Consider VA Linux, a company that I recently helped take public. Some of my friends, hearing that my firm would be leading the IPO, asked me about VA Linux a few days before it was to offi- cially hit the market.
My firm had announced that the IPO price would be $30 per share. Because the company was a huge player in the Linux space, I expected the price to run well beyond that within the first few hours of trading. I didn’t know by how much, but I told my friends that if VA Linux traded comparably to Cobalt (a Linux hardware company) or Red Hat (a Linux software and services company), it would go up quite a bit. I thought it could easily reach $125 by the time the mar- ket closed that day. I told my friends that if they could get in on the IPO through their broker, to consider it, but that they should under no circumstances pay more than $100 a share on the open market.
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BEGINYEAR INTEREST ENDYEAR
YEAR AMOUNT RATE INTEREST AMOUNT
1 $100.00 12.25% $12.25 $112.25
2 112.25 12.25 13.75 125.99
3 125.99 12.25 15.43 141.42
4 141.42 12.25 17.32 158.74
5 158.74 12.25 19.44 178.18
6 178.18 12.25 21.82 200.00
1 100.00 26.00 26.00 126.00
2 126.00 26.00 32.76 158.76
3 158.76 26.00 41.28 200.04
Figure 9.1 Doubling a $100 Investment.
At the crack of dawn on the day of the IPO, my friends spoke to their broker. They asked him what he thought the stock would open at. He told them $30, the IPO price. Based on his assess- ment, they put in a market order for 100 shares.
VA Linux turned out to be the best-ever performing IPO on its first day of trading, closing up more than 700 percent above the IPO price. The stock opened at $300 per share, traded as high as
$320, and eventually closed at about $250 per share. But despite the run-up, many individual investors lost their shirts that day. All market orders were executed at $300 per share or more. Many of the people who bought into VA Linux between $300 and $320, and didn’t sell for a quick loss, lost 50 percent or more on their money.
Unfortunately, my friends were in that group. Their stock was bought at $300, and as it started to plummet, they were torn as to what to do. They ended up selling half of their shares within the first three trading days, at about $200 each, but the damage was already done.
My friends broke the cardinal rule of investing in a high-tech IPO: Never, never, never put in a market order on a hot commodity.
What did they do wrong? First of all, they trusted their broker.
Anyone who’s ever followed a high-tech IPO knows that these stocks never open at the IPO price, and the broker certainly should have known that. His belief that the stock would open at
$30, the IPO price, was just plain ridiculous. Adding insult to injury, my friends bought high, and they then had few options, other than holding onto their remaining stock and waiting for it to rebound or else selling low.
If they decide to wait, they may have to wait awhile. At this writ- ing, VA Linux has just reported two of the best quarters in the his- tory of any public company—its revenue was up 537 percent in its first public quarter and more than 700 percent in its second. How- ever, despite the numbers, VA Linux’s stock currently sits at $33 per share, less than 14 times next year’s consensus revenue (as compared to about 100 times at the close of the first day of trad- ing). Despite extremely good news, VA Linux has traded down considerably (see Figure 9.2).
Now don’t get me wrong—over the next few years I expect this to be a great stock or I wouldn’t have taken the company public,
DATE HIGH
9 Dec 320
15 Dec 195
14 Jan 144
15 Feb 120
15 Mar 104
14 Apr 37
15 May 50
15 Jun 31
Figure 9.2 VA Linux Stock Chart.
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50
0 Dec
9 15Dec 14Jan 15Feb 15Mar 14Apr 15May 15Jun Date
Daily high
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let alone bought VA Linux myself (at $33 per share). But there’s an important lesson here: Never buy a stock based on hype, espe- cially when the hype has warped the price so drastically.