Internet Insanity Redux
The Motley Fool - July 10, 1998 18:29
KTEL AMGN DIS MSFT AOL AMZN YHOO KO IOM V%MFOOL P%TMF
July 10,
1998/FOOLWIRE/ -- Whenever I write about Internet companies, readers
chastise me for failing to warn individual investors of the risks. So to
address what's so obvious that it sometimes goes unsaid, here's a word about
risk.
The market is a voting machine, not a weighing machine, as Ben Graham
famously said. It does not work like a scale to spit back a precise
measurement of a company's worth. Rather, it gives you a daily tally of how
the people, some driven by blind emotion, are voting. But even when the
majority of voters favor, say, the death penalty, that doesn't make it
right. Serious investors must operate with their own scale comparing a
measured view of reality with the sometimes intemperate view of the
populace. That means you shouldn't buy a stock that you believe to be
overvalued (or have no idea how to value) simply because you think it will
go up. That's the proverbial greater fool (small f) theory: a stock's price
today may seem nutty, but someone even nuttier will pay you more for it
tomorrow.
In buying an ownership stake in a business, you want to pay what it is worth
in economic terms. When too many people ignore this goal, the madness of
crowds begins to exert its inexorable logic. Momentum investors jump on
simply because a stock is rising. Folks who have made a killing margin their
accounts to buy more stock. Others late to the game pay any price to get a
piece of the action. That's why a stock's price can go straight up. While
sophisticated speculators may play this game with a certain degree of
cynicism and skill, the game only works if there's a large contingent of
market participants who don't know any better, who are oblivious to the
mania in which they're participating, who will insist that a stock's rise
makes sense, that stories of tulip bulbs and South Sea Bubbles are
irrelevant.
Yet, if you take a tour through our Daily Trouble archives, you'll find that
stocks that go straight up do indeed collapse. Drops of 50% to 75% from the
highs are fairly common. Look at a chart for Iomega (NYSE: IOM) or the
recent action in K-tel (Nasdaq: KTEL). An implosion can be swift as
speculators become literally spent. A correction turns into a full-fledged
reversal as margin calls lead to more selling, which leads to more margin
calls. Major ugliness. Many companies working the broad Internet space have
been touched by mild to full-fledged versions of this mania, and the end
result is predictable enough. Even the very best businesses, the ones likely
to be giants ten years from now, can easily see their stocks sliced in half.
People investing in Internet-related stocks who aren't aware of this risk or
don't know the reference to tulip bulbs should seriously consider selling
these stocks until they understand better what they're doing.
That said, I'm often equally astonished by the ridiculous comments coming
from the bears and skeptics. For example, anyone who says to you that what
goes up must come down is simply lazy and undiscriminating. K-tel at its
high was more overvalued than any of the tier one Internet companies will
ever be because it simply doesn't have a meaningful future as an Internet
business whereas other companies, however overvalued, actually have terrific
businesses. That's why its stock will continue to fall and will eventually
stay down and others will likely correct but eventually provide value for
shareholders who didn't pay too much. Physics has nothing to do with it.
Let's look at a few other common remarks.
The Internet frenzy is like the biotech mania of the '80s. To a limited
extent, this analogy works. Out of dozens of hot biotechs, only a handful
have become an Amgen (Nasdaq: AMGN), whereas most have disappeared or will
eventually. Many smaller outfits with one real product have been taken over
by major pharmaceutical companies. Similarly, giants such as Disney (NYSE:
DIS) and Microsoft (Nasdaq: MSFT) have already begun snatching up viable
small fry in the Internet space.
The analogy breaks down, though, in that the leading Internet firms already
have hundreds of thousands if not millions of customers and are generating
healthy revenues and sometimes actual profits. By contrast, getting a new
drug to market takes, on average, about seven years and tens of millions of
dollars. Potential drugs are often derailed along the way by poor trial
results, a thumbs down from the FDA, or lack of money. Moreover, most
approved drugs fail to match early sales projections due to side effects,
competition, reimbursement troubles, and so on. In the land of high-risk
investments, many Internet companies are infinitely preferable to your
standard biotech because it's much easier for the average investor to know
what she's buying, to use the product, check out the competition, and
consider meaningful financial results.
These stocks are so overvalued, they're screaming shorts. This comment is
often based on a stock's eye-popping price-to-earnings ratio or lack
thereof, as if earnings for a young company were a sufficient measure of
value. They're not. More important, valuation is never a sufficient reason
to short a stock. In shorting, you must be able to borrow shares and to hold
onto your position even if the stock rises against you. Many Internet stocks
have a small float of actively traded shares, making borrowing and holding
the shares difficult. What's more, the Internet is a classic open situation
-- meaning that the very difficulty of arriving at a proper valuation means
that it's hard to know when these stocks are really overvalued or, more
important, when a marketplace fed by mania will reach the inflection point
at which the stocks will fall.
Smart short-sellers need a thesis for when and why a stock will fall. The
irrational risk-taking of some short-sellers has contributed to the very
Internet mania they mock. I personally don't think any of the tier one
companies -- for example, America Online (NYSE: AOL), Yahoo! (Nasdaq: YHOO),
or Amazon.com (Nasdaq: AMZN) -- should be shorted at any price. Sensible
shorts have stuck to third-tier companies with poor prospects and
significant floats.
The valuations are all crazy. Valuations may seem sky high, but they're not
all crazy if you take the trouble to understand each company's market niche
and business model. The market is forever trying to move to a price that
discounts all a company's future free cash flow by way of a risk-adjusted
rate of return. Applying this imperative to an industry in hypergrowth is a
process fraught with risks of miscalculation that more mature businesses
don't present. Yet generous though reasonable assumptions about long-term
prospects can justify prices that may initially seem absurd.
Consider Yahoo!, whose ultralight business allows it to generate gross
margins of 88.5% versus 22% for online retailer Amazon or 34% for souped-up
Internet access provider America Online. While one could argue about how
"sticky" each company's customer base is (how high the costs are to a
customer for switching from one of these companies to a competitor), it's
clear that Yahoo! could eventually deliver extremely high operating profits.
Indeed, a 36% jump in revenues from the first quarter of this year to the
second led to a 151% surge in operating profits as margins leaped from 12.1%
to 22.3%. With the cost of online ads rising and overall online ad spending
growing, Yahoo!'s ad/commerce revenues should continue to soar, boosting
operating margins along the way.
America Online's ad/commerce run-rate is about $500 million a year. Though
Yahoo! is far behind AOL in that area, its reach seems comparable. Imagine,
then, that Yahoo! can do $1 billion in revenues by 2001 with Intel-like
operating margins of 50%. Assume a 35% tax rate, and the company would
deliver $325 million in net income. Divide that by 65 million shares and you
get $5 in earnings per share. Now paying 36 times guesstimated FY01 earnings
may not sound like a smart move. In fact, I wouldn't do it. But it's not in
any simple sense ludicrous. Indeed, it's about what Coca-Cola (NYSE: KO)
trades for today.
-- by Louis Corrigan |
