LOST IN SPACE by James Grant [Grant's Interest Rate Observer, March 26, 1999]
"To own a company like AOL," a portfolio manager recently advised The Wall Street Journal, "you had to throw out traditional measures of valuing companies. We had to say we have to own what we think is the dominant franchise in the Internet. It was a space that as a money manager you simply have to be in."
Here's a new theory of investment psychology: the compulsion to join a mass movement leads not to tears, but to profits. Needless to say, the author of this hypothesis did not express his motives in terms of personal capitulation. Rather, he mused on history. As a matter of course, he stated (he will thank us some day for not naming him), revolutionary technologies command unprecedented valuations. Railroads in the nineteenth century and radio in the twentieth were the examples he vouchsafed for the Journal's readers.
We have some different examples for the readers of Grant's, who by now may be wondering why the front page of this interest-rate journal is not devoted to the AT&T bond issue, the biggest corporate debt offering of all time. The answer (on which we elaborate elsewhere in this issue) is that the stock market these days is bigger than the bond market and, indeed, almost everything else under the sun. As the great bull market goes, so goes (at least for the short term) the U.S. economy.
Concerning the theory advanced 'in the Journal, a preview: it's a quarter true, or at best three eighths. True, revolutionary technologies and structures tend to command ultra-high valuations. But, as far as we have been able to discover, never were companies holding revolutionary promise
valued at anything like today's multiples. Andrew Carnegie, no mean capitalist, accepted a price for his steel company equivalent to 12 times earnings In 1901 (a time of 2% government bond yields, by the way), during the creation of the United States Steel Corp., the greatest amalgamation LIP to that time. Maybe he sold too cheap-it was thought that J.P. Morgan would have paid t4 timesbut nobody was prepared to entertain 3,324 times, as eBay is valued today. The 1999 big-cap U.S. stock market is the all-time valuation Outlier.
Joshua Kahn, deputy staff historian at Grants, went to the library to get the facts. He investigated Radio Corp. of America in the t920s (not forgetting the Meehan pool, the manipulative actions of which anticipated the Internet chat room), Xerox Corp. in the 1960s and Apple Computer in the 1980s. As for RCA, he discovered, the top p/e multiple it commanded in the Coolidge boom was 73, in 1929. In 1922, the first year of considerable earnings growth, it was quoted at 22 times; in 1925, it fetched 59 times. "RCA paid no common stock dividends," according to The Crash and its Aftermath, by Barrie A. Wigmore, "it was highly leveraged with less than 40% of its capital structure in the form of common equity, it was expanding rapidly through acquisitions, and it had pronounced promotional tendencies. RCA was the darling of the 1929 stock market with the biggest trading volume on the NYSE...."
With the introduction of the drycopying 914 Xerox copier in 1960, a great growth stock was born. Forbes looked back at the phenomenon in 1965: "In 1960, sales spurted 17%, net income 25%. And then, whoosh! Sales jumped 66% in 1961 to $61 million, nearly doubled the next year, climbed a further 53% in 1963, did the same in 1964 and will be up about 50% this year." In five years, Xerox's sales jumped to $400 million from $37 million, while its profits leapt to $2.75 a share from 13 cents a share. Those earnings were exuberantly capitalized - as the table on page two points up, the stock commanded triple-digit p/e multiples in the early, revolutionary portion of the decade and lower multiples as the technology matured. By 1975, a plain and dowdy copier company was valued at 21 times trailing net income.
As for Apple, relates Kahn, "it was, like RCA and Xerox before it, awarded magnificent valuations when it burst onto the public market with its revolutionary product, the Apple 11 personal computer, in 1980. In 1981, Apple's stock reached a high of 34 112, sending its p/e ratio to 49 times (144 times on a trailing basis) and its p/b ratio to 11 times. As Apple grew by 50%, 60% and even as much as 70% in the early 1980s, its p/e remained above 30 times." By late in the 1980s, Apple's multiple had dwindled as the PC market shifted.
Which brings us to 1999 and to the "(Investment) space that, as a money manager, you simply have to be in." Unique to this technological revolution is that the revolutionary product is not demonstrably profitable. Amazon.com is famously earningsfree, and Yahoo! and eBay command multiples of price to sales far greater than any p/e ratio accorded RCA, Xerox or Apple in their prime.
"These valuations," says Fred Hickey, owner and editor of The High Tech Strategist, "have never been seen before.... Look at America Online.... It has nearly $150 billion of market cap now, including the Netscape shares. We've never seen anything like that. It doesn't have any book value whatsoever....
"There's never, ever, ever, ever, ever been anything like this - ever," Hickey emphatically continues. "No technology. Never. In 1990, when Microsoft and Intel were monopolies and the PC market was less mature, the market caps at those market lows were $5 billion for Intel and Microsoft." In other words, Hickey observes, AOL - the company whose space you have to occupy "as a money manager" is priced at the equivalent of some 15 times the combined market valuations of Intel and Microsoft as recently as 1990.
What's different about this technological revolution, perhaps, is that it has revolutionized speculation as well as commerce. We say, bring on the counterrevolution!