Dueling Fools: Yahoo! Bear

Usually, in a market with a handful of top players and a bunch of also-rans, the smart money bets on the business in second place. After all, when you're the leader, the only direction you can go is down. Typically, though, only the one immediately behind in the rankings has both the muscle to keep up the fight and the scale to continue growing. As a result, the second-place company is usually best situated to capitalize on its position to leap ahead. That's one reason why legendary General Electric (NYSE:GE) former CEO Jack Welch wanted his company to be No. 1 or No. 2 in every industry in which it competes.

Sure enough, it often works out so that the second-place business is the better investment. You can see why people like to bet on the runner-up when you look at the 10-year total return histories of a couple sets of warring beverage giants:

Over the past decade, perennial runners-up Pepsi and Molson Coors trounced the returns of their respective industry powerhouses, Coca-Cola and Anheuser Busch. For the "second place is the better investment" rule of thumb to work, however, the market needs to be fairly mature. In the wide-open and fast-growing paid Internet search market, however, things are anything but mature.

Consider that in the recent J.D. Power study (link opens a PDF), leader Google (NASDAQ:GOOG) actually increased its gap over No. 2 player Yahoo! (NASDAQ:YHOO). For the second-place firm to be a decent investment, it has to at least hold its own, if not gain ground on its larger rival. As much as I'd like to root for the underdog Yahoo! here, I'd really like to see some sign of life first.

Beware of all things relative
Of course, as my dueling partner Tom Taulli may very well mention, Yahoo! does look dramatically cheaper than Google on several key valuation metrics. The problem, however, is that cheaper is an entirely different concept from straight-up cheap. Throw the "-er" on the end of the word, and you end up in relative valuation territory. That's a dangerous place to be. After all, a company trading at 1,000 times next year's earnings may well be a relative bargain compared with a similar one trading at 10,000 times that same metric. But that doesn't necessarily mean that either one of them is a good buy.

In fact, Yahoo! has looked relatively cheaper than Google for quite some time, but that hasn't helped Yahoo! close the gap. What matters in the long run is how much cash a company can generate for its owners in its remaining lifespan, not how pretty it looks in comparison with its neighbors.

With its most recent earnings report, Yahoo! completely failed to impress me in terms of its long-term future. In spite of a 19% increase in revenue, it managed to see its operating income drop by 25%, cash flow from operations fall by 11%, and net income drop by 38% versus the comparable year-ago period. Add the declining financials in spite of rising revenues to its falling market share, and that earnings release screams trouble. It quite clearly shows that Yahoo! is investing heavily in its expansion, but even with all of that investment, it's moving backwards. That's not exactly a position of strength from which to launch a counteroffensive against its now much larger rival.

No penalty for watching
In spite of its recent stock weakness, Yahoo! still trades at around 32 times its trailing earnings. While cheaper than Google, it's still quite pricy when compared with both the market in general and any number of companies that are actively growing their bottom lines. A turnaround may very well be possible with the launch of its Project Panama advertising platform.

The trouble for investors, though, is that Yahoo! shares are priced as though success is a foregone conclusion. I'd rather wait for evidence of success first before buying. Remember Warren Buffett's Rule No. 1: "Never lose money." There's no penalty for sitting on the sidelines.

Duel on!

• Read the bull argument
• Read the bullish rebuttal
• Read the bearish rebuttal
• Sound off on Yahoo! in Motley Fool CAPS
• Vote for the winner

Coca-Cola and Anheuser-Busch are bothMotley Fool Inside Valuerecommendations. Yahoo! is aMotley Fool Stock Advisorrecommendation. Try out any of our investing newsletter services free for 30 days, and feel free to pick up a Stock Advisor market report -- it won't cost you a penny.

At the time of publication, Fool contributor Chuck Saletta owned shares of General Electric. The Fool has a disclosure policy.