By VW Staff. Originally published at ValueWalk.
Horizon Kinetics portfolio update for the second quarter ended June 30, 2017.
An Overview
It’s One Thing to Not Know, It’s Another to Be Told What Isn’t So.
Part I: Unpacking a Mainstream Index, the NASDAQ 100
Part II: Can One Hide From The NASDAQ 100 In The S&P 500?
Part III: Be Outside the System – It’s OK to Earn a Return a Different Way
Appendix: Anniversary Supplement, Right on Schedule: Google + Facebook Versus AOL, 18 Years and Counting
First, the Label
Indexes are intended to avoid company-specific risk, right?
Second, Valuation: When is a P/E Not a P/E ?
or How To Turn 90 into 22 in Three Easy Steps
Harmonic mean (From Wikipedia, the free encyclopedia)
In mathematics, the harmonic mean…is one of several kinds of average…The harmonic mean can be expressed as the reciprocal of the arithmetic mean of the reciprocals of the given set of observations.
To translate that bewildering language into the 3-step recipe via which an egregiously high P/E ratio is cleansed into a harmless middling sort of group average, observe the following hypothetical portfolio consisting of a range of low, somewhat high and egregiously high-valuations. In fact, if you ponder Stock D’s treatment, the higher the true P/E, the less and less it counts in the average.
Incidentally, a simple average of the P/E ratios of the 91 profitable companies in the NASDAQ 100, results in a valuation of 43.6x earnings. Or, if one calculated the weighted average P/E ratios of the 91 profitable companies (giving proportionately greater weight to the larger companies), then the QQQ valuation is 41.0x. No active manager would be permitted to manage a concentrated, high-P/E portfolio for an institutional client. Only an index enjoys this privilege.
Can One Hide From The NASDAQ 100 In The S&P 500?
Worded differently, a manager/analyst who was so brilliant as to have a stock selection error ratio of merely 1.00%, by not owning these 5 of the 500 stocks, would have underperformed by over a quarter of the S&P 500 return.
In 2015, the 10 best performing stocks in the S&P 500, 2% of the holdings, accounted for more than 100% of the return that year. They included Amazon, Microsoft, Google, Facebook and Netflix.
In 2016, 5% of the S&P 500 companies accounted for 50% of the index return. Failure to own those 25-odd names, and a manager would have underperformed by nearly 600 basis points. Among, them, Amazon, Microsoft, Apple and Facebook.
To outperform, it would been insufficient to have owned each and every one of these companies that (excepting Apple) trade at extremely high P/E ratios, valuations that could contract at any moment for any number of reasons. One would have had to own not only the full positions, but have overweighted them. One would have to take that further risk as well.
Right on Schedule: Google + Facebook Versus AOL
18 Years and Counting
The valuation risk imponderables are:
(1) the maximum share of advertising revenue these firms can achieve;
(2) the time at which the maximum share will be reached;
(3) the P/E at the time that Google and Facebook absolutely dominate advertising; and
(4) whether there will be a cyclical decline in advertising expenditure that will disrupt the growth of these firms, and if so, when it might occur.
It is a very dangerous game to play. In January 2000, with in a few inches of the tech bubble peak, AOL and Time Warner agreed to merge. The aftermath was one of the greatest cases of buyer’s regret in stock market history.
It wasn’t so much the matter of the AOL Time Warner stock dropping 90%, but that it was 90% of a $350billion combined stock market capitalization at the time of the merger agreement.
The Internet Bubble Test (as published July 21, 1999)
The Internet: A Study in Reason and Unreason
(1) The Ultimate Internet Market in a Perfect AOL Future
World population: 6 billion inhabitants
Internet households: 1.5 billion, including the homeless
and Third World homes without electricity or computers
Market share: 100%
Monthly household internet expense: $20/month,
including the indigent worldwide
Revenue/year: $360 billion
Operating margin: 50%, exceeding that of Microsoft
Net profit after tax: $117 billion
(2) The Terminal Internet Equity Valuation
In the presupposed market saturation environment, it is by definition a zero growth environment, which would logically impose low valuations. However, in the interest of maintaining an bullish scenario, we can assume a typical Internet company valuation of 30x earnings, which would be $3.51 trillion.
(3) The Question of Time, Market Share and Other Factors
The time value of money is a powerful influence upon valuation. We will assume complete global usage by individuals of the Internet will be achieved in 20 years; 30 years would markedly reduce the rate of return. Also critical: market share, profit margin, and the final valuation multiple.
(4) The Question of Returns to Investors
Current AOL market cap: $140 billion
Terminal Internet Industry mkt. cap: $3.51 trillion in 20 years
Return to investors: 17.5%/year (at 100% market share)
Return to investors: -11.2%/year (at the current 33% share)
(5) The Question of Sensitivity
Assuming a more reasonable 10% profit margin, net profit after tax is at $36 billion.
(6) The Question of Competition
All of the preceding computations assume that AOL will be an Internet Service Provider monopoly in 20 years, which is a highly unlikely event.
Be Outside the System
Texas Pacific Land Trust – An Alternative Correlation
Last month, the Trust filed a two-paragraph announcement. It has created as ubsidiary called Texas Pacific Water Resources LLC. The intent is to provide water-related services to companies engaged in oil drilling activities in the Permian Basin. These would include water sourcing, treatment and recycling, as well as associated infrastructure construction, disposal and even well testing services.These water costs are so high, that it has become one of the critical variables in determining the economics of drilling in this area.
This is an entirely new business and source of value for the Trust, and one that has the possibility to be conducted on a large scale. An essential asset underlying this venture is the Trust’s 800,000+ surface acres of land, the Trust being one of the largest private land owners in Texas. This asset includes something very valuable in the southwest U.S.: water rights. It does not, as yet, produce any revenues; it is a classic example of a dormant or hidden asset.
True High Yield Investing: What we Sold and Why
Atwood Oceanics 6.5% Senior Note due February 2020
The Business: Atwood is
The post Facebook Versus AOL, 18 Years and Counting: Can One Hide From The NASDAQ 100 In The S&P 500? appeared first on ValueWalk.
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