Puff and Stuff

A few days ago I was at the Frederick Airport performing a pre-flight on an airplane I was renting, when a young generation X pilot came up to me and said, ” Lamb, aren’t you a money manager or something like that?” My reply was, “Yes — I do manage other people’s money.” He then asked if I could take a minute to look over a report on a company that had been sent to him by his broker. Since I had a few minutes to wait while my plane was being fueled I began to thumb through the report.

The report was bullish on an Internet company called Buy&Fly.com. From the brief description at the beginning of the report it seemed that this company would sell, over the Internet, anything from used airplanes to pilot supplies. It had been in business for three years and had a successful sales record. In its first year, the company had sales of $360,000, quickly growing to $3.2 million by the end of their third year. It was interesting to note that the first year’s bottom line was a loss of over $500,000 and by the third year the loss had grown to over $2 million.

The financing for Buy&Fly.com had come from an initial public offering of five million shares of stock at $1 per share six months before this report was written. From an opening price of $6 per share the stock had soared to $15 by the end of its first week of public trading in the fast moving over-the-counter market.

By the time I was given the report, the stock had settled down to a trading range between $12-14 and the analysts that wrote the report felt that the stock was undervalued considering the rapid three year sales growth the company had experienced. He went on to elaborate, in glowing terms, the size of the market and the potential for the company to capture a large part of it. Nowhere did he mention a point in time that the company would begin to make money.

I said to my generation X friend that I thought that Buy&Fly.com was nothing but PUFF and that he would be better off investing in a company that was at least earning money. “What’s puff? I’ve never heard of that” was his quick reply. “It means to exaggerate or to inflate as in ‘to puff up’” was my response. He got quite indignant and started rattling off platitudes about the old methods of valuation and how they just didn’t work any more. He said, “New methods are required to comprehend and value the Internet phenomena. These companies that are in their early stage of development must be judged on their explosive growth in sales. Earnings will come later. It’s growth that is the motivation behind the execrated rise in share price.” To this I replied, “Well I may be a value analyst and believe in the old Graham & Dodd school and this gray hair may date me, but I don’t think basic security analysis has changed that much. Price to earnings ratios, earnings per share, book value and debt to equity ratios still have some credence in analyzing a company’s worth.”

To explain what I meant by this I said, “You as a pilot study the weather for your area of flight before you take off, don’t you?” He gave me that “Do you think I’m stupid?” look and said, “Of course I do.” At that point I walked over to the weather computer and pointed out to him that ten years ago we didn’t have computers that were connected to both private and government weather services. Five years ago we didn’t have satellites covering the globe and reporting storm systems far in advance of their effecting our local area. I explained that basic weather has not changed. There have always been two specific types of clouds, cumulus and stratus and three classifications for each of these. Differing types and classifications of cloud formations cause certain types of weather. That has not changed, it has been this way throughout the history of weather analyzing and forecasting. What has changed is the technology that reports weather information to the user of that information. Great changes have taken place in this area. No longer is the telephone the pilot’s link to official weather services; now it’s the computer and it’s satellite link.

A puzzled look began to appear on the face of my generation X buddy. I said, “There is a direct correlation between the changes in weather reporting technology and the changes that have taken place in security analysis. Today, the computer and its Internet links allow us to receive information on companies as it is released. Anyone interested in Buy&Fly.com can know what is going on in the company at the same time as the next guy. And this also means that we, as individuals, have the opportunity to interpret that information, right or wrong, in differing ways. The stock market, just like the weather, does not change. History shows that the market has its ups and downs, but always regresses to the mean. Likewise, the weather has cold and warm fronts, thunderstorms, sunshine as well as good and bad flying days.”

To tie my weather example to the security analysis I went on explain, “If the information we receive on a company contains nothing but sales information and loss numbers, how can we judge the value of that company or its real worth? What is the yardstick we are going to use to measure value? In the final analysis it is earnings that drive stock prices up and keeps them up. It is earnings that allow a company to grow. The Internet may be the biggest thing since the invention of the wheel, but eventually the wheel maker has to make a profit. That is what I mean when I say STUFF. When a company is bringing hard cash to the bottom line, that’s the stuff that makes it grow. That is the stuff from which dividends are paid. Without STUFF all you have is PUFF. If all you have is PUFF, what happens when the air starts to leak out?”

I don’t know if I really convinced my fellow pilot, but as we headed out to the flightline I heard the sound of paper falling into a trash basket.

Gordon B. Lamb