Twilight Time

“Never in the history of U.S. capital markets have share prices been swept so far away from their mooring to real earnings,” writes Shawn Tully in the current issue of “Fortune.”

“Fortune,” the same magazine that mocks Ed Yardeni for warning of Y2K, risks the same mockery itself.

Its January issue includes several articles questioning the prices paid for Internet stocks. The articles themselves are interesting. It is also interesting that “Fortune” published them. It convinces me that the moment of truth has arrived. Even the major media is picking up the same themes we have discussed here.

Tully approaches the same point made by Warren Buffett in an earlier interview with the same magazine. Ultimately, “the price of a stock is the sum of all its anticipated future earnings.” There is no other reason to hold a stock. It is just a part-ownership of a business — usually such a small part that there is no hope of ever getting any perks out of the deal, such as an occasional ride on the corporate jet. Money is all there is. So just add it up.

And then compare it with what you could get without taking any risk — from U.S. Treasury bonds. Since stocks are not risk-free, you need to make more from stocks than you would from bonds, or why bother. That “risk premium,” historically, has been about 7%.

Stock prices, therefore, should reflect a rate of return substantially higher than bonds — over the long term. And that rate of return has to be based on the actual anticipated earnings…not on how much some greater fool might be willing to pay tomorrow. The greater fool might be good for a speculation now and then…but you wouldn’t want to count on a fool to finance your retirement.

The Internet and tech stocks make it hard to do the math. Because no one really knows how much money they will earn. Since the slate is clear of earnings, investors have been free to write any fantastical numbers they want.

But though we don’t know how much they will earn…we can look at current prices and see how much they would have to earn to justify them. “Fortune” approached this using two different models, in two different articles…the one by Tully and the other by Geoffrey Colvin. They both arrived at nearly the same figures.

“Take AOL,” suggests Tully, “Its earning have to grow at no less than 39.6% a year from now until 2020 to meet investors’ expectations. For Cisco, the hurdle is 32%.”

Microsoft, meanwhile, would have to earn 10 TIMES what it earns today — and do so forever.

First, you will probably not need reminding that even Microsoft’s present reported earnings are a myth. Take out real labor costs — the stock options that it hands out like popcorn — and the company is not profitable at all.

But, even if it were profitable at the reported level — there is absolutely no chance that it will be able to become 10 times as profitable. A turtle would have more chance of crossing the Los Angeles Freeway in rush hour.

And, need I say it, forever is a very long time. Who knows, maybe one or two of the current crop of Rocket Chips will make it. Maybe they’ll somehow hit revenue and profit levels which would justify their prices.

Colvin’s article looks at the question from the perspective of EVA — economic value added. Philip Morris recorded the highest EVA ever in 1998 at $5 billion. In order to justify its current market value — which is more than GM, Ford and the entire American steel business — AOL would have to repeat the Philip Morris performance of 1998 and do it every year until the end of time.

Well, let us imagine that one or two of the networking stocks mentioned above actually does manage to hit the magic numbers — profits great enough to justify the current stock price. They do this by introducing “disruptive technologies.” It doesn’t take much imagination to see that they themselves will be replaced by other disruptive technologies sometime between now and when the universe collapses into a black hole.

What’s more, there are about 100 of these companies…selling for as much as…uh…1,686 times sales. Only one or two will be successes. So after you figure out how much it might really be worth — you need to divide the price by 50 or 100, to compensate for the risk of choosing the wrong one.

The investment world is catching on to the numbers. The moment of truth has arrived. This is the twilight hour.

…and I have to run.

Until tomorrow,
Bill Bonner
January 19, 1999

The Daily Reckoning