Do virtual trees grow to heaven? Mutual fund managers seem to think so, if the tree in question is eBay ( EBAY).

The San Jose, Calif.-based online auctioneer continues to dazzle Wall Street, including Tuesday's better-than-expected results and projections of a 49% rise in earnings. Large-cap fund managers, desperate for stocks with earnings momentum, have herded into eBay: 211 large-growth and large-blend funds, or 20% of the 1,072 funds in the two categories, reported taking a new stake in the company during the past four quarters, according to research conducted by Morningstar for TheStreet.com. The stock is now in 34% of all large-growth and blend funds, up from 9.8% two years ago. And the flock into eBay doesn't show any sign of slowing: The stock is up 5% Wednesday to $93.62.

This "institutional herding" -- when mutual funds flock to a particular stock -- has major implications for investors weighing buying or short-selling eBay. While eBay continues to post growth far beyond Wall Street's expectations, the smart money has bid the shares up to perilously high valuations: Its current price-to-earnings multiple stands at 110; forward P/E is about 60. However, short-selling eBay in the face of stampeding fund managers is a losing proposition.

"It's hard to imagine how a company with a market capitalization of $29 billion can justify that sort of price-to-earnings multiple," said Richard Sias, an associate professor at Washington State University. But Sias, who has written extensively on herding among mutual fund managers, said going short against the stock based on valuation alone might be just as dangerous as going long. "Like Keynes warned, the markets can remain irrational longer than you can remain solvent," Sias said.

The bottom line for investors mulling over a position in eBay: Stay on the sidelines.

Don't Bet Against It

The justification fund managers might use for getting into eBay now can best be summed up by Hollywood mogul Samuel Goldwyn, who once remarked of a high-priced actor in MGM's stable: "We're overpaying him, but he's worth it."

After Tuesday's impressive results, analysts rushed to revise their already optimistic outlooks. First Albany, for example, upped its rating on the stock to buy from neutral, slapping on a $104 price target -- up from a $68 price target in December . In a research note, First Albany analyst Youssef Squali said the stock "looks expensive by most measures." But based on First Albany's new expectations, eBay trades at a price-to-earnings growth multiple of 2, which Squali notes is roughly in line with Yahoo!'s ( YHOO) 2.1 PEG multiple and Microsoft's ( MSFT) 1.9.

"Institutions primarily ask two questions: 'What companies will be here 20 years from now?' and 'What industries are growing quickly despite any short-term gaps in the economy?'" said James Altucher, Street Insight columnist and partner at hedge fund Subway Capital. "eBay, the leader in an industry still growing 50% a year, satisfies both those conditions." Altucher has no position in eBay.

Critics would say eBay's stock is priced for perfection, and that is largely true. However, mutual fund managers are pouring into the stock regardless of valuations and are extremely unlikely to reverse course until some "earnings torpedo" causes them to shift gears, Washington State University's Sias said.


Sitting on the Stock of eBay
The percentage of large growth/blend funds buying into eBay has soared the past year.
Source: Morningstar

"If the institutional ownership is still increasing, I would consider that bad news for shorts," Sias said. Sias' research into how institutional owners have taken stakes in companies over the past 17 years found that mutual funds take several quarters to build up positions (for more on institutional herding, please read this story ). "It is amazing how predictive institutional buying is on a stock's direction." The inverse is also true: When funds start unwinding, it is a strong signal to the investor to get out, Sias said.

In addition to the broad number of funds buying into eBay, a few major institutional holders have taken substantial stakes in eBay, according to institutional tracker Lionshares.com. Topping the list with a 5.1% stake in the company is Janus, the erstwhile hot fund firm that has fallen on hard times . In recent years, Janus has taken enormous stakes in rising stocks such as Nokia ( NOK), Enron and AOL Time Warner ( AOL), only to be burned by an inability to move nimbly out of its massive stakes. The lengthy process of paring its holdings continues to pressure the stock. The company modestly trimmed its eBay stake, according to its most recent statement.

Janus declined requests for comment on the story, but fund managers have sung the praises of eBay in recent weeks.

Don't Bet With It

There has been much debate in the past few weeks over whether eBay, along with Yahoo! and Amazon ( AMZN), is in the midst of a new bubble. eBay, at least, has managed to post earnings growth that largely silences the critics.

But the case against eBay comes down to the distinction between a great company and a great stock. Even one fund manager that holds eBay questions whether its current share price is justified.

"It's somewhat about its fair value at the current time," said Ron Canakaris, longtime manager of the $2.44 billion ( MCGIX) ABN Amro/Montag & Caldwell Growth fund. "We had cut it back when it got to $90 and we're sitting still with our reduced position. Based on our valuation process, we think eBay is fairly valued in the low 80s."

Canakaris, whose aversion to frothy tech stocks in the late 1990s helped his fund largely sidestep the bursting of the bubble, remains high on eBay's growth potential. "It's doing awfully well -- it's a very well-managed company," he said. "Compared with Yahoo! and Amazon, it's more, I won't say reasonably priced, but let's say it's less fully valued."

Burton Malkiel, a finance professor at Princeton University and author of A Random Walk Down Wall Street , notes that it is extremely difficult for a large company to grow rapidly enough to justify a P/E north of 100. Six of the 20 largest U.S. companies in March 2000 sported triple-digit P/Es, and they have all tumbled from those peaks. But, Malkiel adds, "If there's any company that can do it, eBay can -- it's an extraordinary company."

He draws an important distinction between eBay and Cisco ( CSCO). When Cisco sported a triple-digit P/E multiple in spring 2000, its market capitalization was $524 billion -- nearly 18 times greater than eBay's current market cap of $29.5 billion. "Clearly, it's easier to have that kind of multiple when you're a $30 billion company -- it's conceivable that you could have that kind of growth."

Nonetheless, Malkiel said, "I wouldn't buy the stock. You just don't buy big-cap companies at triple-digit multiples. If something goes wrong, you are exposed to too much risk."

All those fund managers would be exposed to the same risk, as well. And when they start selling, it takes a long time to run its course.