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Market Jitters

Volatility “is a unique and necessary condition for the creation of value” in the Internet economy, argues Wall Street analyst and technology strategist Pip Cobourn.

When will investors in Internet stocks be able to take a deep breath, turn away from CNBC, and relax? When will Net companies regain their confidence about going public and about maintaining reasonable share prices once they do? In short, when will Wall Street calm down?

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Phillip “Pip” Coburn, 34, global technology strategist for UBS Warburg, has a simple answer to such questions: Never. Volatility, he says, “is a unique and necessary condition for the creation of value” in the Internet economy. “Tech stocks are going to be volatile forever. When they stop being volatile, they stop being tech stocks. That’s not bad, that’s not good. It just is.”

It’s also vintage Coburn, who conducts himself more like a philosopher and an intellectual provocateur than the Wall Street analyst that he is. Coburn has impeccable Wall Street credentials. A little more than a year ago, he crossed over from the buy side — he was a portfolio manager and technology analyst at New York City money manager Lynch & Mayer — to join the technology-investment group of UBS Warburg, a financial-services giant formed by the 1998 merger of Union Bank of Switzerland and Swiss Bank Corp. Before that, Coburn was an equity trader for CJ Lawrence Morgan Grenfell.

Despite his money-market roots, Coburn seems more a creature of Silicon Valley than of Wall Street. He prefers wearing khakis and sweaters to wearing pinstripes and suspenders. And he shares the startup world’s zeal for changing the rules. In a business that prizes brash claims and nerves of steel, he operates with an aura of detached calm.

Indeed, Coburn spends less time staking positions and more time roving the frontiers of his organization and of the new economy, listening for rumblings of change. “Analysts are known for taking a godlike stance in the marketplace,” he says. “They’re effectively saying that they’re smart enough to be self-sufficient. I take the opposite approach, which is that nobody is as smart as everybody.”

One product of Coburn’s roving is a research report called “The Weekly Global Tech Journey,” a glossy booklet filled with punchy essays that have such titles as “Mashed Potatoes in Martini Glasses” and “Life Happens to the Left of the Decimal Point.” The report is sent to more than 11,000 clients — mostly portfolio managers and analysts. Coburn mixes data points and sector analyses with pop-culture references, digital thinking, and 17th-century philosophy. The expansive scope of his writing isn’t just meant to be interesting — it’s meant to make money. “The fact is,” he says, “companies don’t move markets, markets move companies. It’s important to ‘connect the dots’ between the larger currents in the world and the fundamentals at specific companies.”

In a series of interviews with Fast Company, Coburn shook off this spring’s market jitters to explore those currents and to unpack the logic of value in the Internet economy.

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When will tech stocks become less volatile?

Tech stocks are going to be volatile forever. When they stop being volatile, they stop being tech stocks. That’s not bad, that’s not good. It just is. Technology is different from other sectors of the economy — the rates of growth are different, the levels of complexity are different, the range of outcomes is different, the demands on management are different. And, with the Internet, the intrinsic volatility of tech stocks gets magnified even further. Volatility is a unique and necessary condition for the creation of value — in the financial markets and in society at large.

Not so long ago, people believed that we were close to creating a science out of finance. We got discounted-cash-flow (DCF) analysis, economic value-added (EVA) models. People went through Harvard, Stanford, and Wharton and got loaded up with all of the theories. But over the past five years, the science of finance has been blown out of the water. We are seeing a massive divergence between the ideas behind financial theory and the ability to actually use theory in the marketplace. That doesn’t mean you throw up your hands — it means you change your expectations about the logic of the market, and you rethink the way that you evaluate stocks.

What’s an example of how you change your expectations?

Discounted cash flow has been the Holy Grail of traditional valuation. Anyone can understand that logic. You project a company’s cash flows out into the future, discount them at the appropriate rate, and come up with a valuation. The DCF model makes intuitive sense. It’s the application of that model that becomes difficult. And when you’re talking about Internet companies, implementing the DCF model becomes virtually impossible. I like to say that Internet valuations are based on discounted cash flows, but in a warped sort of way.

One of my colleagues did an analysis last fall that applied DCF logic to the valuations of a bunch of tech companies. She found that for a fast-growing company such as Nextel, 63% of its current value comes from cash flows that are forecast to emerge after 2008. For priceline.com, an Internet pure play, that figure was 96%! In other words, 96% of priceline’s current market value is based on cash flows that are supposed to materialize after 2008. That is absolutely amazing. We can’t figure out what’s going to happen 2 years from now with these companies, so when we try to look as far as 8 or 10 years from now, it’s just massive guesswork.

That is a crucial driver of volatility. Tech companies live and die by big, incremental margins. A small top-line shortfall causes tremendous damage down through the bottom line, as each element of the business model starts to rock like a rickety old ladder. And we have plenty of shortfalls. We analyzed 1999 earnings estimates for tech companies in the S&P 500. Some 47% of those companies missed their initial estimates by 20% or more in either direction. In other words, if analysts had been projecting profits of $1 a share, half of the time the results would be either more than $1.20 or less than 80 cents.

It’s horrible! It’s not because we’re all so stupid — it’s because the world is so unpredictable. But if we’re building models where, in the first year, we can’t get the numbers right half of the time, then what’s the value of taking that model out ad infinitum?

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What do you do in response to uncertainty?

You change your investment model, and you look for different clues about how companies are going to perform in the future. Over the past few years, the equity market has been conducting a large-scale experiment with Internet companies. It has morphed into an upscale venture-capital market. People and institutions are buying stocks in companies at a point in their development when only VCs used to make those investments.

Those of us who consider the Internet to be a great medium for connecting the world should be thankful that this experiment has been taking place because it speeds up the process dramatically. But it also changes how you value the players.

What should we do as investors? We should do what VCs do. We need to know what kind of “growth vector” a company is on. Not just quarterly financial performance necessarily, but all kinds of data points that get at such questions as “Is this company still on a trajectory that will make it a really big business in four or five years? Is it signing up customers at a rate that it needs to? Is it holding on to its customers? Is its revenue-per-customer where it needs to be?”

Now, what happens when data indicates that a company has moved to a slower growth vector? You get a violent correction. If you decide, for whatever reason, that you now expect a company to grow at, say, 40% a year rather than at 75% a year, that has a huge impact on projected cash flows. With that kind of change, you’d also probably wind up making a big increase in the discount rate. Put those two things together, and you get a massive impact on valuation.

Let’s move from money to management. How do you size up the management of a specific company?

We follow roughly 1,200 companies. How many managers in those companies have real experience dealing with changes in their competitive environment that are driven by the Internet? Close to zero. That is a new phenomenon, and it requires companies to rethink strategies, to restructure portfolios, to redistribute power internally, and to break down barriers with customers.

But most of all it requires leaders who are willing to make mistakes, to learn from them, and to try again. To iterate. Here’s the management philosophy that I like to hear: “I’m willing to screw up, then to figure out what and why I screwed up, and to change it. And then I’m willing to screw up again, and do it over and over, until I get it right. Oh, by the way, there are lots of people in this organization with the power to raise their hand when something’s gone wrong, and we’re going to reward those people, not punish them.”

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I really liked a description of one of the CEOs in Po Bronson’s book “The Nudist on the Late Shift.” Bronson was describing the CEO, and the people around that CEO were explaining what made him special. And it was something like, “It’s one thing to decide, it’s another to decide to decide.” That’s a quality I look for in CEOs. The speed of technology, the speed of a competitive environment, changes the relative value of making a decision versus always making the right decision.

If we were in the utility business, and I asked you, “Should we build this new power plant, and can you tell me by 4 o’clock this afternoon?” — that would make no sense. This is a decision you’re going to live with for 30 or 40 years. But if you’re at Amazon.com, you have to be willing to make a decision knowing that your odds of being wrong are reasonably high. You live with that, and move on.

We’ve been talking about topics that are top-of-mind with lots of people. When it comes to Wall Street and the Internet sector, what aren’t people thinking about that they should be thinking about?

Two points. One is how we do our jobs, the other is how we may want to think about the markets. There’s a huge problem with talent here. Everybody talks about a talent shortage in Silicon Valley. Well, we’ve got one on Wall Street too. This market is massively undersourced in terms of experienced people who can explain to investors what’s happening. It’s oversourced in terms of people who don’t feel comfortable with technology, but who make decisions about it. It’s a fast world, and we in the financial community are scrambling to catch up. Tech-company executives are often surprised by questions they get from us: not by how tough the questions are, but by how little sophistication we have, relative to what those executives live and breathe.

It’s a daunting job, really. We watch 1,200 companies, and we divide them into 13 sectors. Each of those sectors has, on average, five or six legitimate subsectors. So we’re talking about 60 different mini-industries that we track. That requires a massive collection of smart people. It’s challenging, especially when lots of smart people are being stolen by the dotcom world itself. These two worlds are colliding. No wonder everyone on Wall Street is dressing down!

My second point is about the times that we live in. People have to understand that we are living through two huge stories. One is, “The Internet — the Social Revolution,” and the other is, “The Internet — the Stocks.” The impact of the Internet is going to be absolutely pervasive. But that doesn’t mean my only job is to worry about Internet stocks, or that the only story all of us have to worry about is how the Internet sector does. I recently heard someone say, “Four or five years from now we won’t even use the word ‘Internet,’ because it will be as pervasive as the air we breathe.” That makes total sense to me. My guess is that 95% of the companies that I look at are being assisted in dramatic ways because of the takeoff of the Internet.

Now, will a lot of those companies go out of business? Yes. Will a lot of investors be disappointed? Yes. Will there be some witch-hunts in five years — some people asking questions like, “How could you have told me to put my money there?” Absolutely. But I’m in the camp that is thankful that all of this investment has been happening. It simply had to happen on a large scale for the Internet to have the impact that it’s having. Sure, there are going to be losers. But there are going to be some dramatic winners too.

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The real question for us as a civilization is whether we will continue to fuel the kinds of mechanisms that allow for social change.

In other words, if we hadn’t crafted this massive VC undertaking for Internet stocks in the public-equity market, we wouldn’t be moving as fast as we are. There’s a “billboard effect” from picking up the newspaper and seeing that eBay rose by 20% in a day, or that a new IPO is up 400% on its first day.

The effect isn’t just that people are more willing to invest in such companies — it’s that brighter people are being pushed to become part of this world. Maybe they become venture capitalists. Maybe they start their own companies. Maybe they come to work for us. But as more people get the courage to become a part of this, as more people understand how valuable their brain is, or that they can have an impact on society — and maybe even become wealthy based on the power of their ideas — the changes will continue moving forward.

The biggest winner is going to be civilization itself. When people all around the world forget about their nationalities and just talk, the social impact will be enormous. We now have analysts in something like 25 countries doing tech. When we exchange email, there isn’t the slightest thought about the political relationships between our countries. It’s just two people communicating. It’s almost invisible — but it’s amazingly powerful.

Polly LaBarre (plabarre@fastcompany.com) is a Fast Company senior editor based in New York City. Contact Pip Coburn by email (phillip.coburn@ubsw.com).

Sidebar: Pip’s 10 Tips

Are you looking for a simple way to explain to puzzled colleagues or to nervous investors how Wall Street works when it comes to high-tech stocks? Phillip “Pip” Coburn, global technology strategist for UBS Warburg, has created a cheat sheet that explains his perspective on economic value in the Internet economy.

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1. Technology stocks should be volatile — and Internet stocks should be more volatile.

2. Tech-stock valuation is about discounted cash flow, in a warped sort of way.

3. The public market in Internet stocks is essentially a form of upscale venture-capital activity.

4. Upscale VC activity is inherently more volatile than traditional tech.

5. Markets obsess on short-term data points in order to determine correct long-term growth vectors.

6. The right brain is winning over the left brain.

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7. There is little upside limitation to the values of the most successful Internet companies …

8. … but there is little downside protection to the values of companies that don’t succeed as planned.

9. Will valuation get easier as time goes on? No.

10. Will tech and Internet stocks become less volatile? Absolutely not.