Learn Not to Overstay Your Welcome

 | Jan 08, 2014 | 6:57 AM EST  | Comments
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We were all rookies once. Rookies are people not experienced enough to understand or interpret the patterns before them. They get confused because they have never seen them and they make mistakes. They make rookie mistakes when they fail to heed the patterns. At that point they can either get discouraged and go home or learn from them and play at a higher level.

Now, the difficult thing for most rookies to accept is that there is something they don't know. They have tended to know only success to the point when they are promoted to the new, more difficult level, so they might react with horror or shock when advice given to them doesn't immediately pay off, particularly advice meant to cut off high-risk plays that otherwise don't seem that risky.

So, they lash out when the advice, which is typically based on empirical evidence or well-known tendencies not otherwise visible to a rookie, doesn't pay off.

Such is the case with my advice and Micron (MU), the DRAM and flash memory maker that has done such an amazing job in the last two years of trying to both consolidate its industries and remain price disciplined so pricing doesn't fall apart (as it almost always has in the 24 years that I have followed the sector).

Here's the setup. DRAMs and flash memory are both commodities. You get blueprints, you get funding, you build the plants, you produce DRAMs and flash. I wish it were more difficult than that. But it isn't.

In times of high demand you can charge a lot for these kinds of chips, until, alas, one of the manufacturers of them says, "you know what, we can build a couple of plants and take advantage of the better pricing to reap big margins." Pricing stays firm until these plants open and then once they start putting out lots of DRAMs or flash memory then pricing begins to erode as the new supply is absorbed by the market. It's the law of supply and demand. The law of supply and demand is brutal and applies to everything from uncoated free sheet paper to gypsum wall board to coal, polyethylene, cardboard, fertilizer, disk drives, DRAMs and flash.

If you are a customer of DRAMs you know the drill. You keep waiting for those new plants to come on line so the average selling price drops, helping your margins, which has been the case for many years in this market and is a main reason why personal computer assemblers could, at times, make so much money.

But if you are stock investor it's all very different. You can't wait for that marginal plant to produce that marginal drive that flips pricing and crushes the average selling price. You have to anticipate that one or many of the commodity players will say "we are going to expand." You have to get out of a commodity stock that's been red hot either right before or during the utterance of those words because you are now in a high-stakes game of chicken. Pros know this. Rookies are oblivious.

Now, experienced hands who trade and invest in commodity stocks know that there are mitigating factors. Some companies, like Micron, might be low-cost producers. Others might be consolidators that are busy actually taking out capacity instead of adding to it, which is what Micron did when it purchased the desperate Elpida, a Japanese DRAM amalgamation of several semiconductor companies, to rationalize the industry. Another mitigating factor is the possibility of a big economic expansion occurring globally. DRAMs are a global market that can sop up any additional supply, ensuring pricing doesn't fall apart.

All of these possible positives played out for Micron in the last 14 months, which drove the stock from $5 to $21, where it stood before it reported that terrific quarter last night.

Given that I know we are only one "expand" utterance away from a retreat, I cautioned that I wanted to hear the call and admitted to fearing that there might be additional capacity announcements mentioned on the call, either by analysts or the company. Fortunately for Micron shareholders, the company parried every attempt to suggest that pricing discipline could be lost.

That allowed the stock to advance.

As soon as I read the call I knew two things:

  1. Micron can still climb higher.
  2. Every rookie who owns it will be furious that I pointed out what could go wrong and what to worry about.

But here's my bottom line: I've made rookie mistakes. I have corrected them. After a commodity stock goes up four-fold, I know there's a drill and I obey it. This time the rookies got lucky. But don't ask me for an apology. I am just, in the end, an empirical observer of cycles. Right now the cycle continued. But never, ever, overstay your welcome with a commodity business.

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