The value of potential is one of the great unknowns, not just in investing, but in most areas of business. How much should a company be prepared to pay for that super-bright college grad? Should an NFL team use a high pick on a college player who has all of the physical attributes needed for success but is nowhere near ready to play? The examples are seemingly endless, but the basic question is always similar... How much is potential worth?
Traders and investors tend to approach this, like most things, as a mathematical problem. Wall Street firms pay analysts enormous amounts of money to predict future revenue and profit at companies and then we evaluate stock based off of those numbers, using forward P/E (the current price of a share divided by the predicted future earnings per share.) There are two basic problems that this presents.
Firstly, reducing this to a mathematical equation makes us inclined to forget that what we are basing everything off here is a guess; a very well educated guess, but still a guess. Secondly, the value that we see in those future earnings is not an objective opinion, it is highly subjective. At certain times some things become popular and this leads to an exaggerated opinion of the value of that thing’s potential.
Once again, this is not just the case in investing. To extend it to the analogies above there was once a time that every major employer was scrabbling for Psychology grads. What could be more useful in business than somebody who understood the human psyche? Now psychology makes a published list of the “20 Most Useless Degrees.” In football, it was once thought that taking a fullback who was still growing made sense; I mean every team would always need a fullback, right?
Our perception of future value is not a scientific thing; it is based on fleeting popularity and trendiness. It also changes over time... the longer it takes for potential to be realized, the more impatient we become.
It would seem to me that this is why Salesforce.com (CRM) reached the highs it did at the end of last month and is now faltering. They are in the cloud business, and we all know that anything associated with the cloud is going to be huge, don’t we? It is that kind of thinking that leads to a situation such as this.
CRM Consensus Recommendation
This is a screenshot from the earnings date page for CRM here on Nasdaq.com and to me it illustrates the stubborn nature of popularity. Analysts, it seems are acting like teenagers in love with the popular kid; no matter how many times they are rebuffed, they continue to adore CRM. The company has missed forecast earnings spectacularly for each of the last four quarters, yet if you look at the consensus recommendation bar above those numbers, the stock is still rated a buy. This may be understandable if there had been spectacular improvement in earnings and estimates were just a little too optimistic, but as you can see that isn’t the case.
I know a technology company such as CRM must continue to invest in the future and at this stage it is revenue, not profit, that is driving the buyers but sooner or later, potential has to be realized. A lot of misses will be forgiven in the name of what could be, but at some time potential has to show signs of realization. The last few days have indicated that the market may be running out of patience and the 500% increase in the stock price over the last five years is beginning to look a little overdone.
MacroGenics (MGNX) is also a stock in a trendy field (Biotech) and has also dropped from previous highs recently, having lost around 20% in the last month or so. They too, have failed to turn a profit, but in a company that only IPO’d in October, this is a little more forgivable. Potential is a great thing in the young, but when the word is applied to a 50 year old it is usually not in a positive way.
In this case recent weakness represents an opportunity for those with an appetite for risk to get in at a more reasonable price. MGNX is in the cancer treatment business, more specifically in the development of monoclonal antibody based therapeutics. They have a fairly broad pipeline and have developed the DART platform [PDF] which has led to collaboration and licensing deals with Boehringer Ingelheim, Pfizer (PFE), Servier and, most recently, Gilead (GILD).
These deals provide much needed cash flow in the short term, allowing more time for the potential of the pipeline to be realized and there could well be more to come. Big pharma have been paying up for similar technology recently (See Merck’s deal with Ablynx), indicating the focus on the combination therapy approach that DART facilitates.
The stock has come a long way in a short time, being up significantly since the IPO and the recent pullback was probably needed, but the potential is still there. It may fall a little more in the next few days, but when buying something on the way down, trying to hit the bottom is a fool’s game. MGNX is trading below $33 this morning and that’s good enough for me.
The thing is, potential is a wonderful thing. It enables us to dream of what could be, and it always comes before greatness, whether we recognize it or not. For a tech based company, however, it can only carry you so far. MGNX is a story yet to be written and investing in the company, while undoubtedly risky, could be exciting as we see how much of that potential is fulfilled. CRM, on the other hand, has begun to be defined by consistently missing expectations. There may still be potential there but its value, and therefore the value of the stock, is decreasing.