Just because a stock is going up doesn't mean that the bulls are right. For the bulls to be right, the stock price has to stay up. Short-term price action in markets and individual securities is validation of nothing.
There are multiple short-term forces at work distorting the price of all asset classes. Stocks do have definable value, even tech stocks, and this discipline requires strict adherence for both risk management and portfolio return maximization.
The stock market is, after all, a mechanism for valuing businesses. From practitioners of technical analysis to growth fund managers to television personalities, many factors distort the valuation of the businesses in the short term. My goal is to use these "dislocations" to establish profitable longer-term positions -- and to explain my rationale so you may do the same.
In this pursuit, I am lucky because I am a disagreeable individual. It isn't a conscious choice; I just don't play well with others. Even my friends just tolerate me because they need someone to drink with or beat them at tennis. When it comes to investing, my personality has proven an advantage. If there is one certain way to have a unique approach and a less market-correlated performance, it is to run counter to the trend.
If this type of analysis interests you, let's work together to find opportunities. Going forward, I hope to look at two or three stocks each week that readers are interested in and try to determine whether those businesses merit investment or caution or even a short position. Please feel free to
to my email address for consideration.
Today let's look at two companies with different profiles --
Research In Motion
-- and determine how a value-conscious investor should approach these equities.
RIMM, Market and Valuation Pioneer
Research In Motion is a great company with a great product. I have a basic Blackberry 7200 that I use all day every day. Still, all companies inevitably have a valuation potential, and RIMM sure has much future success baked into the current stock price. There is a little concept called a product life cycle (closely related to the business cycle). This means that growth is accelerated early in the cycle as product adoption is rapid and slows as the product matures; as this happens, the market also becomes saturated, and competition increases.
The same is true of margins. Margins on products are strong early in a cycle as competition lags and early adopters pay up. We needn't look much further than cell phones, personal computers, DVD players and flat-screen televisions to see what happens to end-market prices as a product matures.
Decreases in end-market prices reduce margins because those prices come down faster than the cost of manufacturing the products falls. That is also why buying shares in makers of consumer electronic components has proven to be such a bad long-term investment. As consumer prices decrease, companies have to squeeze component makers to stay profitable, but there is a limit to how much squeezing is possible.
Investors always overpay for rapid revenue and profit growth and generally extrapolate this linearly and infinitely until an event illustrates otherwise. The way to overcome this pitfall is to identify relevant comparison companies at maturity and establish realistic benchmark valuation for a dose of reality. Let's try this out for RIMM and see how the company stacks up.
I have chosen
for comparison. All numbers are 2008 or forward.
As far as I am concerned, the price-to-earnings ratio (P/E) is the least relevant metric; interestingly, it is the one that market analysts rely on most. Individual financial ratios are of little use without the context of profit margins. I am always suspect of low P/E companies with higher price-to-sales (P/S) ratios. (The P/S ratio is the stock's capitalization divided by its sales over a 12-month period.) This indicates that profit margins are very high. That is generally a good thing, but if you can't find supporting evidence that this is sustainable longer term, the P/E ratio can inflate pretty quickly as margins return to more traditional industry levels.
RIMM trades at unfavorably large premiums to its peers on all metrics, but most significantly the P/S ratio. This is disconcerting especially at this stage of maturity. This is not a small company; the market valuation is already $25 billion. If you ex-out Motorola's net cash position, RIMM is already more than two-thirds the size with one-tenth the revenue.
Sure, Motorola has a more diversified product line, and some of the products have lower or nonexistent margins; some analysts might look at that as a positive. Those additional revenue sources would provide a nice cushion should one of your products, say a smartphone, start to face increased competition and decreased margins.
I don't know why anyone would pay this type of premium for any company, especially one like RIMM, which is already facing the headwinds of the finite nature of growth and market size. If RIMM's product margins fall back to reality, and there is no reason they shouldn't, we can assume a generous P/S of 2 times revenues and a stock price closer to $60, less than half of its current trading price of about $135. Who wants to own stock in RIMM if that happens?
Stem Cells Are KOOL
Let's establish that I have an aversion to large-caps. I don't like my gains to be limited to a double. The notion that risk is diminished buying established large-caps is nonsense. Tell that to all the grannies holding on to
. When there is a lot baked in the cake already, often there isn't anywhere to go but down. Really, if everyone already owns the stock, where is the new money to drive it higher supposed to come from? You want to buy
here as a growth stock? Go ahead, but it already looks pretty grown to me.
As an alternative, how about a nice little company exposed to a hot new growth area with a great balance sheet, big growth, visible profitability and a minuscule market cap? Thermogenesis, active in stem cell research, fits the bill. Microsoft could buy the company with about a month's interest earned on its cash hoard.
Stem cell research is a hot topic right now. With the Democrats on the verge of significantly more influence, stem cells should only get hotter and more interesting. If we can separate church and state in 2007, the U.S. can regain its stronghold on scientific innovation. My scientific sources believe stem cell research will yield positive results. This stuff works; we just don't know how to use it yet.
Like any other new technology, it is difficult to pick the winners early on. Rather than betting on which company is going to be first to a fantastic discovery, I prefer to bet on enablers or tool providers that should benefit regardless. I have already
, a stem cell therapy research company that also offers collection and banking of umbilical cord blood through subsidiary Viacord, as one company that should benefit. Thermogenesis is another: a provider of tools necessary to isolate, collect and preserve stem cells.
The company's technology is validated by a distribution agreement with
. According to KOOL's 10-K, the BioArchive System is an automated cryogenic system used in cell therapy to cryopreserve and archive cord blood stem cells for future transplant. At the time of the filing of its 10-K in September, Thermogenesis had sold 135 of the systems to major cord blood banks and stem cell research institutes in more than 25 countries.
The company is also working on wound care and sealant products based on its technology. From the 10-K , the CryoSeal Fibrin Sealant System is an automated system used to prepare an autologous hemostatic surgical sealant from a patient's own blood or from a single donor in about an hour. This product is expected to receive Food and Drug Administration approval in 2007. The company has a distribution agreement with
, a $10 billion medical device specialist, for this product.
Thermogenesis is also developing other products, such as a "thrombin processing device," used to isolate activated thrombin from the patient's blood or plasma. As stem cell therapies gain traction, the company's extraction and preservation tools should continue to experience tremendous growth. Viacell's cord bank is growing annual revenue at a 20% clip, and there aren't any approved treatments on the market. I assume that as treatments are approved, the number of cells on deposit and accompanying research will increase dramatically, as will the need for KOOL's products.
Thermogenesis is expected to reach profitability next year on a revenue increase of more than 100% to $48 million. With almost $40 million in cash and a $230 million market cap, this stock has plenty of room to grow.
Companies that provide tools for genetic analysis such as
have market caps in the billions. If stem cell research has the potential that some ascribe it, KOOL could be the way to benefit from the next big boom in medical technology and tools.
so I have something to write about in the coming weeks. Hope 2007 is prosperous for all.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Thermogenesis and Viacell to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At the time of publication, Bulwa was short RIMM and long KOOL and VIAC, although holdings can change at any time.
Steven Bulwa is an independent portfolio manager based in Toronto. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bulwa appreciates your feedback;
to send him an email.