An Investment Opinion by Louis Corrigan
FOOL ON THE HILL: Internet Insanity Redux
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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.
CONFERENCE CALLS
~~~~~~~~~~
Please see the Motley Fool's
Conference calls page
for call information and links to synopses.
Yi-Hsin Chang (TMF Puck), a Fool
Brian Graney (TMF Panic), another Fool
Alex Schay (TMF Nexus6), Fool, too
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Contributing Writers
Brian Bauer (TMF Hoops), another Fool
Jennifer Silber (TMF Amused), Fool at last
Editing
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