Cult Stocks (Explained)

It’s a chance at being in on the next hot thing! They’re less expensive than sports teams, but just as overpriced.  Like anything else, sometimes investing is more about showing off than it is about making prudent choices. With Cult Stocks the odds are such that  your only hope of making money comes in the form of a bigger idiot being somewhere down the line willing to pay more for it than you did.

Last week Time Magazine  decided to pay ham-handed tribute to stock market hot streaker Carl Icahn. Time (which also owns Mad Magazine) obviously  isn’t beyond distorting a cover subject’s image a bit. (Anyone remember what they did to OJ?) All of this said, it’s a closer likeness than the one of Carl shown on CNBC whenever he just happens to call in.

For the record, Carl is not the steely eyed seer of the future portrayed so dynamically via head shot on CNBC. And his hands are nowhere near as big as what Time is depicting.  Instead, he’s a stereotypical bent over old Jewish man—the type New York is chock full of. And he’s not the master of the universe, either.

Quick, name an investor.

Ok, other than Carl. I gave you Carl. Name an investor of historical importance. Name an investor whose name has been passed down to us from ancient times--or even the Gilded  Age.

Unless you are really clued in, you’re going to come up with J.P. Morgan. He’s pretty much the only one you have to know. The rest of the titans of finance fell from memory moments after their fortunes were disseminated, their names mentioned only on occasion by their heirs. Most of the rich dead people that come to mind weren’t investors, but rather inventors or actual business operators. The guy who lent the guy with a dream money usually just gets his interest while others get the fame.

No one is going to remember Carl when he kicks, either. But let’s let a sad, old man have a moment in the sun. Carl is a big deal. He is a very big deal, indeed: in a class with Warren Buffett and T. Boone Pickens and Mark Cuban. (And Michael Bloomberg and Sumner Redstone, but that’s stretching it. Although damn fine finance twits, Redstone and Bloomberg made their cash in operating going businesses, not lending money.) And by some extraction Carl is alone as an investor--a pure investor-- with Pickens, since Buffett and Cuban operate the entities they own. But why quibble? All of these guys could quit tomorrow and cash out for more than many states are worth. And none of them invented squat to get where they are.

Carl strayed onto our Scams In The News territory a little while ago. Since he’s topical now, we’ll start our commentary on Cult Stocks with him. Carl just made a killing riding a Cult Stock called Netflix. Netflix itself is a fairly unremarkable operation which largely mails people movies on video discs. If this hardly seems like the thing futuristic dreams are made of, it’s only because it isn’t. Nor is actually becoming a movie studio or pumping content to high end home theaters activities one would think of as ground breaking. If anything, the firm is an unfocused operator in mediums on the waning end of their utility. It’s plying waters of technological half steps and heading in all directions at once. And if you invested in it when Carl invested in it, you would be wiping your ass with C notes.

As tempted as one might be to cry ‘tulip bubble’ at the whole thing, that really isn’t the essence of a Cult Stock. Although any equity can rise or fall based on internal or external events, Cult Stocks attain a patina—a halo—which causes their real market value to rise rapidly and then keeps their price above rational parameters. At least for a while. (See the raft of 3 D Printing stocks.) They attain this halo in two different ways.

Way One: If the Cult Stock  were a peanut farm, how valuable would it be? Everything has a limited market. Everything has inputs and outputs. Strip away what it is the business actually does and look at it as if it were a generic business, or peanut farm. Many Cult Stocks would make fantastic peanut farms. Some are larger than the world’s peanut industry by any number of measures. Cult Stocks of this type have special efficiencies,  in scale or profitability. They are making a lot of money in a way the other folks can’t.  

Way Two: The business is transcendent.  It is not a peanut farm at all. No one can make what it makes. It produces as a monopolist a commodity the world must soon consume profitable quantities of. It renders others in its segment obsolete. It creates wealth from thin air. It turns the world, makes the stars shine a new color.  (Or it cures cancer. This is where most bio stocks try to be.)

Netfilx is a Way One stock. Carl made it that way, forced the transformation. Prior to Carl taking his massive stake in the firm, Netflix was merely a very profitable mail order firm. It had been husbanding its nice haul in hopes of innovating its way to a more future-facing business model. Netflix was fairly convinced that mailing people movies is a delivery mechanism with a short shelf life and had been steadily investing in the next big thing. Then Carl showed up. Carl and his thugs said “Stick em up” and made Netflix pay out its R&D cash in the form of dividends now.

That’s a rather negative view of it. Carl has done this before. It’s his trademark move. Carl refers to his initiatives as enforcing investor rights. Other people take the view I have expressed.

Carl does have a point, however. Counting on Netflix to innovate its way out of the mail order business is like counting on AOL to innovate its way out of the pay for email business. Most R&D projects are odd ball wish fulfillment exercises and thorough wastes of money. No right thinking banker would touch a start up direct to Playstation movie studio with a twenty foot pole. In the view of people like Carl, the fundamental best social utility for firms such as Netflix is to make hay while the sun is still shining. By throwing off it profits to investors, Netflix frees up capital to find innovation on its own—or hookers or speed boats. One could argue that the launching of another movie production house or the enveloping for cash of Time Warner by AOL serves no grand moral nor economic purpose.

That said, history indicates Carl is wrong. Nearly every innovation we have today is the fruit of a long term R&D program. Crackpot notions with connected sponsors are the mother’s milk of our standard of living. Factually, bankers don’t speculate. (Or they shouldn’t.) Innovations such as photo offset printing, the automobile and the light bulb would have never come about without companies making continual and speculative investments in them.

(Or they come about through a process I will call Cascade.)

I mention Carl and his ilk here not merely to pick on them, but also because they are instrumental to both Way One and Way Two.  First, only  a guy like Carl can make Netflix do anything. Netflix could have been spending its R&D cash on innovations in sea foam pillow stuffing or astrology readings and, chances are, the lapdog board of directors and equally disinclined to look a gift horse in the mouth investment banks would have let them. (Quick: what is the next innovation in movie delivery systems? Telepathy?) There is a role for the guy who says “WTF”, especially if he owns a large chunk of the dump. Second, people follow guys like Carl—either to mimic them, guess their next move or triangulate around them. They are the catalysts of both Way One and Way Two.

That, in a nutshell, is the entire Cult Stock dynamic. The only significant nuance is the operational theory of the guy like Carl. Carl’s theory is that businesses exist to make him money and that they should pay him money as they make their money.

There are other theories. Once upon a time there was a company called IT&T. Arguably IT&T was International Telephone and Telegraph, but it also owned hotels and land and a movie studio and a bunch of other things. The theory behind IT&T was that it was economically indestructible, that it could make massive profits in any cycle of the economy. (That the economy goes into cycles with equal numbers of winners and losers depending on condition is the supporting theory.) This theory and the guys like the guy behind it were once very influential and many stocks like IT&T became Cults. And then theory went out of vogue. And IT&T (or ITT) was chopped for parts.

In IT&T’s case, the theory was simply wrong. (There are not an equal number of winners and losers in any business cycle. In general, everything is in the same water. When things are good, it’s good for everybody. When things suck, they suck everywhere.) But the important thing to remember about investor theories is that they are fairly much disposable. In true Cult terms, they are the cosmology. Unlike cosmology in actual religious Cults, in the stock world what is touted as a principle as fundamental as the law of gravity today is often dismissed as utterly irrelevant the next. All of it is dependent upon the perceived current track record of the theory’s promoters.

Dogged followers of Carl would have been led to the promised land of Netflix and scored big. But they also would have followed him into the black hole that is Herbalife. This is where Carl drifted into our radar, so it’s a good illustration.

We cover scams here. Herbalife is a Double Threat Scam Artist, both a phony baloney patent medicine purveyor and a pyramid scheme. The originators of the Herbalife/Nutrisytem scam bailed out once it became a stock. Those unfortunates running Herbalife now are merely stuck with an investment vehicle based on criminality. At one point a guy like Carl named Bill presented a paint by numbers assessment of the firm, detailing its the emperor has no real customers fleecing of the hopeless dupes nature.

This was no act of altruism on Bill’s part. Bill was hoping to convince his own followers to organize an attempt to ride Herbalife's stock price down to zero. (Short sell into oblivion.) It would have worked, too, but Carl stepped in to save Herbalife—solely it seems because Carl doesn't much like Bill.

The history of Cult Stocks are rife with such incidents.

Just as all religions are not Cults, the vast majority of stocks are not Cult Stocks. (Herbalife is not a Cult Stock. As a stock, it is fairly ordinary.) The analogy between religions and stocks ends here. There is less to stocks than there is to religion. And becoming a Cult Stock is not necessarily a bad thing. Most stocks aspire to have a Cult phase—or an award in overall valuation for the occasional home run. Public Trust companies always seek to be more than just the sum of their assets, and the good ones arguably are.

At the dawn of the modern stock era, slightly before the American Civil War, most public trust companies were aspiring Way Two Cult Stocks. This caused the reputation of the market as a whole to flounder. Such luminaries as Ulysses Grant and George Armstrong Custer fronted so many failed Way Two stocks that it negatively impacted their reputations. In response to spates of skullduggery the market has emplaced certain valuation barriers. The effectiveness of these measures is historically uneven, but in general you need more than just a sales pitch to get your firm listed and traded. That said, stocks themselves are financial commodities and the market will print up as many shares as there is demand to buy them.

Cult Stocks are very prone to fast movements in price. They are more the prisoners of current market emotional truth than other stocks are. They sell for more, they fluctuate widely and then they crash. If there’s still something there there when the smoke clears, the stock goes onto be something which trades within general market ranges. It’s the new kid in school and then it’s just Stinky the Fat Kid. Most Cult Stocks are new or in new industries.   

To take us back to our example of Netflix, it’s only slightly new. Nothing I’ve said should disparage the firm’s enviable track record. They are the cause of woe in the cable television business. They’ve put Blockbuster out of business. As stupid as renting movies by mail sounds, it’s a killer move and it’s all theirs. It was already trendy and profitable before Carl set up the slot machine to pay out. That it is paying out so well—perhaps at the cost of its future—is what makes Netflix so Cultic. Lots of old dogs have been Culted up by the likes of folks like Carl.

(Carl’s smash and grab approach isn’t particularly new. Carl is just particularly good at it.)

Most Cult companies do not become so as a result of investor activity. The majority of existing firms which are transformed into Cult stocks can attribute their rise to the influence of an actual operator or a breakthrough product. But an old stock suddenly becoming a Cult stock is more an exception than the rule. The vast majority of them are start ups, their rise powered by an overabundance of expectation.

You can’t bottle it. They’ve tried.

The original Cult Stock was the Bicycle Trust. Its core idea was to standardize the parts and construction methods of the bicycle industry. Enthusiastic backers felt that the bicycle would  change the world, that entire cities would be reconfigured to accommodate this new form of transportation. The Trust became flush with investors and merrily sold stock, first to build itself up and then to fund its operation. And for a time, the Trust’s shares were the hottest thing out there. Once it became clear that the bicycle was more a fitness craze than an innovation in personal transportation, the Trust went bust. And its shares collapsed.

But it wasn't quite done. It emerged from bankruptcy as the first large scale auto manufacturer. Large scale may be a bit of a misnomer, but they were bigger than all of the other firms. (This was at a time when Henry Ford was still working as a machinist.) It eventually issued stock again and then got hot when it attempted to create the first mass production electric car. (Sounds like a familiar concept, doesn’t it?)  Again its valuation did the happy dance. And then it died for the final time.

This fairly much traces what happens to the vast majority of Way Two Cult stocks. I am calling this process Cascade. You think something is such a good idea that you are willing to pay any price to bring it in. Predictably, you go broke. Then another group of guys buys all your crud on the cheap and tries to make a go of it. Then one of two things happen: (1) the thing’s a zeppelin—it’s a bad idea and no amount of money will make it work; or (2) the infrastructure has been acquired at an affordable price thus enabling the product or service to become profitable to produce. Event 1 is more common than event 2, but event 2 is how many industries become established.

A lot of Cult Stocks are on their way to the cascade process. Others become amalgamated—picked up and absorbed by firms in tangential businesses. Amalgamation itself, although not currently trendy (don’t tell Warren Buffett) is often the cause of a stock attaining Cult status. It should also be said that amalgamation is the fate of most stocks, Cultic or not.

It’s hard to predict the fate of the current crop of Cult Stocks. The best one can do is attemot to draw historical allusions.

Former Cult Stock Blackberry seems unlikely to continue as a going concern. It has essentially fallen prey to the cascade process, as has nearly every original leader in the handset business. The best analogy one can find is in the old stereotype industry. The stereotype was an early method of setting printing type by the page. Various systems for doing this were the rage of the stock market in the 1800s. And it was a fight no one won. In the end, stereotype forges of various makes became the industry of small businesses. Every dollar spent by the investors was lost and the innovation essentially became public domain property. It was only after electrification that one public trust company (Linotype) was able to exploit the field. As with stereotypes, it seems that the money invested in Blackberry went to advance the field as a whole, but not create much return to the investor in that firm. (Broadly speaking.)

Current Cult Stock Apple is essentially in the fashion business. How long it can continue to be cool and charge a premium for commodity type products is unclear. Like Google, it rides high on a mound of cash in reserve. Both firms are potential targets of Carl-like activity. Oddly, rigging the cash machines so that they pay out in cash may be one of the few ways either firm can maintain their Cult status.

Amazon is the Bicycle Trust of the 21^st Century. The idea of being a mail order house for everything is as old as Sears. Its efficiencies are all government subsidies. (The internet, the post office and increasingly spotty exemption from sales taxation.) It needs to start making real money fairly soon or it is destined for the fate of the stereotype.

Tesla may be one of the few Cult Stocks with an actual future as an independent entity. Not at its current valuation, of course. But it is otherwise acting like every start up car company in history. Historically all major car companies are founded with a technological focus (an efficient electric engine) and an orientation to the top of the market. Once it has its name and methods established, the firm then telescopes down market, making masses of cars for the masses. I think what takes people aback with this firm is that no one has started a car company in a very long time. If you hold up the mirror of history, this is what many of them looked like when they started up.

Henry Ford didn’t start off by making the Model T. Ford’s first company made Cadillacs. Cult Stocks like Tesla have always been a part of the auto industry.

Several firms started to jump into the auto market with the collapse of the Bicycle Trust. Ransom Olds and then Henry Ford proved that the market for cars was larger than first anticipated. (Again, this is prior to the Model T’s introduction.) In keeping with the perception that cars were the coming thing, two identical trusts were formed to amalgamate the auto industry.

United Motors was the first of these Cult Stocks. It’s literal model was to sell stock and use the funds to buy businesses in the emerging automotive industry. And it would keep printing stock until it owned all of the industry. Or a lot of it. Absolutely no effort was made to rationalize or coordinate the affairs of its holdings. (Shades of Warren Buffett.) In a lot of ways it was its own sector spider or ETF. It was run much in the same way the later IT&T, a method called “portfolio control”. (Again, shades of Warren Buffett.) Most of what United Motors wound up owning were the former assets of the Bicycle Trust, making it another example of cascade. Through various twists and turns, including a bankruptcy or two, the firm became known as Maxwell Manufacturing. The firm eventually renamed itself after its savior CEO and is today known as Chrysler.

The other completely identical trust was called General Motors. Both United Motors and General Motors were Cult Stocks in their day.