It's been our most controversial holding. We've watched it run up to the sky, and fall back down. It is one of two companies purchased by the Rule Maker Portfolio that was not unquestionably dominant in an industry that had been through at least one business cycle.

It is Yahoo! (Nasdaq: YHOO). And sometime in the next five business days we will be selling our stake in it. This is a bittersweet moment for us Fools, because Yahoo! was one of those companies that held out so much promise. When the Maker bought Yahoo! in 1999, the managers were quite clear in their understanding that the company was not yet a Rule Maker. In fact, it had at the time only one-fifth of the revenues needed to cover the minimum hurdle at the time. Yahoo! was designated as a "Tweener," a company that had moved from the stage of being a leader in an emerging industry to being the hunter of some, but the hunted by others.

The Rule Maker that never was
I disagree with this assessment, though I do have the benefit of three years of hindsight since the original decision. Yahoo! in 1999 was still very much a Rule Breaker, a company that was leading a business revolution that had barely begun. In February 1999, less than 1% of all Americans had made a purchase online. Internet usage was still doubling every six months. There was nothing permanent about the online world. Any lead that existed at that time was still very much nascent. Google, now the undisputed Web search engine, had only just been formed. Remember how we were wondering whether Yahoo! was going to lose out to Excite, Netscape, Lycos, or AltaVista? Not even close. Yahoo! is bigger than these three combined. But plenty of people reading this may not remember these questions at all, because they were not yet on the Web in an appreciable way. That fact in itself is telling.

So, yes, Yahoo! has won the portal fight, unless one defines AOL (NYSE: AOL) as a portal, which is not altogether inaccurate, or if one considers the inroads made by Microsoft's (Nasdaq: MSFT) MSN to be a threat, which they very well may be. But it doesn't seem in review that this was a fight worth winning. Yes, the company is still in the game, but what did that get it?

More to the point, what is Yahoo! going to be when it grows up?

I have an answer to the first question, but it's not really satisfactory. Yahoo!'s win against the other pure portal companies was more of a victory by default, since most are just shadows of their former selves, subsumed into larger companies, and, in the case of Excite, bankrupt.

As for the second one, I have no idea, and I don't think that Yahoo! does, either. And therein lies much of the problem. Although Yahoo! is continually trying to broaden its revenue away from advertising, that still counts as the majority of its income -- 75% in 2001, down from 87% in 2000. Unfortunately, this improvement was much more due to the collapse in the Internet advertising market than significant improvements in other revenue areas. Yahoo'!s revenues in other areas appreciated only slightly. 

So, while I am fond of many of the moves that Yahoo! is making -- including offering co-branded broadband service with SBC (NYSE: SBC) and its recent takeover of online jobs network -- it should be clear that there is nothing definite about Yahoo!'s ability to diversify away its exposure to the advertising business. Yahoo! strikes me as a service in search of businesses it can provide, rather than a business looking for additional services. That's a problem for any company that would be designated a Rule Maker.

In the buy report for Yahoo! we used the following description of the company: "Add it all up and you have a company that is in excellent position to take advantage of an absolutely enormous market opportunity going forward."

Not that long ago, the Internet was viewed as an enormous market opportunity. Seems like a simpler view from simpler times. I think that the Rule Maker's logic in purchasing (and holding and adding to) Yahoo! was pretty strong except for one major consideration: risk. Well, OK, so the words "extra risk" were used, but they were addressing Yahoo!'s position as a not-yet-Maker, and not the fact that the company was priced at absolutely ridiculous levels. Yes, Yahoo! was always quite focused. Yes, its profits were always growing. Yes, its balance sheet was sterling. Yahoo! was being valued at various points in 2000 at hundreds of times earnings, over 75 times book value, and 150 times free cash flow. Take your pick, but the amount of growth that was being assumed was mind-bending.  

A confused, highly priced company
People have snarled at the ridiculousness of Yahoo!'s valuation since the day it went public back in 1995. The company ended that day valued at $1 billion, meaning that people who bought on the day of the IPO and held on still have a solid 10-bagger. But they've taken an awfully circuitous route to get there, seeing as at one point shares that now sell for $18 and change were scratching $250 a stub.

We cannot change history. We can learn from it, and it should help us make better decisions for tomorrow. The issue is not how much we've lost on Yahoo! but what would happen from today forward.

The answer is that I don't know, but I don't particularly like what I see. Last week I discussed a few things that bother me about Yahoo! --  the biggest of which is that it issued more than 10% of its share float in a single year as stock options. I have no patience for this type of dilution, and I have no confidence that big potential stock option dilution will not continue into the future. If they just issued all of those options to account for the massive losses in stock price over the previous year... well, that's worse.

The fact is that like anything, stock is a form of currency. If management prints more of that currency without any additional assets to back it up, it is devalued. When the Russian government ran out of money, Boris Yeltsin screamed, "Well, print MORE!!!" (I'm guessing he screamed in Russian, but what do I know). Yahoo! addressed the loss of wealth among its employees last year by doing the same thing. So, while I would not compare Yahoo! to some Weimar Republic tin-pot economy, I would say that when a company seems to freely dilute its own currency, I -- and all shareholders -- have the option, nay, the obligation, to call them out on it and do it in a way that they understand.

In the next five business days, the Rule Maker will be selling all 106 shares of its Yahoo! position. We will keep this money in cash for the moment, to be deployed soon in some sort of index fund for safekeeping.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann is Senior Editor for The Motley Fool and owns no shares in the companies mentioned in this article. The Motley Fool has a disclosure policy.