To understand why technology shares took such a roller-coaster ride in 2000, we need to remember that the stock market is run by humans. And by our nature, we are not always rational.
In case you need proof, turn the clock back to December 1996. Remember "Tickle-Me-Elmo," that season's "gotta have" holiday gift? Stores ran out of Elmo, and crazed consumers reportedly paid more than $500 for the doll from "toy scalpers" so they could get Elmo in time for the holidays. The following spring, stores were bulging with Elmos that cost about $30.
It paid to avoid the Elmo mania. And so it goes with stocks as well. Gotta-have stocks come and go, and while they are "in," otherwise reasonable people take leave of their senses and pay much too much for them because so is everyone else. (Such herd behavior, by the way, certainly isn't new. Bernard Baruch, a self-made millionaire and frequent adviser to U.S. presidents in the first half of the 20th century, said that "economic movements, by their very nature, are motivated by crowd psychology." He wrote those words in the wake of the devastating market crash of 1929 as a fresh introduction to the book Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, first published in 1841.)
To see what happened to technology stocks in the most recent example of crowd psychology, look, for example at the Standard and Poor's 500 Index -- which offers a glance at the performance of the nation's top 500 companies. It ended 2000 down by about 9 percent from the start of the year, hurt by the selloff in Internet and technology stocks, which make up about 30 percent of the index. (For more information on the composition of indexes, see What's in an index?) And to really see the damage sustained by the tech and Internet shares in 2000, look at the Nasdaq Composite Index, which is dominated by technology shares. It ended 2000 down about 38 percent, easily qualifying it as a "bear market." (A bear market is one that has dropped sharply. By many standards, a market turns into a bear when it drops more than 20 percent.)
To look at this bearishness on the level of a single company, look at eToys, the Web retailer based in Santa Monica, Calif., that issued its first stock in May 1999 and is now in the process of closing down its business. After "going public" (as a first issuance of stock is known), eToys' stock hit a peak of $86 during 1999. But not everyone went tech-crazy. There were holdouts who grumbled mightily about fundamental underlying value. "Look at eToys," they said. "That company is priced at $1 billion. But there are no profits. How can a company that has no profits be worth so much? The emperor has no clothes!"
One year later, these grumbling so-called value investors turned out to be right. With no profits, over time the price of an eToy share spiraled down from its peak of $86 to 22 cents (yes, you read that right! 22 cents!) at the close of stock market trading on December 20, 2000. During that same period the value of the company's outstanding stock -- its so-called market capitalization -- plummeted to $29.1 million from $1 billion. The same is true of Amazon.com, the Seattle online retailer and erstwhile darling of the Internet industry. Amazon sold for $113 a share at its peak in 1999. But it had cratered to $16.69 a share by December 20, 2000, at the close of trading. That means the market cap of the company fell to $5.9 billion from $26 billion in less than a year.
In conclusion, a new-tech buying frenzy pushed the prices of Internet and technology companies very high. But the prices fell when the paradigm began to shift. The fashion for investors changed, and fancy dot-coms were "out" and healthy balance sheets showing net profits came back in.
Understanding Value Stocks
So much for history; what's an investor to do at this point? Well, to get back to investing basics, it's good to remember that the fundamental underlying value of a company is ultimately the best indicator of whether it will grow. (For other investing basics, learn about dollar-cost averaging and diversification in Protect yourself from market swings.) And it's good not to pay attention to the wilder stock-buying trends. But don't just take it from me. Take it from investor Warren Buffett. A man of modest beginnings, Buffett's personal net worth is about $30 billion, most of it in the company he controls called Berkshire Hathaway. He was one of the loudest critics of the Internet and technology boom -- despite having a personal friendship with Bill Gates, chairman of Microsoft, the software giant.
Buffett's strategy, overall, has been to buy good companies and hold onto them. "We own parts of businesses when we own stocks," he has reiterated. "If we're right on the business, the stock market will take care of itself." So, what's a good example of a company that a prudent investor might like? Tootsie Roll Industries. That's right, I'm talking about the Chicago-based maker of Tootsie Rolls, Junior Mints and other candies. The company is about 100 years old. For the past 10 years it has been slowly increasing its profits, or earnings -- the amount left over from its revenue after it pays all its expenses. Tootsie Roll reported net profits of $40 million in its 1995 fiscal year. And that moved gradually up to $71 million in its 1999 fiscal year. The stock has moved up practically in lockstep with the growth of the company's earnings.
Tootsie Roll shares rose from $18 a share in its 1995 fiscal year to a peak of $46.94 in its 1999 fiscal year. The December 21, 2000, share price was $45.44. Clearly Tootsie Roll stock weathered the technology and Internet stock downturn well.
Value Mutual Funds
If you don't want to spend your nights and weekends finding the Tootsie Rolls of the stock market, remember that there are plenty of good mutual funds out there that specialize in buying so-called value companies at reasonable prices. Two good examples are the Dreyfus Midcap Value fund and Smith Barney Fundamental Value A. Both funds have performed well over the long haul. And neither one buys stocks that are overpriced. This made them seem quite dull during the tech and Internet stock rally but has made them stable, safe havens during the market's violent downturn.