23 May 2005

Windfall Profits

How can you tell when one of your
investments has just hit the jackpot?

Many years ago I met a guy who’d developed a backup battery to help cars start on cold mornings. Car batteries were nowhere as near as good then as they are now. He figured there’d be a great market in places like northern Europe, Canada and the northern United States where freezing winters often meant cars wouldn’t start on cold mornings.

The giant battery maker Eveready agreed. They offered him $500,000 for his invention.

Did you ever hear of such a battery? Of course not – because he turned down Eveready’s offer. Figured he’d make a lot more on his own...but it never got off the ground.

A while later I introduced another friend of mine to a stock promoter I knew in Vancouver. My friend had just started a business, had one location in southern California, and planned to franchise it nationwide.

The stock promoter thought it was a great idea and offered him $5 million on the spot for 50% of the business.

Well, to my friend this just confirmed the value of his idea. Positive he could make a lot more money than that, he decided to do it on his own.

Unfortunately, he was very good at starting businesses – but hopeless at developing and running them. A year later, he was bankrupt.

These are examples of what I call “windfall profits.” A windfall profit is like winning the lottery. Something completely out of the ordinary happens to drive up the price of your investment. But they quickly evaporate if you don’t grab them.

The question is, can you recognize them when they happen? My two friends couldn’t – and they’ve both regretted their decisions not to take the money many, many times since.

The trap is that you can take a sudden jump in the value of your investment as proof of all your expectations. After all, if your stock just doubled more or less overnight, surely this can only mean there’s more to come.

Maybe. How can you be sure? After all, the last thing you want to do is to take a profit just because it’s there – and then see it double or triple again.

To make the distinction you need to find out why your investment has zoomed up. If there’s been some dramatic improvement in the business – or if Wall Street has just recognized the value you saw in this company – then maybe there’s more to come.

But if the cause is some extraneous factor, then it’s probably time to take the money and run.

For example, during the internet boom I owned shares in a company that rented out exhibition equipment...booths, signs, and all the other stuff you see at trade shows. I’d bought it because it was a solid, stable – if boring – business that was throwing off steady profits and dividends.

One day I checked the price and noticed that it had gone from a dollar to around $2.50 per share. Unfortunately, a few days earlier it had been over $3.

I quickly found out that the reason for this jump was that the company had been talking – just talking! – to an American outfit about putting its business on the internet.

How could putting up a website suddenly double or triple the number of exhibition booths this company could rent out?

Clearly, impossible.

All that had happened was that the suckers caught up in the “sex appeal” of the of the internet boom has suddenly piled into this stock.

So I called my broker and immediately dumped the shares. A few months later they were trading at less than I’d originally paid for them.

The saddest thing about these windfall profits is that they don’t happen very often. I wish I had more than one to talk about.

But I don’t.

But I’m certainly ready to grab the next one that comes my way...if it ever does. And I hope you will be, too. – Mark Tier.

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