Irrationality Squared

The stock market is, on the whole, an efficient mechanism. In general, many more stocks are priced right than are priced wrong. (What the “right” price is is obviously a complicated question, but let’s call it simply the present value of all future cash flow.) But even though that means you should avoid saying “Investors are acting irrationally” whenever possible, when it comes to the powerhouses of the Internet, investors are acting irrationally.

And I don’t mean that investors are bidding these stocks up to unreasonable and unsustainable levels. I mean exactly the opposite: Investors in the last three days have been dumping America Online and shares for no good reason at all.

In saying this, I’m assuming that if you bought Amazon at $200 a share on Monday (I’m going to focus on Amazon here, because it’s been hit harder than AOL, but the logic applies equally well to AOL), you did so knowing that Amazon was going to report earnings on Wednesday and knowing how Amazon’s business model worked. So for you to buy at $200 and then sell at $170–Amazon is down more than $25, or 20 percent, today–something important must have changed about the company’s business or about its future prospects. Otherwise, one of your two decisions–to buy and then to sell–makes no sense.

Now, according to Amazon’s latest earnings (that is, losses) report, nothing important has changed about either the company’s business or its future prospects. This was, as they say, a report with no flies on it. Amazon hit the top end of analysts’ expectations for revenue growth, doing $293 million in sales, up more than 200 percent from a year ago and, perhaps more impressively, 16 percent from last quarter (which included the whole Christmas shopping season.) Two-thirds of the company’s sales came from repeat customers, which seems to mean that Amazon is building precisely that kind of customer loyalty that its entire future success depends on. And the company says it’s on pace to have 11 million customers by the beginning of the fourth quarter, which would represent impressive growth.

Of course, Amazon made no money. In fact, it lost $36 million, and CEO Jeff Bezos said that the operating losses for the rest of the year will be larger, not smaller, as the company expands its spending on marketing, acquisitions, distribution, and infrastructure. Effectively, Amazon is still buying its customers, and profitability is still many months, perhaps years, away.

So why call the sell-off irrational? Because nothing Bezos said in his conference call, and nothing in the numbers, was surprising. Amazon’s commitment to losing money in order to build market share has been unshakable since the company began, and Bezos has frequently said that he wants to hold off on profitability as long as he thinks money is better spent acquiring new customers. The company’s sales are growing faster than expected. And the company’s business model–deriving cash not simply from sales but also from the interest it gets when it takes your money today but doesn’t pay its suppliers until next month–is not only intact but stronger than ever.

Now, Moneybox has been the site of more than few skeptical columns about Net stocks in general and’s stock in particular. And my doubts about Amazon’s ability to turn its current customers into lifelong shoppers remain. But there is a logic to the company’s business model. Amazon is effectively investing almost no new capital in its business and still doing $1.2 billion in sales, where a company like Barnes & Noble would have to invest something like $450 million. So even if it’s not profitable, its use of capital is so negligible that its potential upside is immense.

That doesn’t mean Amazon’s worth $200 or even $170 a share. But it does mean that if it was worth $200 a share on Monday, it’s worth more than that now. That the traders don’t see that is a measure of how flimsy their understanding of their own investments really is.