Internet Outsider

Shameless Book Promo

Apologies for going off topic again, but the Goldman bonus discussion seemed to strike a chord, so perhaps this one will, too.  Also, many of you have asked about the book I was writing last summer, and there's finally news on that front.

The book is called The Wall Street Self-Defense Manual, and I believe it is finally available on Amazon and elsewhere.  I've published some excerpts on the book's web site, and Slate ran a couple of additional excerpts last week (here and here).  My publisher has also kindly allowed me to provide a downloadable PDF preview of the Table of Contents, Introduction, and Chapters 1 through 3.  To download this Preview, please click the link at the bottom of this post.

The first Slate excerpt shows why the average mutual fund will cost you approximately half of your potential retirement nest egg over 50 years.  The second excerpt argues that most ordinary investors should not buy hedge funds, a position that earned a predictable blast from some hedge-fund industry boosters.  As a result, I am now engaged in an online debate with fund-of-funds manager Ed Easterling on www.HedgeWorld.com .

The premise of the book is that the biggest risk to most investors' returns is not market crashes but the lack of a big-picture framework with which to make intelligent investment decisions.  Put differently, most investors know a lot more about how to intelligently buy a car than they do about how to intelligently select a mutual fund or construct a portfolio.  Because investors don't know these things, they are likely to follow bad. inappropriate, or irrelevant advice, buy inferior investment products, and/or fall prey to the biggest investment risk of all--their own emotions.  The goal of the book is to dispel some of the myths that permeate 90% of what one hears about investing, arm one with the knowledge necessary to avoid expensive mistakes (some of which are so common and accepted that they aren't recognized as mistakes), and, thus, help one invest more intelligently.

One warning: The book doesn't offer any secret tips on how to pick stocks.  Rather, it argues that most small investors should never pick stocks (or, for that matter, actively managed funds), and explains why not.  The mere suggestion of this often sends some people into apoplexy, so perhaps we will get some good counterarguments here.  In any case, if you have the time and inclination to read the book, I thank you in advance, and I hope you enjoy it.

Thanks again for the patience w/r/t the slow posting over the last few weeks.  I'll now try to get cracking again.

Download wall_street_self_defense_manual_preview.pdf

Blue Nile Disses Search; Evidence Mounting

Jeff Matthews has an excellent post on Blue Nile's Q4 comments about irrational search pricing.  Like FTD, Blue Nile missed Q4 and blamed keyword price spikes.  Also like FTD, Blue Nile plans to shift marketing dollars offline.

Yes, this is anecdotal.  Yes, it's just one vertical (make that two).  Yes, we've heard anecdotal reports of irrational keyword pricing for 18 months.  Yes, there will always be naysayers, and, no, this doesn't prove anything.  But even Google fanatics will surely agree that it's hard to spin it as positive (except for the near term--see below).

As Matthews points out, moreover, for at least one search customer, it suggests a fundamental and profound shift in search trends.  Blue Nile CEO Mark Vadon didn't say "We've always thought search was overrated.  We've always thought prices were too high."  He said (effectively): "Until now, we have advertised almost exclusively through search because it was the most cost-effective vehicle around.  Now, prices have increased so much that it's no longer cost effective.  So we're going to be pulling our search dollars and spending them elsewhere."

Two key points:

First, assuming the conditions Vadon describes apply to more than Blue Nile and FTD, this is good for Google in the short-term.  What it means is that Google's recent (and, perhaps, current) results have been inflated by an influx of irrational keyword bidders, which has driven up both revenue and profits.  This suggests that Google's recent results--like those of most online advertising companies in 1999--have been better than they would have been in a more rational environment (including the disappointing revenue growth of Q4).  It also suggests that, when the fever subsides, Google's results will return to trend--again like those of most online advertising companies from 2000-2004--as many of the irrational bidders irrationally bid themselves out of existence. Because investors almost always extrapolate future expectations from recent results, moreover, this means that expectations for the next few quarters could still be too high.

Second, we will never have proof that keyword prices are topping out (or, worse, have overshot) until it's too late.  Unfortunately, until the uncertain present has become the always-obvious past, all you get are data points.  So suffice it to say that, if keyword prices have overshot, what we are seeing is exactly what we might expect to be seeing: Anecdotal evidence and plummeting stock prices (someone always knows--just not you)

Thanks to an IO reader for the tip...

Google: Fun While It Lasted

The early brouhaha about an "earnings miss" seems overblown, because much was attributable to the company's gift of $90 million to the Google Foundation and a spike in the tax rate.  This said, expenses did jump--sales and marketing especially.  Despite the marketing juice, moreover, revenue suffered the first real deceleration in a year, and more probably lies ahead.  Most importantly, for the first time since Google went public, it failed to exceed the Street's printed revenue estimates.  This suggests that near-term investor expectations have finally exceeded reality.

With respect to deceleration, the main revenue drivers over the past year have been: 1) Google Sites, and 2) International.  Year-over-year growth of Google Sites revenue had been screaming along at 110%-120% for the last four quarters.  This quarter it dropped modestly, to 107%.  While this was truly a modest drop (and still amazing performance), it came despite the company's having a full quarter of "3 term" instead of "2 term" links at the top of each search page.   International, meanwhile, had posted year-over-year growth of 130%-150% for five straight quarters through Q2.  Q3 was 120% and this quarter 102%.

One likely cause of the deceleration, in my opinion, is market saturation: After five spectacular years, the company may finally be picking the last of the low-hanging search fruit (virgin queries).  Eventually, growth will converge on the product of query growth and keyword price growth, which isn't anything like 100% a year.

When factoring out the Google Foundation gift, Free Cash Flow came in around $500 million, up about 60% year-over-year.  This is an extreme deceleration (Q3 growth was 120%, Q2 600%, and Q1 217%), and it suggests that a $3 billion estimate for 2006--at the higher end of Street expectations--is probably a stretch.  At the very least, it suggests that FCF estimates aren't going to keep rising ad infinitum. 

This, in turn, suggests that multiple compression is probably upon us.  How much?  Given the growth trajectory, 30X-40X seems more reasonable than the 50X the stock commanded a few weeks back.  And that's assuming something nastier isn't lurking over the horizon.

In any event, stay tuned for the winners of the Google Earnings Sweepstakes!

Google Earnings Sweepstakes: Reader Consensus

The readers have spoken. 

In the last day, approximately 25 Internet Outsider readers have entered the Google Earnings Sweepstakes.  I have eliminated one outlier that seemed preposterous (famous last words) and averaged the rest.  Here's what we've learned:

IO Reader Google Q4 Net Revenue estimate: $1.379 Billion

IO Reader Google "Next Morning Open" prediction: -0.006%

The average Net Revenue estimate calls for sequential growth of 32% and year-over-year growth of 111%.  The 32% sequential growth would modestly exceed last year's sequential growth in this period of 30%.  The year-over-year growth would constitute a modest acceleration from the 109%, 110%, and 108% in the first three quarters of the year.  The IO Reader consensus is in line with the highest Street analyst estimate (per Yahoo! Finance) and 7% above the Street consensus of $1.29 billion.

Interestingly, the average Reader Market Reaction estimate is, essentially, zero (-0.006%).  This means that, in aggregate, IO readers think the market is doing what it is supposed to: appropriately discounting the expected Q4 results.  It also means that the true market (or, at least, reader) expectation for the quarter is $1.379 Billion, not the $1.29 Billion that the Street is formally forecasting.  Of course, Street analysts tend to aim low, especially when they like a stock, so it seems reasonable to assume that the IO Reader expectation is pretty much in line with the real Street expectation.

Which suggests that, all else being equal (which it isn't--we're only talking revenue), if Google does less than $1.379 Billion in net revenue, the stock will drop.  If it does the printed Street consensus of $1.29 Billion, the stock will drop a lot (the word "tank" seems appropriate).  If it does $1.379 Billion or more, the stock will rise.  And if it does $1.45 Billion or more--in line with the higher IO Reader estimates--the stock will skyrocket.

What do I think?  I think the IO Reader consensus is certainly within the realm of reasonable.  If you put a gun to my head and made me play, I would put my estimate around $1.325, slightly above the Street and slightly lower than the IO Reader consensus.  I would expect the stock to drop modestly on that (still remarkable) performance.

Given Google's extraordinary performance thus far in its history, it is certainly possible that the company's growth will accelerate on a year-over-year basis, but there is no way I would be comfortable estimating that.  Even suggesting that the company will be able to MAINTAIN its shocking growth rate is scary.  At some point, gravity--and market saturation--will take hold, and growth will slow dramatically (and take the stock price down with it).  The only question is when.

Reminder: I don't own Google and this blog does not contain investment advice.

Hey Google Gamblers! Belly Up To Q4 Craps Table

As Google's recent gyrations have illustrated, the stock is now firmly in the thrall of fear and greed.  Down 9% one day.  Up 5% the next.  Up 2% at 10am.  Down 2% at 11am.  "Eighty times free cash flow--We can't take the risk!"  "Biggest opportunity in the history of the world--We can't afford to miss it!"

Making matters more interesting is the stock's apparently frightening valuation.  No investor in his or her right mind would ever pay 60X forward estimated free cash flow for a company this size, so the (sane) bulls must believe that estimates are still too low and that Google will at least double free cash flow this year and grow it another 50%-75% in 2007 (making the real cash flow multiple a more palatable 30X-40X).  Any hint that Google will no longer blow away Street estimates, therefore, and the stock will tank. 

On the other hand, given the hair-trigger panic demonstrated last Friday, there does seem to be some skepticism around.  As Battelle noted, a Yahoo! search employee has predicted a Google Q4 whiff, and his blog has no doubt been extensively scrutinized by bulls and bears alike (presumably contributing to Friday's panic).  So blow the numbers away again, and the stock will pop.

What's the risk/reward profile?  Probably an instantaneous gain or loss of at least 10%-20%.  Is it possible to get enough of an information edge to make the odds of either outcome better than 50/50?  Given that Google is probably the most-analyzed stock in the world right now, I doubt it.  But this presumably won't stop thousands upon thousands from placing their bets.

So in the spirit of entertainment--which, for those who lack material inside information, is all this really is--Internet Outsider hereby inaugurates the first quarterly Google Earnings Sweepstakes. 

As of this writing, the Street consensus net revenue estimate for Google's Q4 is $1.29 Billion.  To enter the Sweepstakes, please post a comment containing:

1) Your Google Q4 Net Revenue estimate, and

2) Your prediction, expressed as a percent, of where the stock will open the next morning (e.g., "+13%" or "-21%").

To increase the entertainment value, please feel free to share some of your logic.

What do you get if you win?  Glory.  A prime posting of your name and winning prediction on Internet Outsider.  Of course, because market forecasting involves two assumptions--1) fundamentals, and 2) market perception of such fundamentals--the Sweepstakes may have two winners.

Good luck!  May the best soothsayer win...

On Google's Valuation

As Google's stock blasts through $400 en route to ?, it makes sense to revisit the (in)sanity of the company's market value.  And, in doing so, it also makes sense to review what is and isn't relevant to this exercise.

First, what isn't relevant: How much Google is worth relative to other companies, some of which have been around ten times as long.  Yes, it's easy to appall general-interest readers by observing that Google's market value dwarfs that of Time Warner, Verizon, SBC, Viacom, etc., but, in this case, it's also meaningless.  If Time Warner were growing nearly 100% a year and had 35% profit margins and a 100%-plus return on capital, it would have a mind-boggling market cap, too.  And the same goes for everyone else. 

Another thing that is irrelevant: How much Google is worth relative to trailing GAAP net income.  Given Google's enormous non-cash expense of stock-based compensation (the value of which was set back when the stock was $85 instead of $400), combined with its astounding growth rate, ratios based on trailing net income don't tell you much. 

What does?  Ratios based on cash flow.

The first step in calculating such ratios is determining what value the market is actually placing on Google these days.  Based on Q3's fully diluted share count of about 290 million and today's closing price of $416, the answer is about $121 billion.

The next step is getting a handle on current and expected free cash flow.  Google has generated $1.2 billion of cash so far this year, and after a big Q4 (strongest quarter of the year), will probably end 2005 having generated $1.7-$1.8 billion.  This is an absolutely fantastic sum of cash flow for a seven year old company.  It is also, however, slightly less than I expected a couple of quarters ago, back when the stock price was $250ish (because the company is spending an almost equally fantastic amount of money on land and Googleplexes).

Combine these two numbers, and Google's market value is now about 70-times current free cash flow.  This is undeniably expensive, especially for a company this large.  Of course, given the 100%-plus year-over-year growth rate, the current ratio is not as meaningful as it might be.  More meaningful is Google's 2006 cash flow.  If Google were to, say, double its free cash flow next year--to about $3.5 billion--the stock would be trading at 35-times free cash flow.  This is a more reasonable but still hefty multiple. 

For comparison, the relatively moribund Time Warner, which will generate about $4 billion of free cash flow this year and perhaps 20% more next year, trades at about 20-times that (still a high multiple compared to historical means).  If we KNEW Google was going to generate $3.5 billion of FCF next year, and we ALSO KNEW that Google was going to continue growing much faster than Time Warner into 2007 and beyond, the 35X versus 20X multiple would be eminently reasonable.  Alas, we don't.

What's more, based on the company's massive capital expenditures of the last couple of quarters, combined with the current estimate of another $800 million in 2006, it seems unlikely--to me--that Google will double FCF next year.  More likely, if all goes well, the company might throw off another $2.5 to $3 billion (which means the multiple is closer to 40-45 times, VERY hefty for a company this size).  And what the company's growth prospects will look like in another 12 months is anyone's guess.

Valuation, unfortunately, is next to useless in predicting near-term stock movements, which result from the difference between near-term expectations and reality.  It is, however, helpful in assessing risk. 

The bottom line: Relative to its cash flow and growth rate, Google's market value is still far from insane: If the rapid growth continues (and the stock stops skyrocketing), in a couple of years, the multiple could be quite reasonable.  On the other hand, the chances that the company will continue its rocketship trajectory for the next couple of years without any sort of stumble are, in my opinion, small.  Furthermore, although the company has blown away top-line estimates in the last two quarters, it has not exceeded (my) expectations for free cash flow.  On the contrary, the free cash flow estimates have decreased, which suggests, to me, anyway, that the company is less likely than it once was to blow away numbers on the high side.

All of which means that, although I obviously wish I'd gotten aboard this rocket ride a few hundred dollars ago, I'm now happy watching from the ground.

Disclosure and Reminder: I don't own Google, and this is not investment advice.  Please see Why I Don't Own Google and the "About" tab for some details.

Why I Don't Own Google, Part 1

Several readers have asked what I think of Google's stock and why I don't own it.  The focus of this forum is on the fundamental business performance of companies, rather than on stocks, so I haven't said much with regard to the latter.

Before I respond, let me explain a few things and also say again thanks for asking.  Given the wholesale destruction of my reputation a few years back (please see this post and the disclosure statement I wrote in Slate for a summary), I am, as ever, grateful to even be asked such questions.  Let me also remind everyone that, as a condition of my regulatory settlement, I cannot give investment advice. Because there is plenty I can say about stocks without providing investment advice, however, I will take a moment to spell out what this restriction entails. 

The key distinction between investment advice and market punditry is the one-to-one relationship between an advisor and his or her clients.  Investment advisors do not merely analyze and prognosticate about securities; rather, they study the specific circumstances of each investor client--goals, risk tolerance, existing portfolio, time-horizon, etc.--and then make recommendations tailored to the the needs of that client.  A "buy" for one investor will always be a "sell" for another, and only an advisor can know the difference.

Most analysts and market commentators are not privvy to the circumstances of particular investors, and therefore do not actually provide investment advice, even though their commentary and opinions are often characterized as such.  (Wall Street stock ratings, for example, are not investment advice: No analyst is in a position to know what every investor should or shouldn't do and no single action could ever be appropriate for all investors).  This distinction is what allows CNBC, investment newsletters, the Wall Street Journal, Bloomberg, syndicated research services, stock blogs, and other publications to offer general opinions and advice about securities without being considered investment advisors. 

In a forum like this (blog, magazine article, TV appearance, research service, etc.), I can offer opinions about stocks and even ratings, as long as the opinions are general rather than personalized in nature (an email exchange does not create a professional advisory relationship, but it is personalized, which is why I have to apologize in advance for not answering email queries about specific stocks).  I haven't published ratings, though, and, for several reasons, I have no plans to.

First, although publishing ratings would be legally permissable, it would also--to me, anyway--feel inappropriate.  The distinction between advice and commentary is not as obvious to lay observers as it is to lawyers, and I don't want to honor the letter of my settlement agreement while appearing to ignore the spirit of it.

Second, rating systems--no matter how carefully defined--are often misinterpreted.  For example, when a stock is rated "buy" (or "outperform" or "1" or any other common term), analysts are usually said to be "recommending purchase" or "urging investors to buy."  That they usually are not, in fact, doing this, but are instead just opining that the stock will go up a certain amount or outperform a particular benchmark (only one of many factors to consider when evaluating a purchase) is often lost in translation.  And having already been carpet-bombed for this confusion, it scares the bejesus out of me.

Third--and here's the most interesting and, probably, annoying part--I believe the best investment strategy for most investors is not to buy and sell stocks at all, but simply to allocate assets to low-cost passive funds.  I didn't use to believe this.  When I worked on Wall Street, it seemed absurd to think that the massive amount of energy, brainpower, and money expended on buying "good" stocks and selling "bad" ones was usually wasted (or worse).  In the years since leaving the business, however, I have examined the evidence, and I have been startled and disappointed to realize how conclusive it is.

The active vs. passive debate is complex, and one it tends to incite riotous responses on both sides.  For now, therefore, I will simply say that the stock market is obviously not efficient if "efficient" is taken to mean that prices are always correct.  (Prices are often patently incorrect: NASDAQ 5000 and NASDAQ 1200 cannot both be the correct present value of the same future cash flows.)  The evidence, however, strongly suggests that prices are not so obviously incorrect that the mispricings can be consistently exploited to generate market-beating returns.  I do believe that a handful of investors possess the talent, discipline, knowledge, and skill to beat the market, but only a handful.  Most apparent investment skill, unfortunately, is simply luck--the random range of outcomes of decisions involving approximately 50/50 odds (stocks can only go up or down).

All of which is a long-winded way of saying that, although I obviously have opinions about stocks--and will occasionally share them in publications like this--I feel that publishing ratings would be encouraging an investment strategy (active trading) that I don't believe is appropriate for the majority of investors, especially small ones.  It is nice to pretend that the investment playing field is level, but the idea that an amateur with Yahoo Finance can, in his or her spare time, compete with a full-time hedge fund professional with a $50 million research budget is, in most cases, ludicrous.   

For those who know all this, are trading for fun, or make stock-picking decisions for a living, this position will sound like a cop-out, and I'm sorry about that.  My hope is that the business analysis alone will be interesting, and I promise to stick my neck out and make concrete (and embarrassing) predictions in this realm.

So...the first reason I don't own Google is that I invest mostly in index funds.  To indulge my prior habits--and to put my money where my long-term conviction is--I do have long-term positions in a few Internet stocks, but I view this more as entertainment than as a serious attempt to beat the market.  If I see an opportunity where my conviction level is high, I might make another investment or two, but I'm not actively looking.  And for reasons I'll explain in the next post on this topic, Google would not clear this hurdle today.

I wrote a series for Slate last year called The Complete Guide to Wall Street Self-Defense, in which I discussed many of these issues at length.  For those interested in the passive vs. active debate, I would recommend David Swensen's recent book, Unconventional Success (pictured above), as well as anything by John Bogle, Charles Ellis, Larry Swedroe, and others.  An investment advisory firm called Index Fund Advisors has built an exceptional web site aggregating most of the academic and journalistic work on this topic and offers a "twelve-step" plan designed to help investors kick the trading habit (full disclosure: IFA's president invited me to speak at a conference earlier this year; I did not receive a fee, but I was reimbursed for travel, hotel, and meals).