THE RISK MANAGEMENT OF INTERNET STOCKS

 
 
 We wrote this article on New Year's Day, 2000.
 
 

Globalization and democracy are the two major trends at the dawn of the century. The Internet, a complementary technology, enables both scope and customization in the transmission of information. The result of this development is an effervescence of human ingenuity and an increase in choice and efficiency in the spheres of business, knowledge, and entertainment.

As investments, the Internet companies have an astronomical potential, selling at sky-high prices. This presents difficult investment issues for those who have Internet stocks in their portfolios or for those who would like to invest in them. We consider these stocks along the dimensions of valuation, risk control, and market behavior. Our comments do not pertain to investments in Internet startups, but to investments in companies that have track records of profitability and the prospects for sustained earnings growth.

Valuation

Consider the usual formula for valuing a stock:

  d
 P/E = ____________ 
 (k - g)
 
 where: d = the proportion of earnings distributed
 k = the required return on the investment
 g = the rate of perpetual growth in the company's
 dividends 

Assume a constant, or somewhat constant, required rate of return. Now let an expectation of sustainable growth (g) increase. It can be easily seen that due to the effect of compounding over an infinite period, the justified P/E of the stock will approach infinity. Infinities usually present severe conceptual difficulties in the sciences.

The Internet is a transformative technology with a vast potential. To quote a venture capitalist, "We will reach a billion people through wireless and through Internet connections in about fifteen years...There are six billion people in the world." The present value of this technology cannot be measured by a formula, which suggests that another concept is necessary.

Risk Management

Consider again the above stock valuation formula. At a level of an infinite P/E, let long term growth expectations decrease very slightly due, for instance, to changes in the international environment or the macro economy. The fall in stock values can be very large.

Risk, as defined by the mean-variance model, is not a particularly useful concept except for retrospective performance measurement. Very useful is Peter Bernstein's (1999) definition of risk:

 
 "Today's obsession with risk management focuses too intently
 on the measurement of risk. The more we stare at the jumble
 of equations and models, the more we lose sight of the mystery
 of life. All too often, reason cannot answer. Even the
 most brilliant of mathematical geniuses will never be able to
 tell us what the future holds. In the end, what matters is the
 quality of our decisions in the face of uncertainty...Once we
 recognize that the models that support these projections have 
 an R2 of less than 1.00, we have to accept the possibility
 that the optimism...is misplaced. Forget the probabilities 
 that the optimism is misplaced. When the R2 is less than 1.00, 
 the crucial element in the decision is the consequences 
 of being wrong." 

Profits are for everyone, and losses are for no one. Yet, what matters to stock investors are their abilities to bear the consequences of adverse market fluctuations, assuming that their investments are fundamentally sound. Beyond mere discomfort, considering your current investment in Internet stocks - could you bear the consequences if they dropped in 10% multiples? We are here discussing companies with proven business models. If you find this disturbing, you should probably reduce your asset allocation.  If you are not invested in Internet stocks, and wish to be, a decent drop is probably a buying opportunity; assuming a continuation of the New Era economy.

Investors and Markets

Mr. Bernstein discusses a kind of global rationality that, in theory, can be used to directly calculate all the facts. Liberal societies, however, are more like ecosystems. It is possible to specify the conditions under which complex ecosystems will flourish, but it is not easy to directly specify exactly what will happen. For instance, it is possible to say that when energy, carbon molecules, and water are available, life will most likely develop. In the field of economics, it is possible to say that when peace and freedom pertain, and when societies possess the institutions (such as laws and private property) that enable individuals to reap the benefits of cooperation, growth will occur.

In this societal process, markets have a short-term function. They validate successes (usually) incrementally; and they also enable societies to conduct experiments, some of which will be successful or not. The function of long term investing is to direct investment to the companies which have the greatest potential for success; after the investor has weighed the mostly local facts (such as the quality of management) in the balance. This is the definition of rationality.

Many investing contradictions can be resolved by the idea - invest in good companies for the long term and structure your portfolio so that this is possible, the latter takes care of the macro prediction problem.

Since the company is the most significant entity, we usually reduce our portfolio positions incrementally as prices rise, thus maintaining  a set proportion of stocks in companies and industries. This is how we manage short term risk.

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