We're about to turn the page from December to January, an event once again marked only by excessive consumption of champagne and the wearing of silly conical hats (someone please find out who makes those things and sell the daylights out of them). Only a scant three years ago, however, we were involved in the most overwrought calendar-flip of all time, Y2K. In retrospect, the acceleration of technology spending going into this pseudoevent was one of the most important contributors both to the tech bubble and its subsequent bursting, but all we could focus on then was whether elevators would, for reasons still not clear to me, get stuck.
Nothing happened then, and while I didn't think anything would, Dec. 31, 1999, fell on a Friday, and I had a column for TheStreet.com to write for the following week. Better get it done before the universe inverts on itself and we all plunge into a space-time warp, I thought. Besides, the market closed early that day, and I had nothing better to do. The topic I sat down to write about was whether we had lost our collective minds regarding the Internet. While my initial thesis was that the market was in need of a cold shower, I switched arguments as I started to write. The resulting column likened the Internet sector's valuations to a long-term call option on an industry, and it concluded that while any one individual stock, Yahoo! ( YHOO), for example, was overvalued hopelessly, betting against the entire sector was dangerous. The logic of buying the sector had been demonstrated in software. In 1986, spreadsheets were dominated by Lotus Development, word processing by Word Perfect, databases by Ashton-Tate, networking by Novell ( NOVL). Microsoft ( MSFT) dominated only the PC-DOS operating system. But if you bought Microsoft then and held it, you could have prospered considerably throughout the 1990s as your various other software holdings dropped off the radar screen. You didn't know which stock would win the software game, but the bet of the software industry growing was pretty safe.
After the Train WreckSo far, that logic hasn't held. Even though the Internet is a much bigger part of my life (and I suspect yours) today than at the height of the farce, Internet stocks have benefited only the most aggressive shorts since then.
Let's compare the sector with the broad market. TheStreet.com's Internet Index measures the Internet sector. This group contains giants such as Microsoft, IBM ( IBM), Cisco ( CSCO) and Oracle ( ORCL), as well as troopers such as eBay ( EBAY) and Amazon ( AMZN), along with high-profile flotsam such as AOL Time Warner ( AOL). The Russell 3000 represents the broad market. The relative performance should surprise no one.
All call options are characterized by a limited loss feature. As the joke runs, that's all you can lose, and I'll guarantee that you'll lose it. The relative performance of the DOT to the Russell over the past year suggests we have realized the maximum loss. What will it take in earnings growth to justify Yahoo!'s price, and should anyone be willing to, once again, buy the entire sector in hopes of extracting a glistening pearl from a humble oyster?
Can Yahoo! grow so rapidly? Probably not, and I haven't seen anything over the past three years that would indicate the Internet industry can grow at such a pace, either. So, should we load the cannon and point it at Yahoo!'s head?
The 0.66 number for Z corresponds to a probability of 74.7% that Yahoo!'s earnings won't grow that much. Convert this number to odds, 0.747/(1 - 0.747), and we find that we only have odds of 2.96:1 of winning our bet against Yahoo!.
|It Can't Go Lower, Right? |
Trees Grow to the Sky, Don't They?At the close of business on Dec. 18, 2002, Yahoo! was selling at 110.53 times expected 2003 earnings, which translates to an earnings-to-price ratio of 0.905%. This number can be compared with the 4.034% yield on the 10-year note, which also is an E/P. The analyst consensus for Yahoo!'s long-term growth rate was 23.34% a year. At year-end in 1999, the comparable numbers were an expected P/E of 983.38 and earnings growth of 56.06%, so some measure of reality has descended upon the land. A one-year call warrant's volatility was at 70.1%, comparable with the 1999 number. The estimated P/E of 110.53 implies average annual growth of 41.567% for 10 years.
|Earnings Growth Required to Justify Yahoo!'s Multiple |
The BetIf Yahoo!'s earnings did in fact grow at 41.567%, the company's earnings would be 31.33 times as great at the end of 2012 as they are today. If we plug these numbers into the rangebound formula below to see how many standard deviations, Z, we would have to move from the current price to get 33.1 times current earnings; we can solve for Z = 0.66.
The key to this surprising conclusion is Yahoo!'s high volatility, which increases the probability that we will move outside of this bound. If we lower the volatility to the 41.9% seen on the Nasdaq 100, the odds of Yahoo! staying inside this bound increase to 6.72:1. A successful bet against Yahoo! or any other Internet stock so situated requires a belief that the market is overestimating both earnings growth and volatility. If we extend this premise from Yahoo! to the sector as a whole, we see that the portfolio argument -- buying the group as a call option on an industry -- still holds. Even better, the members of the DOT or any other Internet index are battle-tested survivors at this point, not the cold-pizza-and-foosball crowd of 1999. Three years ago, betting against the Internet won. That bet is not likely to be as good today.