WALL STREET, U.S.A., January 14, 1999 -- Internet stocks, and tech stocks in general, are hot stuff -- even the most casual observer of Wall Street knows that. Stocks like Yahoo and Amazon have gone completely haywire in recent months, reaching values that have nothing whatsoever to do with what the companies are actually worth. This isn't to say they're bad investments -- but it's worth taking a look at what can happen when people start getting ahead of themselves and investing in stocks that aren't ready for prime time. It just so happens that I have a real-life example for you. Most of the names have been omitted, to protect the guilty and the foolish -- but the following episode really happened.
Years ago, there was a highly respected computer magazine that covered Digital Equipment Corp. (DEC) and the minicomputer industry. In less than three years of publication, the magazine had acquired a reputation for being the most technically-astute information source in the DEC market. They earned that reputation by testing and reviewing products more thoroughly than the other magazines, and by not being afraid to blast a product in print when it didn't perform well in tests. They also had a knack for sniffing out the Next Big Thing in the industry -- or at least in their own segment thereof.
Around that time, Gene Amdahl -- former IBM mainframe creator and later the founder of Amdahl Corp., which made IBM-compatible mainframes -- started a company called ELXSI (pronounced A-lex-y). This new company's mission was to develop a machine that would do for DEC customers what his Amdahl machines had done for IBM shops -- give customers a better, cheaper alternative to the original.
ELXSI came out with a line of superminicomputers that ran Unix and a clone of DEC's VAX/VMS operating system at the same time. This was no small feat. What's more, the ELXSI machines ran much faster than the DEC products they were intended to replace.
When the higher-ups at the magazine got a glimpse of the machines ELXSI was producing, they were impressed. ELXSI was clearly a company on the move, likely to make a ton of money selling computers to companies who'd been running VAXes and Unix machines.
What's more, ELXSI represented a chance to make some money in the stock market. The editorial calendar started featuring heavy coverage of the company -- one issue had no fewer than four articles on ELXSI, all of which portrayed the company in a favorable light. The editors were convinced that ELXSI was headed nowhere but up.
This is where the "cautionary tale" part comes in: these guys bought shares of ELXSI stock, in advance of some of the favorable stories. I hear you saying, "Hey, isn't it unethical to try to influence stock prices and make a killing?" Indeed, the previous editor, who had led the magazine from its founding until a few months before this tale unfolded, had a strict policy: his staff members were not to invest in the companies they wrote about, period. It wasn't so much that they were influential enough to push stock prices up or down -- it was more that he wanted to avoid even the appearance of conflicts of interest. However, when he left (to start a competing magazine with another publisher), that policy was discontinued. There was no longer a ban on buying stock in any company, regardless of whether or not it would introduce editorial bias.
A couple of the top editors -- enamored as they were of ELXSI, which they felt had the potential to become the next DEC -- bought stock in the company. At the time, it was trading for something less than $1.00 a share.
When one of the junior staffers got wind of this, he briefly considered contacting the Securities and Exchange Commission and telling them that something shady was going on. But he decided there probably wasn't enough factual evidence for them to use as the basis for any action -- and, in fact, he wasn't even sure any action was necessary or justified. However, what the higher-ups were doing stuck in his craw -- that they might make a lot of money through such a scheme, while he sat at his desk and drew an entry-level salary, was something he couldn't stomach.
In a lapse of judgment he would live to regret, the junior staff member called his own stockbroker and ordered some shares himself. As it happened, he bought the stock at a lower price -- 71 cents a share or so -- than his bosses had been able to get.
However, any satisfaction our hero derived from the transaction was short-lived. After rising to about $1.25 a share, ELXSI plummeted. The company was unable to turn a profit -- despite making a superior product -- and went into a nosedive. Things went from bad to worse, and over the next couple of years, the stock went down as low as about six cents a share. Finally, they sold out of the computer business entirely -- the next year's annual report stated that they were no longer actively engaged in any business at all, but that they had about $8,000,000 in the bank, left over from the sale of their computer business, and that they were trying to figure out what to do with that money.
In a stunning corporate turnaround, management decided to trade hardware for software -- very soft ware, in fact: pancakes. ELXSI bought a couple of dozen Bickford's pancake house franchises and several Howard Johnson's restaurants in New England. Along with the business about-face, they did a 1-for-25 reverse stock split, to get their shares out of the penny-stock category -- albeit only moving into the dollar-or-so-stock category.
Over the next several years, the pancake business proved a better investment than the computer business had been. The stock price slowly recovered, from its split-adjusted low of $1.50 a share to $2.00, $3.00, $5.00 a share, all the way up to around $8.00. Our junior-editorial-staff shareholder underwent a couple of career changes during the same time -- not as drastic as ELXSI's career change, but significant nonetheless. He held onto the stock, though, on the logic that having ridden it all the way down, he might as well keep hanging on, in case what went down decided to come up. When he finally sold his shares in 1995, he actually got back about 40% of his original investment -- not very good, but better than he’d have done if he’d sold a few years earlier!
As it turns out, if he'd been even more patient, he'd have recouped even more of his investment -- ELXSI is selling for 11-3/8 as of today: 64% of what he paid for it. (Remember, ELXSI had a 1-for-25 reverse split, so the original 71-cent shares would have been worth $17.75 if they'd held their value.)
There are a couple of morals to this story; I realize I'm mixing them together by relating the whole thing at once. But a couple of things should be clear, to anyone planning to jump into a promising-looking but unproven stock. Number one: Things aren't always what they seem -- a good idea and a profitable company are not the same thing. And, perhaps more important, number two: When you try to beat the system, the system usually ends up beating you.
Copyright © 1999 John J. Kafalas
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