Internet / Electronic Commerce – 9 March 1999
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premise: an inexhaustible supply of future riches to be
transported to England from South American gold and silver
mines. Never mind that throughout the bubble, the alleged
riches were owned not by the South Sea Company, but by
the King of Spain, who had no intention of allowing anyone
to ship them anywhere but Spain. The tulip bulbs bought
and sold during the “tulipomania” in the Netherlands in the
1600s had no more inherent value or impact on the world
economy than Furbies, Cabbage Patch Kids, and Beanie-Babies
do today. The biotech stocks of the early 1990s
promised a revolution in medicine and agriculture, but were
true “concepts” that, even if successful, were unlikely to
affect many other industries. In our opinion, there are good
reasons for investors to pay through the nose for the leading
Internet stocks.
The Internet stocks have always seemed absurdly
expensive (and the valuations are indeed eye-popping),
but for several reasons we believe they are more valuable
than most people think. Stocks go up or down not
because they are trading at particular multiples of
published projections but because, for a variety of reasons,
investors decide to buy or sell them. As implied above, we
believe that the leading Internet stocks are “valuable” as
portfolio investments for reasons that have little to do with
precise projection and valuation of future cash flows
(including actively putting your money where the growth
is or defensively moving it out of harm's way). For
several reasons, moreover, we believe that even when
viewed through the lens of a more rigorous valuation
framework, the stocks are worth more than a casual
observer might think. These reasons include: 1) that no
one knows with any degree of certainty what the future
cash flows will be or what the real risk associated with
them is (the leading companies have been blowing away
expectations from the get-go); 2) the potential for
unprecedented returns on invested capital, which will
ultimately equate to higher P/E multiples), and 3) benefits
from the “network effect,” through which franchises are
made more valuable and sustainable with every new
customer or supplier they add.
With these types of investments, we would argue that it is a
mistake to be too conservative in projecting future
performance. Yahoo!'s valuation is ridiculous, right?
Well, if you believe the projections that suggest that Yahoo!
will earn $0.47 next year, it looks pretty ridiculous, yes.
Yahoo! has dusted estimates for the last ten quarters,
however, so it seems likely that the $0.47 might be
conservative. How conservative? We don't know. But
consider the following: When Yahoo! went public, it looked
like the biggest joke in history—a list of web sites with $1
million in revenue and a $1 billion valuation. Investors the
world over (understandably) crowed about manias and
insanity, but Yahoo! was actually trading at an absurdly
cheap 10X Q4 1998 annualized earnings. Investors who
failed to ask themselves two questions—1) how big the
company could actually be, and 2) how fast it could get
there—missed the boat.
Wit h these types of investments, we would also argue
that the real “risk” is not losing some money—it is
missing much-bigger upside. Investing in hyper-growth
stocks is not about preserving capital (that's what bonds
are for); it is about making sure that you are on board the
train if and when it leaves. If you are long any equity and
if you are one-hundred percent wrong and the stock goes
to zero, you can lose 100%. When the long-term upside is
only 20%-30%, 100% is a disastrous loss—and the
risk/reward ratio is poor. When the upside is 300% or
more, however, the possibility that any individual
investment in a balanced portfolio will to zero isn't as bad.
We do not entirely agree with Alan Greenspan that buying
high-quality Internet stocks is like buying a lottery ticket—
we don't believe the odds are that bad—but we do agree
that many skeptical observers of the sector have the wrong
mindset. We would argue that in this sector, the real “risk”
is not that you lose money if the sector corrects, it's that
you miss a potential 3X-10X upside.
Whether or not the stocks are “overvalued,” we do not
believe that valuation alone will bring them down. The
most obvious characteristic about Internet stocks is that
they seem frighteningly expensive by classical measures—
but this hasn't stopped the best ones from appreciating
10X-20X from what were already stratospheric levels.
General market pullbacks and sector boom-and-bust spikes
aside (“volatile” ain't the word), we do not believe the
market is going to wake up one morning and decide to
jettison the Internet stocks “because they are overvalued.”
We believe that the broad-based Internet mania will end
when the fundamentals at the leading companies stop
improving, and it is because we don't believe this will
happen in 1999 that we are recommending the stocks.
We believe that what will be left when the gold-rush
finally subsides are a few fast-growing companies with
huge market capitalizations—and a lot of tulip bulbs.
This is one reason why we recommend investing the
majority of an Internet portfolio in the sector leaders; all
Internet trees will definitely not grow to the sky. When the
leading companies finally start missing numbers (or, more
likely, when estimates stop going up), we think the sector's
multiples will contract significantly. The risk of waiting
until this happens before investing, however, is that there
may be major upside between now and then, and the
“corrected” valuations might be compellingly higher than
today's. In our opinion, when the Internet stocks finally
look cheap, they won't be worth owning anymore.
It is important to keep in mind that a major driver of the
Internet stocks is an imbalance of supply and demand.
The price of any good or service is determined not by its
inherent “worth” but by the law of supply and demand--and
good Internet investments are in short supply and great
demand. As described, we believe that there are
compelling reasons for investors to invest in the Internet
(demand), and, unfortunately, a relative paucity of great
opportunities through which to do so (supply). If you want
to live in Manhattan—an experience that many reasonable
people would consider less than worthless—you have to
pay mind-boggling Manhattan prices. If you want to
invest in the stocks of companies that appear to be on their
way to becoming the leading growth companies of the |
