Smile! A Happy Ending

By Jerry Pournelle

March 6, 2006

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There was a time when investment was comparatively simple. Conservative investors looked for industries that had reasonable and steady profits, and analysis consisted of projecting demand for the company's products, and guesses as to whether the company could keep making and selling the stuff at reasonable profits. Companies that got past that analysis were generally known as Blue Chip stocks, and safe for investment by widows, orphans, and pension funds. You didn't expect the price of the stock to change much. It would rise to keep up with inflation, more or less, and if the company were particularly successful against its competitors it might increase market share from, say, 20-22 percent, with a corresponding rise in its profits and dividends, but that would pretty well be it.

In those days high flyers were companies that retained their earnings to invest in new products. Investment management funds such as "Supergrowth" were considered really quite good if they delivered a consistent 10 percent return on investment. There were stories of people who made spectacularly higher returns from the stock market through shrewd investment strategies--one of the best known was Hillary Clinton who parlayed a $5,000 investment into something like $100,000 in a year--but this was rare enough as generally to make the news when it happened.

All that changed a few years ago. Suddenly a stock that had a consistent 8 percent return on investment was "flat" and not worth paying attention to. The analysts now looked for stocks that would grow, and by grow they didn't mean just incremental growth. It was exponential growth or nothing. Earnings remained important only if they met or exceeded expectations. Where in the old days a price to earnings ratio above 12 was considered getting up there in price--it meant the stock wasn't earning 10 percent return on investment--it's now the case that a P/E ratio of under 10 marks the stock as undervalued.

It all got insane during the dot boom. Companies would come out with values based not on earnings (they had yet to have any earnings) nor even on income (they didn't have an income yet) but on "projected income."

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