Internet / Electronic Commerce – 9 March 1999
4
early 21st Century, you unfortunately have to pay mind-boggling
Internet prices (at least for now).
The details are important, but we would not talk
ourselves out of buying a leader because of a small
amount of hair on the story. The best stock-picking tool
in this sector right now is a shotgun, not a rifle (it's all
about the “story.”) The best companies, moreover, have
been able to evolve along with the industry, avoiding
destruction and pursuing new opportunities (which makes
it frustrating to say “well, until they fix that problem, they
won't have me as a shareholder”—because by the time
they fix it, the people they do have as shareholders may be
2X as rich). As one investor we respect says, “when the
microscopes come out, the returns become microscopic.”
We would not waste a lot of time looking for “cheap”
names--no Internet stocks are cheap, and you get what
you pay for. We do not believe that the Internet bubble as
a whole is tulipmania, but there are plenty of tulip bulbs
masquerading as companies out there. If the sector
corrects, we believe the stocks of the weakest companies
will drop 70% or more, and we don't think they will
necessarily come back. When the biotech stocks finally
blew up, the stock of one of the strongest companies in the
industry, Amgen, dropped 50% in a month--but it is now
trading at more than 3X its high prior to the correction. A
lot of the lesser names just disappeared.
We would not short these stocks simply because they are
expensive—too often in the industry's short history, this
has been fatal. Just because a stock should regress to a
historical mean doesn't mean it will—especially when
every investor in the world is trying to accumulate it.
Although the Internet stocks are desperately tempting to
short on valuation, we would carefully analyze the
risk/reward ratio before doing so. The most you can make
when you short a stock is 100%. As has been made clear
over the last two years, the most you can lose when you
short these stocks is, well, 1,000%-plus percent—which is
not exactly a compelling risk/reward proposition.
Based on the sector's propensity for boom-and-bust price
spikes, we would actively manage risk exposure. At least
three times over the last year, the Internet stocks have
spiked wildly in a frenzy of panic-buying and short-covering
and seemed as though they would never come
back down. Each time, though, when the euphoria wore
off, they pulled back 30% to 50% from their spike highs.
In the event that we get another one of these spikes, we
wouldn't panic—we would trim positions into the run and
buy in again once the bloom falls off the rose. The stocks
are very sensitive to catalysts (such as the gushing press
about the growth of e-commerce over the holiday season),
so before adding to positions, we would also think about
what might be coming next.
What we look for in Internet investments. In trying to
pick the sector's long-term winners, we tend to look for the
following: 1) businesses that are possible only because of
the Internet and could not exist without it—such as AOL,
Yahoo!, eBay, Doubleclick, and to a lesser extent,
Amazon.com; we do not believe that major Internet market
value will be created by porting existing media and
retailing concepts online; 2) enormous market
opportunities—if the concept works, we want the company
to be able to get huge; 3) platforms or foundations that can
evolve to take advantage of new opportunities as they
develop (Yahoo! started as a directory; Amazon.com as a
bookstore), and 4) strong, deep management teams that are
motivated by more than increasing their net worth—if Bill
Gates just wanted the money, he probably would have
stopped about $75 billion ago.
What we worry about. The sector's valuations worry us.
As described, however, we do not believe that valuation
alone will knock the stocks down. We believe that the
valuations will begin to conform more with historical
norms when 1) the fundamentals slow down, or 2) the
supply of quality investment opportunities finally exceeds
demand (never before have so many investors been
seeking so few shares). As far as the fundamentals are
concerned, we are keeping close tabs on four major growth
drivers: 1) new online users, 2) advertising dollars, 3)
commerce dollars, and 4) technology and services dollars.
Of these, we are currently most focused on the number of
new users, which is the first of the major metrics that we
believe will slow down. With regard to the supply/demand
imbalance, we also acknowledge the possibility that this
spring's massive IPO pipeline, combined with recent
billion-dollar financings from Amazon.com, Inktomi,
Network Solutions, and others, will begin to sate investor
demand for Internet shares. Our hope and belief, however,
is that the ever-growing demand will continue to outpace
supply—especially considering that only a minority of
filed IPOs can be labeled “high-quality.”
To review…we find it helpful to consider the following
when assessing the Internet sector's valuation and
volatility risks. 1) whether allocating a small percentage of
the portfolio to direct investments in one of the largest
economic trends in history is worth the valuation risk (we
think it is); 2) more specifically, whether the risk of losing
50%-75% in a correction is offset by the risk of missing
further 3X-10X returns (we think it is), and 3) whether the
Internet's potential to hurt other, “safer” investments
increases the value of owning a small basket of these
stocks (we think it does).
Opinion Key [X-a-b-c]: Investment Risk Rating(X): A - Low, B - Average, C - Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12 mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 - Reduce, 5 - Sell, 6 - No Rating. Income Rating(c):
7 - Same/Higher, 8 - Same/Lower, 9 - No Cash Dividend.
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