We can learn a lot from our mistakes. Better yet, we can learn a lot from others' mistakes, and avoid repeating the same mistakes ourselves. In that regard, a perfect antidote for irrational exuberance is American Sucker, a memoir by David Denby, an American film critic turned sucker during the technology bubble and subsequent crash of 2000-2002. The book is an engaging and fun read, yet offers many important and sobering lessons for all investors. With the first technology bubble being ten years old, now is a good time to review some important lessons from American Sucker, lest we become suckered into Technology Bubble 2.0, or some other bubble that should come our way:
- Don't try to get rich quick. Stocks go up in the long run, but short term price movement is anyone's guess. Denby wanted to make a million dollars quick to buy out his wife's share of his apartment; that caused him to over-leveraged himself and take too much risk in the market.
- Diversify, diversify, diversify. Never bet heavily in any single sector. Near the peak of the technology bubble in early 2000, Denby invested most of his liquid assets in technology stocks. As a firm believer in the New Economy, Denby felt no need to diversify into Old Economy stocks. That was a big mistake. As a rule of thumb, no single stock or sector should account for more than 20 percent of one's portfolio, no matter how much one likes or believes in it.
- Avoid stocks at high valuations. Focus on the fundamentals, and don't get carried away by euphoria or fear. Denby was putting his money where the story was good, buying stocks like JDS Uniphase (JDSU), Broadcom (BRCM), Internet Capital Group (ICGE), and Nokia (NOK), near the peak of the bubble in early 2000. He bought these stocks at exorbitant valuations, and suffered hefty losses when the bubble burst. In general, stocks with P/E greater than 20 are too expensive and best avoided.
- Avoid stocks when everyone is talking about them. Instead, invest in stocks when nobody seems to care about them. When Denby invested in hot tech stocks in the early 2000, everybody was feverishly talking those hot stocks everywhere he went, the newsstands were filled with 500-page internet magazines, and stock market coverage dominated televisions and radios. When everyone lost interest in the market in late 2002, it became the perfect time to buy.
- Don't plunge into stocks all at once. Denby sold bonds, index funds, and general stock mutual funds to invest almost all his liquid assets into tech stocks near the top of the bubble in early 2000. Consequently, he no longer had the liquidity to buy more and diversify when stocks dropped, nor did he have the courage the cut losses. Because his positions were so big, it was painful to realize huge losses, and foolish to sell if the markets staged a strong recovery. By going into the market slowly, and diversifying through time by dollar cost average, for example, one avoids the mistake of investing everything at the top of the market.
- Be open minded. Pay attention especially to those who disagree with you. One of Denby's biggest mistakes was listening only to those who agree with his bullish viewpoint of tech stocks, while completely brushing aside warnings from his New Yorker colleague John Cassidy, SEC Chairman Arthur Levitt, Fed Chairman Alan Greenspan, Jeremy Siegel, and Robert Shiller that the markets were extremely overbought and in a bubble. Even Denby's internet guru, Henry Blodget, who rose to fame for his accurate predictions about Amazon (AMZN), warned him by telephone in July 2000 not to expect huge gains from the market year after year. Instead of heeding the warning, Denby chose to hear only what he wanted to hear, focusing instead on all the buy recommendations for internet stocks that Blodget was still issuing. Listening to people who already agree with you won't give you any new insights. Successful investors must constantly challenge their assumptions and beliefs by listening mainly to people who disagree with them.
- Stay within your circle of competence. Denby knew next to nothing about technology stocks, which caused him to be misguided easily by the bullish media and gurus like Blodget. Investing in his career and real estate (his Manhattan apartment), by contrast, was within his circle of competence and paid off handsomely for him.
- Run quickly, or not at all. By July 2000, Denby noticed that much of the excitement surrounding the dot.com boom was rapidly fading. Although the Nasdaq had fallen from its all-time high, Denby was still in the black at that point and should have sold out. By holding on, his gains turned into losses. Running too late, when the market reach a bottom, on the other hand, would have been a serious mistake, which Denby did not make.
- Avoid initial public offerings (IPOs) during bull markets; buy them during bear markets. Denby bought IPOs like Corvis, which not only had no earnings but also no revenues. The stock dropped precipitously during the bear market in 2001-2002. In bull markets, demands for stocks are so strong that many mediocre companies go public, only to go bust later. On the other hand, only the financially sound companies can afford to go public during bear markets, and demand for stocks is low during a bear market, so you are more likely to get better value for your money. Visa (V), which went public in 2008, is an example of IPO to buy during bear markets. Conversely, we are now in the middle of a rampaging bull market, and much hype have now surrounded internet IPOs like LinkedIn (LNKD), Pandora (P), Zynga (ZNGA), Angie's List (ANGI), Groupon (GRPN), and Yandex (YNDX), all of which are mediocre companies with poor business models and are best avoided.
- Keep things simple; invest in companies you understand. Denby's only winner in stocks, ImClone, was a stock he understood. He was friends with the company's CEO, Sam Waksal, who showed him how Erbitux (cetuximab), the company's main drug in development, has $1.6 billion in potential annual gross revenue based on a simple arithmetic: $1000 per dose taken biweekly (26 doses per year) for 60,000 new patients with advanced colorectal cancer. The drug was likely to get FDA approval because there were very few options for the drug's target patient population, who were likely to die anyway, so the risk to benefit ratio is very low.
- Refuse to participate in insider trading. Sam Waksal was later charged for insider trading when he tried to sell his shares in ImClone and tipped off family and friends (including Martha Stewart) to sell before making public FDA's rejection of Erbitux in 2001. Denby was not tipped off, and he should consider himself fortunate in avoiding the legal troubles. The potential loss averted by insider trading is peanuts compared to the penalty for breaking the law.
- Don't lose faith in stocks. Instead of making a million dollars, Denby lost almost a million dollars from the technology bubble bust. He was wise enough, however, to know that the market will always come back, eventually. So in late 2002, when the Nasdaq fell to a low of 1100, down 80 percent from its peak, the S&P 500 down 50 percent, and with fresh cash from sale of his Manhattan apartment, Denby knew it was a good time to buy. Having wised up, he would go slowly and diversify this time. Many others who got burnt by the technology bubble learnt the wrong lesson and swore off stocks forever. Big mistake. By mid 2003, the Nasdaq had already gone up over 40 percent from its low on October 9, 2002, and a new bull market was born.
History repeats. Now that we are in the middle of a bull market, with more and more mediocre companies going public, and exorbitant valuations developing around internet IPOs, it is incumbent upon ourselves take actions to protect ourselves from Technology Bubble 2.0.
Now is the time to begin shifting from low quality stocks to high quality stocks, and from cyclical stocks to defensive stocks. See Focus on Stocks, Not the Stock Market, for distinction between cyclical and defensive stocks, and 9 Dow Stocks to Own for the Long Run, for distinction between low versus high quality stocks.
Avoid or sell any hot IPOs during the current bull market. The hottest IPO of all coming our way soon is probably Facebook (FB), whose widely expected IPO will give the company a market value of $100 billion or more. That is incredible expensive for a young company with only a few years of operations. Even Philip Fisher, father of growth investing, would advise us to stay clear from promotional companies. The lessons we can learn from American Sucker are truly timeless.