Herding Behavior Explains The Sky-High Prices Of Amazon And Salesforce

by: Mark Cabaniss

This article offers a theory of why the prices of some stocks are so high, relative to their low or no profitability. Although the discussion below is applicable to any high-priced, "hot" or "trendy" stock, two such stocks, Salesforce.com (NYSE:CRM) and Amazon.com (NASDAQ:AMZN) have been the subject of much discussion here on Seeking Alpha, and elsewhere, and so this article focuses on them. Amazon earned one cent per share last quarter, and has forecast a loss for the upcoming quarter. For its part, Salesforce lost money last quarter, and is forecasting a loss for the entire year. Despite these dismal numbers, Amazon has a current price of over $250.00 per share and Salesforce of over $150.00 per share.

The common explanation for the high prices of these non-profitable, or barely profitable, but still hot stocks is that investors are looking past the low profits or even losses of today, and looking ahead to the bright future, when there will be profits. I offer a different theory. I conjecture that investors, specifically fund managers, are not looking to the future at all with these stocks, and instead are looking only at the present, and absolutely nothing else.

Let us start with the premise that no one knows much about the stock market. Sure, there are a few geniuses who do -- David Einhorn, Warren Buffett, -- but they (and their results) stand head and shoulders above the rest of us, who can be described by the old saw, "the blind leading the blind." Nonetheless, we keep trying to gain knowledge, and attain a level of understanding like the aforementioned Great Men.

However, we are, by and large, destined to move along as a herd, impelled by events beyond our control and understanding. This would seem a mere truism -- that the mass of investors move as a mass, that the majority of investors sell when the majority are selling, etc. However, what is important to understand is that herding dynamics apply not only to all investors, but also to smaller sub-groups within the market, such as fund managers. Additionally, when we think of "herd behavior," or "crowd behavior," we tend to think in pejorative terms, that is, of investors as a mass of lemmings jumping blindly off a cliff. However, the herding instinct can actually be quite rational, self-interested, and protective -- more like a line of shoppers outside a store waiting for the 50% off sale than the proverbial lemmings.

It is a well-known facet of investor psychology that people tend to hold onto their losers because to sell them would be to acknowledge failure, and that would be painful. So pain avoidance causes people (us) to sweep bad performance or underperformance under the psychological rug, so the speak. What this means for fund managers is that investors will not be quick to desert them for underperformance. In other words, it is OK for fund managers to underperform the market (not by too much; everything has limits) some, to get "gentlemen's Cs," as it were.

Statistically, it looks like this: Even though 84% of actively managed stock funds underperform the market, studies show that investors don't move their money for slight to medium underperformance. That is, as long as a fund can get returns close to market returns, they will keep their investors. Obviously this is true, otherwise you would expect to see 84% of funds see an exodus, their investors gone to search for the entrance to Lake Wobegone, where all funds generate above-average returns.

So, if you are a fund manager, there are H-U-G-E rewards in slightly underperforming or matching the broader market averages. "What are the huge rewards?" you ask. Why, your own salary, pally. If you are a fund manager and you only slightly underperform the market, you get to stay employed and get to keep receiving your own salary, which can be a L-O-T.

So for professional money managers, the real goal is simply to match the market, and thereby stay employed. This makes the herding instinct among managers very strong -- they are all crowding into the exact same stocks, doing what everyone else is doing, because this is the rational choice for them.

According to Yahoo Finance, Salesforce is 99% owned by institutions. To give this figure some context, Salesforce competitors Oracle (NASDAQ:ORCL) and SAP (NYSE:SAP) are 62% and 23% institution owned, respectively, (again, these figures are from Yahoo Finance). Salesforce doesn't even have a real PE, since it doesn't have real earnings, but even if we use its imaginary, non-GAAP forecasted "earnings" of $1.48 to $1.51 for fiscal 2013, we get a forward "PE" of 100. In contract, Oracle and SAP have current PEs of 16 and 18, respectively. So it would seem that with respect to Salesforce and its competitors, there is a direct correlation between the level of institutional ownership and overvaluation of the stock, at least as measured by PE.

Let's look at the same numbers for Amazon and one of its competitors. Amazon has an institutional ownership level of 67% and a forward estimated PE of just about 100 for fiscal 2013. Looking at Wal-Mart (NYSE:WMT), we find that Wal-Mart has institutional ownership of 31% and a PE of 16. So again, here it seems that -- at least looking at this limited example -- there is a direct correlation between the degree of institutional ownership and overvaluation, as measured by PE.

In sum, I think that the forgoing numbers suggest that the institutional buyers who own so much of Amazon and Salesforce are following momentum, that is, each other, which means that they are all chasing beta, or average performance. This is rather counterintuitive to those of us who read Seeking Alpha because we actually are seeking alpha, or market outperformance. The discrepancy lies in mental semantics -- individual investors see "stock market returns" as money generated from stock market investments, while professional money managers see "stock market returns" (at least partially) as money generated as salary for investing in the stock market.

Now, picture a 26-year-old fund manager. He has gone straight from his bicycle to his acne medication to his degree at a prestigious school, to a job managing money. Now, I don't want to be too hard on this straw man I'm constructing, so let us suppose that while he isn't really any smarter than anyone else, he also isn't any dumber, either. Even at his tender years, he knows full well the difference between a bird in the hand and a bird in the bush. To him, the costs of losing his job are known, quantifiable, and huge. On the other hand, while the potential rewards of significant stock market outperformance -- of becoming the next David Einhorn or Warren Buffett, are huge -- so, too, are the risks one must run to get that outperformance. And neither the risks nor the rewards are quantifiable.

This is a recipe for risk avoidance, or herd behavior. The fact that the herd as a whole might go over the cliff does not matter, as the manager can always say, "Well, nobody saw it coming," or "Everyone lost money last year," or whatever. After all, how many of the money managers and stock market gurus of the 1990s who promoted Internet Bubble 1.0 lost their jobs? Without naming names, I can think of plenty who are still around today, helping to puff up Internet Bubble 2.0, and I'm sure you can, too.

So that is one possible explanation of how stocks without earnings or with negligible earnings can nonetheless have high valuations. Money managers who continue to throw other peoples' money at shares of companies such as Amazon and Salesforce literally may not care about earnings or fundamentals, because for them, the only thing that matters is what everyone else is doing. For them, exactly matching the market by buying whatever everyone else is buying is far and away the rational choice. Investors pondering the dictum "The market can stay irrational a lot longer than you can stay solvent" need to remember that the market has a built-in bias to chase beta, not alpha.

Investors with strong stomachs might want to consider shorting these two momentum stocks, but before you do read about Chemdex in this linked story, and beware that even the great Einhorn has had to cover a short that he called correctly. In other words, don't do it if you don't have strong hands. If you are worried about the strength of your hands, that is, your ability to hang onto a short that is going against you, consider buying puts. That way, you are limited as to losses, while the upside can be substantial.

Disclosure: I am short AMZN, CRM via long-dated puts. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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