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Nortek, on the other hand, earned $41.6 million in 2000, $8 million in 2001, and $55 million in the first nine months of 2002. Its stock went from $28 a share to $45.75 by year-end 2002—a 63% gain. In January 2003, Nortek’s managers took the company private, buying all the stock from public investors at $46 per share. Nortel’s stock, meanwhile, sank from $56.81 in February 2000, to $1.61 at year-end 2002—a 97% loss.

Pair 8: Red Hat and Brown Shoe

On August 11, 1999, Red Hat, Inc., a developer of Linux software, sold stock to the public for the first time. Red Hat was red-hot; initially offered at $7, the shares opened for trading at $23 and closed at $26.031—a 272% gain.11 In a single day, Red Hat’s stock had gone up more than Brown Shoe’s had in the previous 18 years. By December 9, Red Hat’s shares hit $143.13—up 1,944% in four months.

Brown Shoe, meanwhile, had its laces tied together. Founded in 1878, the company wholesales Buster Brown shoes and runs nearly 1,300 footwear stores in the United States and Canada. Brown Shoe’s stock, at $17.50 a share on August 11, stumbled down to $14.31 by December 9. For all of 1999, Brown Shoe’s shares lost 17.6%.12

Besides a cool name and a hot stock, what did Red Hat’s investors get? Over the nine months ending November 30, the company produced $13 million in revenues, on which it ran a net loss of $9 million.13 Red Hat’s business was barely bigger than a street-corner delicatessen—and a lot less lucrative. But traders, inflamed by the words “software” and “Internet,” drove the total value of Red Hat’s shares to $21.3 billion by December 9.

And Brown Shoe? Over the previous three quarters, the company had produced $1.2 billion in net sales and $32 million in earnings. Brown Shoe had nearly $5 a share in cash and real estate; kids were still buying Buster Brown shoes. Yet, that December 9, Brown Shoe’s stock had a total value of $261 million—barely 1/80 the size of Red Hat even though Brown Shoe had 100 times Red Hat’s revenues. At that price, Brown Shoe was valued at 7.6 times its annual earnings and less than one-quarter of its annual sales. Red Hat, on the other hand, had no profits at all, while its stock was selling at more than 1,000 times its annual sales.

Red Hat the company kept right on gushing red ink. Soon enough, the stock did too. Brown Shoe, however, trudged out more profits—and so did its shareholders:

FIGURE 18-4 Red Hat vs. Brown Shoe

Note: Total returns for calendar year; net earnings for fiscal year.

Source: www.morningstar.com

What have we learned? The market scoffs at Graham’s principles in the short run, but they are always revalidated in the end. If you buy a stock purely because its price has been going up—instead of asking whether the underlying company’s value is increasing—then sooner or later you will be extremely sorry. That’s not a likelihood. It is a certainty.

Chapter 19

Shareholders and Managements: Dividend Policy

Ever since 1934 we have argued in our writings for a more intelligent and energetic attitude by shareholders toward their managements. We have asked them to take a generous attitude toward those who are demonstrably doing a good job. We have asked them also to demand clear and satisfying explanations when the results appear to be worse than they should be, and to support movements to improve or remove clearly unproductive managements. Shareholders are justified in raising questions as to the competence of the management when the results (1) are unsatisfactory in themselves, (2) are poorer than those obtained by other companies that appear similarly situated, and (3) have resulted in an unsatisfactory market price of long duration.

In the last 36 years practically nothing has actually been accomplished through intelligent action by the great body of shareholders. A sensible crusader—if there are any such—would take this as a sign that he has been wasting his time, and that he had better give up the fight. As it happens our cause has not been lost; it has been rescued by an extraneous