On April 20, 1999, Wharton professor Jeremy Siegel walked into his Philadelphia office to find a very full e-mail inbox. It was overflowing with hate mail.

The dean’s office had forwarded him an e-mail that said, “Not only is this guy (Siegel) a dinosaur, but he knows absolutely nothing about forward business models. I hope that he may soon retire from dear old Wharton or to the funny farm — whichever comes first. He is nuts, period, and should have a muzzle.”

Now, Jeremy Siegel is one of world’s top investing experts. And he is the undisputed authority on finance and economics. Why the hell would someone send Siegel such an insulting e-mail?

You see, just the day before Siegel’s inbox was flooded with caustic e-mails, he had written an unprecedented article. It was titled “Are Internet Stocks Overvalued? Are They Ever” and appeared on the April 19, 1999 issue of the Wall Street Journal.

In the article, Siegel used AOL as an example to show that internet stocks weren’t worth what investors were paying for them. He argued that even though AOL’s market cap ranked within the top ten U.S. companies, its sales ranked a pathetic 415th. Siegel also pointed out that AOL’s P/E ratio was 700 when the average P/E of the stock market had only been 17 over the last 45 years.

The same day, AOL’s stock fell 17% shaving off an incredible $22 billion from its market value. Other internet stocks, including the dot-com index also fell about 17%.

That day, when Siegel appeared on CNN’s Moneyline show, even Lou Dobbs asked him, “What in the world — Jeremy, if I may ask, you write one article in the Wall Street Journal, and see what you did! Why did you do that?”

Although Siegel had quite accurately called the top of the tech bubble, investors weren’t ready to listen. His article made them furious. After all, the Dow had closed above 10,000 for the first time ever, Apple Computers launched its brand new iBook laptop and any stock in the business of technology had catapulted into a seemingly endless bull run.

In such a market, investors viewed Siegel’s article as a party pooper. One e-mail said:

“Good morning, Mr. Siegel. I hope you’re happy. You cost me $14,000.00 for no reason! What do you have against this mammoth company (AOL)? Are you jealous because you didn’t get in on the run-up? Did you want to buy in cheaper? You have no business making decisions like this. After all, you’re still a child when it comes to Internet knowledge. You’re a preschooler in diapers when it comes to recognizing opportunities. By the way, when was the last time you got laid? You’re a party pooper. Thanks a lot, jerk.”

Such e-mails, according to Siegel, are a sign that stocks are in a bubble. Investors had “made the fatal error of falling in love with their stock.” In his book, “The Future for Investors” (which I highly recommend), Siegel points out 3 other lessons from the tech bubble.

Whether we are in a bubble or not, every investor needs to learn these lessons. I will explain them and then, using Siegel’s advice, show you what stocks to invest in and what not to buy. Read on…

Lesson 1: Valuations Are Critical. As Siegel pointed out using his AOL example, high P/E s are a no-no. Portfolios invested in the lowest P/E stocks of the S&P 500 returned 3% more each year than the overall index. Portfolios invested in the highest P/E stock feel 2% behind the index.

Lesson 2: Never Fall in Love with Your Stocks. “You must at all times be objective: If the fundamentals do not justify the price, you should sell, notwithstanding how optimistic you are or how much money you’ve made or lost on the stock,” says Siegel. So many investors had fallen in love with their AOL stock in the late 1990s that they couldn’t let go of it. And that’s evidenced by the emotional e-mails Jeremy Siegel received.

Lesson 3: Beware of Large, Little-Known Companies. Thankfully, my stock screens didn’t turn up many stocks in this category. But the lesson is certainly worth learning. Historically, companies with the largest market caps have also been easy to understand businesses. General Electric, Microsoft, U.S. Steel, Standard Oil, General Motors, AT&T and IBM have all been leaders in terms of market cap at some point in time since the 1920s. They also make products that everyone used and had huge name recognitions.

Then came along Cisco Systems — at $400 billion, it had the world’s LARGEST market cap in the year 2000. But did anyone know what exactly Cisco made? Not really. According to Siegel, “It was astounding that the vast majority of Americans, including many shareholders, had absolutely no idea what Cisco did. That the world’s most valuable company would be virtually unknown is unprecedented.”

By 2002 the bubble had done its job of sucking euphoric investors in and then spitting them out, dizzy and broke. At that time, Cisco’s market cap was a mere $50 billion, less than a tenth of its peak value. Bubble or not, anytime a company’s market cap gets huge and yet nobody knows what exactly the company does, its time to get out.

Lesson 4: Avoid Triple Digit P/E Ratios.  A stock’s P/E reflects earnings expectations. But no firm deserves a triple digit P/E no matter how good its earnings are. Take Taser International Inc. (TASR: NASDAQ), trading right before noon today at $9.42. This once high flying non lethal weapon maker has a current P/E of 525. Does Taser’s lofty P/E justify its earnings expectations?

Analysts expect the company to report an EPS of $0.03 this quarter. If Taser meets these expectations its P/E should be price ($9.42) divided by expected EPS (0.03). That’s a P/E of 338 — still very lofty EVEN if Taser meets its earnings expectations. And if Taser were to trade at the S&P average P/E of 18, the stock would have to fall to $0.54!

So based on the above four lessons from the past stock market crash, I ran some simple screens. Here are some stocks you should and shouldn’t be investing in:

What NOT to Buy

What to Buy

As you can see from this screen, P/E ratios along with a few other parameters can be powerful indicators. Tolerate a higher P/E only if you are certain of the stock’s long-term earnings potential. And you should never buy stocks that have high valuations based on concepts and names instead of earnings.

In Jeremy Siegel’s words, “Valuations always matter, bubble or no bubble. Markets will ultimately deal a severe blow to those who believe that growth is worth any price.”

Regards,

Sala Kannan
May 12, 2006

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