FOOL ON THE HILL: An Investment Opinion
There's never been a safe 'Net stock. But Geez, even the big boys, the ones that have been able to garner first mover or big dog status, or even -- gasp! -- profitability have been shellacked of late.
We're not talking about the companies that are well on their way to the slagheap of irrelevance. We're talking about THE growth stories of the Internet. Yahoo! (Nasdaq: YHOO), Amazon.com (Nasdaq: AMZN), eBay (Nasdaq: EBAY), America Online (NYSE: AOL), CMGI (Nasdaq: CMGI).
Each of these companies is down sharply for the year, but none has fallen in the same pattern as the other 'Net companies. Somehow, no matter the short-term froth, these companies are big and powerful enough that they are immune from economics, negative sentiment, cash positions, and everything else that has clobbered the mere mortal dot-coms.
Except it's just not true. It never has been. And investors who parked their money in these companies thinking that they were somehow "safe" are getting a rude lesson showing them the error of their ways. The weakest companies on the Internet are dying a deserved death, but the big boys are now lurching downward behind them.
You know that quote by Ben Graham, about the stock market being a voting machine in the short run, a weighing machine in the long run? Well, welcome to the long run, baby. Questions about the business models of these companies have conspired to knock their market caps down by an aggregate of $240 billion off of their highs. That is 35% more money than Lucent (NYSE: LU), America's most highly valued telecommunications company, is worth.
But Net Stocks Were Never Safe
After the massive sell-offs in March and April, these were considered by more aggressive investors as the "safety 'Net stocks," for all of the qualitative reasons that crushed the others. I hate to break it to you, but eBay, with its current price to cash flow ratio of 330 and price to earnings of 1000+, was never safe. Portfolios that contained several 'Net stocks and then Pfizer (NYSE: PFE) "for diversification" were playing with fire. With even the best companies in this realm, evolving profit centers and maturing businesses made even the most involved valuation techniques really educated guesses.
Over the last few weeks, the business prospects for Yahoo! and Amazon have come into question: first Yahoo's continued dependence upon advertising for more than 80% of its operating revenues, then Ravi Suria, an analyst at Lehman Brothers, called Amazon's creditworthiness into question.
Yahoo!'s problem is that other 'Net companies, some of its best customers, are turning off their advertising dollars as they try to preserve cash. Should the demand for Yahoo!'s advertising stock dry up, its revenue growth could be deeply impacted as a result. Amazon is running up against the problem that it is not profitable and is perceived to be burning through cash, with prospects of profitability far in the distance. In essence, these companies are having to make the transition from being granted huge multiples for the hazy notion of their "potential" to being knocked downward for the uncertainty of the same.
All four of the above companies have a solid benefit that other companies would kill for: enormous aggregated markets. The cost of developing these markets has been huge for Amazon and AOL, not so much for Yahoo! and eBay. But each has taken the practical decision of putting off greater profitability (or profitability at all) for the sake of increasing their levels of aggregation. And since these companies have virtual marketplaces, most of these expenses in growing businesses cannot be capitalized, and thus cannot be depreciated, meaning that they are not recoverable as non-cash adjustments over time.
I'm not the biggest fan of "diversification." In fact, I think it's a recipe for lower overall returns. Rather, I am business-centric, focusing squarely on the company and its prospects for returning profits in the future greater than the current value of the stock. But with 'Net stocks, and I do own them, I've always been cognizant of the fact that the risks were huge. They still are. They're just much more visceral now that blood has been drawn from other companies in the same realm.
It's easy to feel like you've made a good choice when a stock you own runs up into the stratosphere. It is much harder to do so when your portfolio is bleeding red ink. But negative market sentiment also offers the business-centric, Foolish investor significant opportunity for outsized gains.
This flies in the face of the Rule Breaker tenet of finding companies with Relative Strength of 90 or above. It also happens to separate market events from business events. In the end, the market will zig when it zigs and zag when it zags. In a recent article, former Fool Randy Befumo stated it quite eloquently when he pointed out that a few months ago investors were willing to take the long-term view on Amazon, while their scope is currently negative two months, back to the last 10-Q.
OK, They're Risky, So What?
Amazon may succeed or fail, but neither event will happen because investors are being optimistic or cautious. It will happen because the company has the opportunity and ability to create profits from the 14-million customer base it has aggregated. But have no doubt, the chance of it doing so is considerably lower than that of Duke Energy (NYSE: DUK) earning 6% net profits over the next 20 years. Duke Energy shareholders expect bond-like returns on their investments. Amazon investors do not.
There is a larger worry that the weakness in Internet content companies will drag down that of the infrastructure companies. I'd call this a distinct possibility, and would say that the same pattern will emerge in such a case: the weak companies will be shattered first, but even the big boys, Juniper (Nasdaq: JNPR), Nortel (NYSE: NT), and Cisco (Nasdaq: CSCO) may feel the pain of seeing the easy money from Web companies dry up, as sales decrease and bad debt from financing activities increase.
That's the risk, at least. And for companies priced as high as these relative to sales, the realization of such risk could come at a huge cost to shareholders. But this should not be a surprise to investors. You've got to understand in buying huge-multiple, hyper growth stocks that any reduction in that growth will prove painful. So the answer is no, there is no such thing as a safe Internet stock, none immune to economic cycles. But that's no reason not to invest, it's just more reason to be really careful with your money.