James Cramer, well-known stock commentator and investment manager, gave a speech the other day that helps explain why the Nasdaq stock index darted past 5,000. At 5,000 the Nasdaq would have gained 23 percent since the beginning of the year. The reason is that the Nasdaq increasingly values losses more highly than profits. This is a peculiar and probably dangerous development.
In his speech, Cramer listed 10 stocks that his investment fund is avidly buying. Most have losses. Some have tiny profits. All “make the Web faster, cheaper, better and easier to access,” he said. “I love every one of them, just as I loathe the rest of the stock universe.”
Let’s compare some of these stocks to General Motors, the world’s largest manufacturing company. In 1999, it sold about 8.6 million vehicles. Its after-tax profits totaled $5.6 billion on global sales of almost $180 billion. These profits equaled about $9 a share. With its stock trading at about $75, this represents a price-earnings ratio of about 8 (8 X $9 = $72).
GM’s “market capitalization” is about $50 billion. This last indicator–“market capitalization”–is critical. It measures the stock market’s valuation of a company. “Capitalization” results from multiplying a company’s share price by the number of shares outstanding. A firm with 10 million shares selling at $10 has a “market capitalization” of $100 million.
Now consider a Cramer pick, Ariba Inc. It provides Internet services that allow businesses to streamline procurement and trade products as varied as water and oil-drilling equipment. In its last quarter, it lost $5.6 million on sales of $23.5 million. First traded in mid-1999, its stock recently fetched more than $300; the original sales price to the public was $11.50. Ariba’s market capitalization exceeds $30 billion, almost two-thirds of General Motors’.
With time, Ariba may become highly successful and profitable. But its current stock price defies any plausible estimate of future profits. A U.S. Treasury bond earns 6 percent. To make only 5 percent on its $30 billion market capitalization, Ariba would need after-tax profits of $1.5 billion. Traditional stock analysis is dead, Cramer says. “The goal (of investment managers) used to be to find the most profitable companies, and these would be the most profitable stocks. That’s no longer the case.”
This reflects a powerful logic. Without making any money, companies can generate immense trading profits. Early investors–founders and venture-capital funds–reap big profits when the company sells stock at an “initial public offering.” Typically, prices are many times the original investors’ costs. The first public buyers can profit by immediately reselling to the broader public at still-higher prices.
The whole process depends on the frenzied demand for tech stocks. So far, demand has not disappointed. This year, there have been 82 IPOs (through early March), reports Renaissance Capital, a firm specializing in IPOs. On average, the IPOs have already risen 150 percent. Only 11 dropped in price.
There were once words for this: “Speculation,” “the greater fool theory of investing,” “herd behavior.” But while the process rewards, it seems respectable.
Cramer embodies the market’s present spirit. Everyone wants tech stocks. Hardly anyone wants the rest. These companies, Cramer says, have “organic growth.” They can (the theory goes) defy Alan Greenspan’s higher interest rates. What we have is capitalism without profits.
Not literally, of course. Many tech stocks have profits. But even these are typically valued at phenomenal multiples. Cisco Systems has a PE ratio of about 190. Unsurprisingly, the lopsided demand for stocks has split the market. The Nasdaq–heavy with tech stocks–flourishes, while other markets languish. In 2000 (through early March), two-thirds of the stocks on the New York Stock Exchange had dropped in price, reports Jeffrey Warantz of Salomon Smith Barney. Meanwhile, almost 60 percent of Nasdaq stocks had risen.
The broader implications are troubling. One function of profits has been to channel investment capital to the most deserving firms. But because today’s stock market increasingly ignores companies’ profitability, it may be sending the wrong signals. America’s entrepreneurial spirit is a good thing, but could there be too much of it? The stock market may be encouraging a surplus of fragile start-up companies–an ultimately wasteful process.
Some Internet stocks have already slipped. One is TheStreet.com, an online financial news service. Cramer is a founder and its star commentator. Its stock went public last May at $19 a share. It leapt as high as $71; recently, it’s traded between $11 and $13. This suggests that some Internet stocks could fall 80 or 90 percent. What happens to the economy if many do?