Pretty, It Ain't: Scott Sipprelle Paints a Picture of New Market Realities

When stocks are moving up, investors want to know what will be the next hot trend or which specific stocks are the best ones to own. When they're moving down or, worse, sideways, they want to know when the bad times will end.

Scott Sipprelle has plenty of thoughts on both subjects. A former investment banker with Morgan Stanley Dean Witter, Sipprelle now helps run the MRG Nucleus hedge fund in New York. His thoughts on the way Wall Street really works last popped up in this column in March, and last week I asked for his thoughts on stock buybacks for tech companies for a column I was writing. Scott answered the buyback question in one sentence, below. But he also fired off additional thoughts that answer some of the burning questions investors are asking right now. Here then, with italicized annotations forming something of a "conversation" between Sipprelle and me, is a blueprint for the rest of 2000.

There are two kinds of good investments: those that provide a high return on capital and those that provide a high return of capital. When you invest in the former (whether it be tech or otherwise) and it acts like the latter, it's time to reassess your investment assumptions.

In other words, Sipprelle's basically a traditionalist. Good companies invest in their businesses. Good investors invest in good companies. If they don't want to make their own investment decisions, then they place their money with someone who will. That's not to say there aren't instances where companies do well by calling the bottom of their own stock. But it never should be their forte.

As an addendum to our tech-wreck hypothesis articulated in February, my guess is that it plays out as follows:

1. New austerity in the capital markets starts to affect corporate spending/investment ambitions.

We've already begun to see the austerity in the form of cancelled and postponed initial public offerings as well as some layoffs at dot-coms and other companies. As previously noted, the weaker the business model, the weaker the opportunity for public financing. Prudent companies won't wait for the cash to run dry to scale back what Sipprelle calls "investment ambitions."

2. The analysts start to ask companies to show profit sooner.

Obviously, this has begun as well. Never mind that the same analysts assured companies they could go public, even if they had to reveal in their S-1 registration statements that the company "might never achieve profitability." The banking-entrepreneurial-venture capital complex sold the public a bill of goods on this one, and now they're changing the terms and conditions. But that's life.

3. Projected revenue growth rates collapse in search of accelerated path to profitability.

This is the slippery slope nobody wants to discuss. With decreased spending, young companies won't be able to build quickly. But without building quickly, they won't be able to beat the competition or grow revenue sufficiently to offset fixed costs.

Remember, in the long run, investors don't simply want profit. They want lots of profit. Ciscoian (CSCO) profit. Microsoftian (MSFT) profit. Even Fordian (F) profit. But when companies have to inform Wall Street that, because half the sales force was let go last week, they won't come even close to the previous estimates for third- and fourth-quarter revenue growth, stocks that already look sickeningly cheap will tumble further.

4. Stocks get caught in a valuation no man's land between revenue multiples (soaring as revenue estimates fall) and projected price-earnings estimates (which still look high in a historical context).

This really cuts to the heart of the matter. Revenue multiples -- trading stocks based on their sales rather than profit -- never was completely legit. Analysts invented the technique because there had to be a way to value profitless companies. But when revenue growth rates aren't impressive and a company's earnings are tiny, Sipprelle's no man's land is a lonely place indeed.

5. When the dust settles we have a lot fewer companies. The true technology innovators trade at 40-50 times forward earnings estimates, just like in the good ol' days.

The implication here is that many companies go bankrupt or sell themselves at firesale prices, great companies trade at reasonable premiums to their impressive growth rates (not astronomical ones) and average companies trade at average multiples.

It probably takes another nine months to play out. There will be some delicious bottom-fishing in the fourth quarter. Think of all that tax-loss selling. (So many stocks down 90%).

Translation: Professional investors will want to sell their dogs for the tax benefit, giving opportunities to bottom fishers like, you guessed it, Sipprelle. If he's right, good companies will have the ability to outperform Wall Street's suddenly realistic expectations. Investors who do fundamental research into their prospects will be the ones who make money in such an environment. Sipprelle doesn't paint a pretty picture. But at least he paints a picture.

Adam Lashinsky's column appears Tuesdays, Wednesdays and Fridays. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. Lashinsky writes a column for Fortune called the Wired Investor, and is a frequent commentator on public radio's Marketplace program. He welcomes your feedback at alashinsky@thestreet.com.

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