The Internet’s Glass is More Than Half- Full

December 18, 2013

After years of separation, investors have finally rekindled their love affair with stocks. That on-again, off-again romance is definitely back  on again, with billions going back into stock funds each month. Investors' infatuation with bond funds is also ending. Nearly $100 billion have come out of bond funds in 2013. They're just not that enticing anymore.

Does this mean we should expect trouble down the road for the stock market, and if so, what sort?

In our portfolios, we prefer investing more heavily in stock funds when they're scary to investors, not exciting. Slowly but surely, we've been cutting back on stocks ever since the market recovered strongly from the bottom in 2009. Unfortunately, predicting exactly when this bull market will end is difficult, and it would be painful to miss, since the alternatives won't be particularly profitable. We don’t want to end up like those fund managers that stay negative on stock prices for years and fall farther and farther behind while the market goes up and up. 

But we also don’t want to see our portfolios drop more than the market during a major slide the way  many optimists’ portfolios did in 2008 (our model portfolios were down just under 17%, or less than half the market’s slide back then).

Don’t take this the wrong way. We usually prefer stocks. When we launched MAXfunds over a decade ago, we did so primarily to help stock fund investors looking to avoid buying the wrong types of funds at the wrong time. To us, bond funds are primarily a tool to help build lower-risk portfolios and/or partially sit out the stock market when it's close to collapse.

Although we started sounding the alarms too early before the last major slides, we did call the major problems in the markets and economy that would ultimately cause the trouble – growth and tech stock and stock fund overvaluation and proliferation in 2000, and an economy built on a real estate bubble in the mid-2000s. Our Aggressive Growth portfolio (sign up here to follow it online for FREE) wouldn’t be up about 230% since inception (from 3/31/02 to 12/17/13) if we hadn’t.

It's more likely that this bull stock market will simply end in low, yet positive returns each year for a while as fundamentals catch up with prices, with no major 50% slides along the way. 

There are many possible ways this economy or market could come unglued. Let’s look at one possible end to the good times.

Another Dot Com Crash?

The U.S. technology sector, specifically the Internet companies, is leading the U.S. economy and stock market. What other country is even close to minting as many billion, ten-billion, hundred-billion and eventually trillion-dollar businesses just a few years after startup? It's truly something amazing in our economic history, up there with the Industrial Revolution, even more so because we own this one.

But will the party screech to a halt  again, as it did in 2000 when a whole swath of promising dot-coms either went out of business entirely or fell 90% in price? A decade ago, post-dot-com crash, late 1990's stars like Priceline(PCLN) and Amazon (AMZN) were trading in the single digits; now they're in triple and quadruple-digit territory. 

The first dot-com bubble was built on sky-high valuations with the promise of a golden future as businesses monetized the eyeballs. The profits would follow the users. When the profits didn’t materialize fast enough, investors ran for the exits. 

Ironically, the promise was spot-on. It was possible to monetize all of that Internet traffic. The user growth did continue by leaps and bounds, driving ad rates back up. This is in stark contrast (perhaps…or it has yet to be seen) to the alternative energy bubble of a few years ago.

And yet losing 90% of your money in a diversified tech portfolio with experts making the investments was common in that great revolution. Consider it a warning of how risky investing can be. Even when the story's right, the timing and valuations can still be a little off. 

To put it simply, the first tech boom crashed because the expected profit growth didn’t happen soon enough for stock investors (supposedly, long-term investors) once their optimism turned to pessimism. One wonders how many technology companies could have been the next big deal if their backers had only kept the lights on a few more years. Could Pets.com have made it?

The current technology boom is built on profit growth – massive profit growth. But what if the next technology collapse happens because industry profit growth stagnates, or even shrinks?

Much of the new boom is built on online advertising, a revenue stream that took off after Google popularized the once-questionable business model of paid search results, or re-branded, contextual advertising. 

The revenue growth here is what is driving hot IPO's like Facebook (FB) and Twitter (TWTR). Internet advertising was supposed to support the first boom, but ad rates plunged when online ad inventory growth exceeded ad spending and creating that inventory began to cost more than the inventory could be sold for. It was like drilling for oil at a cost of $75 a barrel and then watching oil fall to $25.

What if online and "app" ad rates plummet again, year 2000-style, from a glut of content options built as before with very easy startup financing? What if this time, rates don’t plunge, but we hit an online advertising ceiling? What if the margins selling the space decline from fierce competition?

Internet advertising has been growing by about 20% each year for over a decade, with mobile advertising now up by near-triple digits. When Internet-based advertising hits its eventual GDP market share boundary, it will begin to grow with the economy more at a rate of perhaps 5% a year of nominal, non-inflation adjusted growth. 

Could it grow faster forever? Only if we spend less on say, energy, healthcare, housing and the other major components of the economy and spend more on advertising. Internet advertising won’t make the economy grow significantly faster, or make us choose cheaper homes so we can buy more apps and stuff online.

Can the Facebooks, Googles, and Twitters of the world handle a top-line growth rate of 5%, even if it's still a few years away?

The U.S. economy is just under $16 trillion dollars. Total U.S. advertising of all types is approximately $170 billion — about 1% of GDP — and it moves more or less with the economy. Fast-growing Internet advertising is now around 25% of this total (up from less than 5% during the original dot-com boom).

Radio, billboards, and television aren’t disappearing, although their days of rapid growth are behind them. They'll  always collect a fair share of ad dollars, no matter how successful Twitter becomes at  monetizing the tweets. Newspapers have seen major ad revenue losses to Internet-based advertising, but that cannibalization growth will eventually end.

How profitable can online advertising dollars be for the companies that sell it? Could a fat 25% profit margin — slightly higher than Google or Apple today, and among the highest profit margins of all large businesses in history— be a future limit? Salaries for software engineers are high, and companies like Yahoo (YHOO) have to buy other companies at high valuations just to stay relevant. All of this lowers profit margins. In all likelihood, profit margins will decline.

Let’s say 75% of all advertising goes digital in the future — a wildly optimistic assumption, given TV's huge roughly 40% share now — or about $130 billion a year in revenues to the merchants of Internet ad space. With a 25% profit margin, that would generate about $30 billion in profits.

Fifteen . That's the possible future price-to-earnings ratio of a large tech company with less growth potential once advertising growth taps out. That's higher than Microsoft or Apple today. 

With a 15 multiple on earnings, you get a total market value of $450 billion. In other words, if one company sold all of the digital ads at a 25% profit margin, and that stock traded at 15 times earnings because Internet ad sales were already 75% of total U.S. ad sales, including Super Bowl ads and billboards, you’d have a $450 billion market value – not far from Google’s $350 billion value today.

But what about other ways to make money, like selling apps and other software? I’m not so sure Twitter and Facebook are going to have a Google-grade future beyond ad sales. Well then, what about foreign markets? Global ad sales are $500 billion (less than 1% of global GDP,) and just as McDonald's (MCD) earns much of their profits abroad, we’ll earn money from global digital ad sales. We’re also dominant in tech, even more than fast food. 

Okay. Say our tech companies earn half of all global ad sales online – total domination. And they earn it at a 25% profit margin. That’s 50% of $500 billion at a 25% profit margin and about $60 billion in profits. At 15 times earnings, that’s just under a trillion in total market cap. 

Facebook is now $130 billion, Google $350 billion, recent IPO Twitter $30 billion, and Yahoo at $40 billion. There are hundreds of private Internet-based businesses worth tens, if not hundreds, of billions, all getting in on this ad sales action. We’re basically two-thirds or more of the way to a trillion-dollar market value for those primarily in the Internet advertising revenue business. How much upside could be left for investors?

That doesn’t mean someone couldn’t create a cool new app or website in their dorm room and turn it into a $100-billion dollar company in a few years again. In fact, that may be easier to pull off now than it's ever been. What it means is that they'll be stealing it from an established player once the online ad ceiling kicks in. This is already taking place. How much ad space has Facebook stolen from Google? Google from Yahoo?

It's possible that the online ad ceiling may have already kicked in and investors just won’t realize it for a few years. Could a tech crash 2.0 take the whole market down? Why should McDonald's have to tank just because Facebook does? It might not tank as much, but if Google and the others fall to 10 P/E ratios because of slow growth fears, why buy McDonald’s at 20 times earnings for growth that's just as slow? 

We’d probably see a 50%+ slide in tech stocks and a 25%+ slide in "value" shares, nearly as bad as the 2000-2002 market, only with fewer "fantasy" companies with no real profit potential simply disappearing from the marketplace. It will be a tech valuation compression, not one that wipes out more than half of the companies in business.

Didn’t this already happen to computer sales, once a limitless growth area of 50 P/E ratios? Facebook will be the next Dell when online advertising growth eventually slows.

This slowdown risk exists even before you factor in the highly competitive nature of most pure Internet-based business models. Facebook investors must always be prepared for Facebook to become the next Friendster or Myspace, or even GeoCities, for that matter. 

McDonald’s and ExxonMobil (XOM) are much less likely to get wiped out in a few years by a new competitor. It really doesn’t matter to McDonald’s investors that Buffalo Wild Wings (BWLD) is doing well. No solar upstart is going to wipe out Exxon in a few years. 

Factor in stalled topline growth options in digital ad sales, potentially lower ad rates, and a highly elevated risk of competitive disruption, and you have a recipe for a P/E ratio lower than the market. That’s a long way from 25 – 50+ P/Es in tech now.

You can only stuff so many digital ads into a person’s brain in a day. Just like you can only get so many Coca-Cola products into the American stomach. When that day nears, the valuations will come down.