We’ve been talking about the dangers associated with investor enthusiasm for growth and momentum stocks – what I’ve dubbed “gromentum” stocks. The same phenomenon crops up every few years. Investors get wildly excited about some hot sector and drive stock prices into the stratosphere. Worse, any investor – or advisor! – who sticks to Ben Graham’s “intelligent” investing eventually finds itself on the outside looking in. Somehow, “intelligent” investing becomes “dumb” investing. Meanwhile, “semi-intelligent” investing becomes smart investing.

As Churchill might have said, history is the worst possible guide to the future – except for all the alternatives. Therefore, let’s look back at the history of gromentum investing, picking up in the mid-1990s. I’ll give three actual examples of clients who self-immolated via gromentum stocks,(1) changing the names and facts slightly to protect the guilty.

The doctor

Although still a relatively young man, a doc we’ll call John built himself a chain of clinics across northern Florida, selling the company to a large health care firm in 1993, but remaining as chairman. Doctor John engaged an Atlanta-based advisory firm, asking them not merely to manage his portfolio, but also to teach him the investment game. The advisor did a fine job on the portfolio, but Doctor John was hopeless as an investor. By the end of 1994 he’d managed to reduce a $1 million personally managed portfolio to $665,000.

But in 1996 Doctor John discovered investment gold. Instead of mucking around in incomprehensible financial statements, he turned to “charting.” All you had to do, it turned out, was to find stocks that had been increasing rapidly in price and buy them! What could be simpler!

For two years Doctor John would bring his personal portfolio results to his quarterly meetings with his advisor. At first he did this for amusement, but over time he lost his sense of humor. His advisor, who supposedly understood capital markets, was underperforming the client, who understood nothing, every single quarter!

In 1998 Doctor John began moving money from the advisor’s account to his personally managed account, and by mid-1999 John no longer saw any reason to keep the advisor around. He also saw no reason to keep going to the office. Instead, he became a day trader.

It was also about this time that Doctor John discovered the magic of buying on margin. Not only did all your stocks go up, but margin allowed you to leverage those results! What a deal!

All went well for about six months, but then the bottom fell out of the stock market. Gromentum stocks (aka Internet stocks, tech stocks, growth stocks) began to plummet in price. It was a shocking experience for Doctor John, who now owned nothing but gromentum. It got more shocking when he began receiving margin calls. Matters went from bad to worse, and in early 2003 Doctor John filed for personal bankruptcy protection.

The Internet entrepreneur

Not every experience with gromentum stocks ends in bankruptcy (amazingly). Consider Kyle, who co-founded a B2B(2) Internet firm in 1995, then the newest of the new new things. Although Kyle’s firm had yet to produce a profit, it went public in early 1999 and soon Kyle’s net worth, on paper, was more than $300 million.

Kyle found a broker who would lend against his B2B stock, and he engaged a San Francisco-based advisor who built a diversified portfolio, designed to offset the concentrated risk of the B2B stock. But Kyle wasn’t all that interested in diversification, he was interested in becoming a billionaire before he was forty. He knew the B2B space and that’s the kind of stocks he wanted to own.

Kyle’s advisor argued against this foolishness, but Kyle forged ahead, and at first his “put all your eggs in one basket” strategy worked well. Alas, in the spring of 1999 it stopped working, and with a vengeance. Every B2B stock on the planet collapsed at the same time, including Kyle’s own B2B. Unfortunately for Kyle, as an insider in the company he was “locked-up,” that is, he couldn’t sell his stock for a certain period of time following the IPO.(3)

Poor Kyle watched in horror as his net worth plummeted from over $300 to just under $10 million, at which point he was able to sell out.

You might suppose that a middle class kid like Kyle, who’d graduated from Pomona with a lot of student debt, would be delighted to end up with almost $10 million, but in fact Kyle was deeply embittered. It’s one thing to go from nothing to $10 million, but quite another to go from $300 million to $10 million. Kyle blamed everyone on the planet for his misfortune, including his wife, the B2B’s underwriters, his former financial advisor, his partners at the B2B. Lawsuits flew, divorces were granted, Kyle’s kids stopped speaking to him. He’s not bankrupt, but he’s probably the unhappiest multimillionaire on the planet.

The cautious institution

What we’ll call Sitwell was a nonprofit institution that, for more than a century, had served its constituency in northern Indiana with distinction. For fifteen of those years, Sitwell had been advised by a well-known Chicago firm that had built it a conservative, well-diversified portfolio.

But nothing good lasts forever. In 1996, a new member joined the Sitwell investment committee, a stockbroker who specialized in Internet securities. This committee member was dismissive of the Sitwell portfolio and encouraged the institution to move into the modern era and engage money managers who understood the new economy.

At every committee meeting, the stockbroker would show the committee the results of her personal stock picks, which were always quite dramatically better than the performance of Sitwell’s boring old advisor-designed portfolio. No one knew that these stocks were picked after they’d appreciated, not before.

In early 1999 the broker and her allies convinced the committee to terminate Sitwell’s advisor and to engage only two managers. One was a not-to-be named growth manager, then a very hot fund, and the other was a then-famous tech manager. The committee was unaware that the broker had been paid a fee to introduce these managers to  Sitwell.

After peaking in early 2000, the growth manager lost 66% of its capital over the next two years, while the tech manager lost an astonishing 93% of its capital. Sitwell nearly collapsed and the state Attorney General began to make inquiries. In the end, Sitwell was quietly merged into another organization. Other than having to retire from the board in disgrace, the conflicted stockbroker, who had almost singlehandedly destroyed a gracious and useful institution, escaped without punishment and continues to practice her profession today.

(1) To protect client confidentiality, none of these examples involved a Greycourt client. They are, instead, examples I learned about through friends in the industry and, in one case, through a personal connection. Greycourt had similar experiences, however.

(2) Business-to-business.

(3) Typically, when a company goes public, insiders may not sell their shares for some period of time, usually 90 to 180 days. Supposedly, this is to keep insiders from cashing in, leaving the public holding the bag. More likely, it’s to keep the underwriters from taking a bath, since insider selling immediately post-IPO would drive the price down before the underwriters can unload the stock.

Next up: The Semi-Intelligent Investor, Part 5

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.