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.
RIMM, Market and Valuation PioneerResearch 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 Palm ( PALM), Nokia ( NOK) and Motorola ( MOT) 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? Not me.