Updated: July 7, 2011 3:15PM
Dear Mr. Berko: My broker is advising me to buy three high-growth stocks: 150 Red Hat, 50 Amazon and 25 Netflix. I already own 15 shares of Google, which I bought in 2007 at $693, and he recommends that I buy another 15 shares at today’s lower price. Please advise me, as this is for my IRA and hope to retire in four years when I’m 67. — D.F., Bloomsburg, Pa.
Dear D.F.: I think your broker was born on the day when God ran out of brains. He’s certainly proof it doesn’t take brains to be stupid.
I like Red Hat (RHT-$46). This company provides open-source software solutions to businesses around the globe and has strategic alliances with Advanced Micro Devices, Intel and Wipro, but I wouldn’t touch RHT with a polka pole. Anything that trades at 80 times earnings will soon run out of gas.
I also like Amazon (AMZN-$198). AMZN may be the finest online retailer in the Milky Way with a great record of revenues and earnings growth. I won’t recommend AMZN because at 70 times earnings, it burns too much fuel.
I also like Netflix (NFLX-$246). NFLX is an enormously successful movie-rental subscription service whose business model was scorned by Blockbuster a dozen years ago. But I won’t buy the stock. It trades at 82 times earnings, and that’s a dangerous speed.
These issues were excellent investments l5 years ago. And if I had been wise enough to invest $5,000 in each back then, those investments would probably be worth several gazillion today. The big bucks have been made, the excitement has faded, the momentum is slowing, the bloom is off the rose and today’s buyers are the poor schnooks who have visions of sugarplums and red candy apples.
Yes, their revenues and earnings will continue to grow, but soon — in fact, sooner than you might expect — that tremendous growth in share values will decelerate. It’s happening now.
I’m reminded of Carl Sagan’s musings about the exponential growth of bacteria that reproduce by dividing themselves in two every 15 minutes. That’s four doublings per hour and 96 doublings per day. Although a bacterium weighs less than a trillionth of a gram, its descendants after one day of wild asexual abandon will collectively weigh as much as the Rocky Mountains. In two days they will weigh as much as the sun, and in four days, the entire universe will be made of bacteria.
But Sagan tells us not to worry because a confluence of events always arises to contain rapid growth. The bacteria become shy about reproducing in public, they may begin to fight with one another or they just become tired and lose interest.
And while RHT, AMZN and NFLX are not bacteria, they are subject to the same limitations, and past hot stocks like Cisco, Lucent, Jabil Circuit, Google, etc., are good examples, In a finite world, soaring growth rates will self-destruct or be inhibited by a confluence of opposing events. But if the base from which this growth rate takes place is very small (NFLX, AMZN, RHT), this law may not immediately engage and the fat lady will continue to sing for a while. But as that base gets bigger and bigger, the fat lady will stop singing and the party ends.
A high growth rate forges its own anchor, and I believe this phenomenon applies here. RHT, AMZN and NFLX have some oomph remaining but not much. Google (GOOG-$560) on the other hand now trades at a reasonable 20 times earnings, but its slowdown is beginning to accelerate. By the way, please note the tremendous insider selling in GOOG. Don’t buy Google, either. It may take a long time for it to return to $700.
Address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775 or email him at email@example.com.