Siebel Case Study: How I Chased Momentum and Didn't Get Burned

With the Nasdaq Composite's roughest week fading into a bad memory, I want to tell you a tale of two highflying stocks my investment advisory firm considered last year. One was Siebel Systems (SEBL Quote), which was at the edge of the firm's safety envelope. The other was Emulex (EMLX Quote), which was far beyond it.

During the Nasdaq's worst week ever, Siebel stumbled, but Emulex was ripped apart. There are some useful lessons here for investors.

What follows is a five-month, 95.7%-return case study investors can use as an example of how to spot a great company's earnings surge, ride it to profit and bail out (if necessary) when market volatility wreaks havoc.

San Mateo, Calif.-based Siebel has emerged as the world leader in customer relationship management (CRM) software for large corporate enterprises. By excelling within its lucrative niche, the firm offers clients like IBM (IBM Quote), British Telecom (BTY Quote) and Yahoo! (YHOO Quote) arguably the best software package available to manage -- within a single system -- sales, customer service, marketing and e-business applications across multiple channels (i.e., Internet, call center, field sales and distribution).

Since its September 1996 initial public offering, Siebel has enjoyed explosive sales growth: from $100 million in 1996 to a projected $1 billion in 2000. In fact, last year a study by Deloitte & Touche revealed Siebel possessed the strongest five-year sales growth rate (some 782,978%) of all publicly traded technology stocks.

By remaining independent while its CRM rivals were snapped up (Vantive by PeopleSoft (PSFT Quote) and Clarify by Nortel Networks (NT Quote)), Siebel continued to gain share in an industry which did $3 billion in licensing sales alone last year (more for service support), and which is expected to grow 50% per year.

The company was founded in 1993 by Thomas Siebel, who cut his software teeth at Oracle (ORCL Quote) as one of its first 50 employees. He remains Siebel's chairman and chief executive officer, and was one of Business Week's "Top 25 Executives of the Year" in 1999.

As our firm's chief investment officer, I added -- with some trepidation -- Siebel to our Great Earnings Momentum Stocks, or "GEMS," model portfolio on Nov. 1, 1999 at a split-adjusted price of 58 1/4. (Our model portfolios are managed accounts in which we invest our clients' money. Any difference in our clients' account starting dates can, and often will, produce materially different results for different clients.)

The Least Overvalued

At the time, Siebel's valuations seemed a little high. Among the many factors we track, we noticed Siebel shares came with a PEG (the price-to-earnings ratio divided by the earnings growth rate ) of 2.22, a price-to-sales ratio of 16 and a range (which we define as current price divided by the 52-week low) of 5.7. Experience has shown it's usually advisable to shy away from buying earnings momentum stocks with PEGs above 1.75, price-to-sales ratios above 10, and ranges above 5. Still, we took the plunge, at the edge of what we consider to be the safety envelope for short-term earnings momentum trades. Siebel was probably the least overvalued of the stocks we were looking at and was fundamentally, the strongest.

In the weeks and months that followed, Siebel continued to soar, its price-to-sales ratio reaching 45 and its price-to-earnings ratio 283 by its peak during the wonderful week of March 10.

Along the way, we considered many similar highfliers that turned up on our screens for earnings momentum, among them Costa Mesa, Calif.-based Emulex, which builds high-capacity fiber channel host adapters, hubs and software for speeding up computer data flow.

But during the interval when Emulex, like Siebel, basked in Investor's Business Daily's rosy top 2% rankings of stocks with highest earnings momentum and relative strength (two key indicators for us), it was never "safely" overvalued. Instead, Emulex shares routinely sported a price-to-sales ratio between 35 and 64, a PEG between 5.7 and 10.0 and a range between 15 and 33.

Put simply, while Siebel appeared overvalued to us, Emulex seemed insanely so. We held our Siebel position guardedly and passed on Emulex, watching as developments continued to unfold.

On Jan. 25, Siebel delivered stellar fourth-quarter 1999 results, with revenue more than doubling to $268 million and earnings per share of $0.19, up 90% from the $0.10 reported in the same quarter a year before (and well past consensus forecasts of $0.15). Amid a flurry of analyst upgrades, the stock jumped 10 1/4 the next day to 95 3/8 on heavy volume.

The next week, the company continued to demonstrate its ability to move fast, inking deals with supply-chain optimizer i2 Technologies (ITWO Quote) and demand-planner Manugistics Group (MANU Quote), to bring Siebel's customer-focused expertise to the hugely emerging business-to-business exchanges.

Then trouble began to brew within the markets: the antitrust ruling against Microsoft (MSFT Quote), the unsustainable cash burn rate of the dot-coms, Greenspan's continued saber-rattling. In hindsight, they would all soon take their toll.

Time to Bail

On Monday, April 3, with many of our algorithm's sell signals flashing red (for example, Siebel shares were now more than 20% off their high), we reluctantly removed Siebel from our GEMS portfolio at a price of 114, bagging a nice 95.7% gain in five months. (We continue to maintain a long Siebel position within our five-year Best Guess 2003 portfolio). The next day the Nasdaq tanked.

During the ensuing convulsions, Siebel survived the Nasdaq's worst week remarkably well, diving no more than 57% from its all-time high, and recovering smartly soon thereafter with another great quarterly report. It shot up again this week when Standard & Poor's announced on Tuesday that Siebel would be added to the S&P 500 index, replacing CBS (CBS Quote).

In contrast, Emulex slid disastrously down 84% from its March 27 high and has stubbornly stayed low ever since. To be sure, there were other factors: While Siebel's earnings surprised again on the upside, Emulex's disappointed on the downside, missing the whisper numbers .

Still the lesson is clear: For momentum without the madness, insist not only on stellar earnings growth, but keep your highflying, high-risk stock picks well back from the risk-adjusted edge of doom. Good hunting!