U.S. News & WORLD REPORT
Pop?
Internet mania has pushed the prices of fledgling, profit-challenged companies into the ionosphere. Most will plummet back to earth.
BY WILLIAM J. HOLSTEIN AND JACK EGAN
Last week, Brazil was devaluing its currency. Europe was worried about its joblessness and lagging output. Japan was driving down the yen, and a major Chinese state-owned investment bank was going bankrupt. But none of that seemed to dampen Dennis Patterson's fervor for trading Internet stocks.
Patterson teaches law at Rutgers University in New Jersey. But in between lectures, paper grading, and trips to the archives, Patterson becomes a late 1990s Master of the Universe, fearlessly executing trades on the Internet with his laptop computer. "I had a broker, but I thought I could do better by myself so I fired him," says Patterson. The 43-year-old academic spends two or three hours a day watching CNBC and exchanging tips with fellow investors on Internet bulletin boards. Last week was one of his best ever: Among other moves, he unloaded Yahoo! at $428 for a 125 percent gain and sold Amazon.com at $183, earning himself a tidy 67 percent profit. "None of these stocks are worth anywhere near what they trade at," he says, "but so what? That doesn't mean you can't make money."
The history of investing is replete with manias, from the Dutch tulip craze in the 17th century to the wild run-up of biotech stocks earlier this decade. But few can top the frenzied pursuit of Internet stocks, which has driven share prices of fledgling, profitless companies with dot com after their names into the ionosphere. After rising 187 percent last year, a basket of 50 Web-related stocks tracked by internet.com gained 55 percent in the first days of trading in 1999 but last week, as international worries grew, gave back 20 percent. "There's a casino mentality out there," says Scott Black, a Boston-based portfolio manager.
Decades of investment experience suggest that some sort of shakeout will occur, as such frothy episodes seldom end well. The only questions are just how nasty it will get and whether it will spill over to the broader stock market as well. If there is a blood bath, investors who thought they owned a piece of the next Microsoft may wake up to find they have purchased Brooklynbridge.com instead.
Signs of excess abound. Companies with intriguing but sketchy business models capture the fancy of Wall Street analysts, who hype the shares. Stocks double in anticipation of splits, making investors clamor for another split almost instantly. Consider Broadcast.com, a Dallas-based company that transmits radio and video over the Internet. The company went public last July, at $18 a share, and got as high as $74 on its first day of trading. Though the firm has only $16 million in annual revenue and earns nothing, the possibility that it might someday become a global broadcast network so excited analysts that the firm's shares soon soared to nearly $200. Days later, they surged again, to about $285, after the company said the stock would split in February–never proving that it can make money.
What will trigger a correction–or worse? It could be something as simple as one of the leading Internet companies failing to hit an earnings target for a quarter. Insiders selling might do it. Or events faraway–say, a Chinese financial meltdown–could spook the market, pummeling every sector, including Internet stocks. There was a taste of that last week.
Broadcast.com closed Friday at about $140 a share, 51 percent off its high. Shares of Amazon.com, the online retailer of books, music, and other goods, have nearly tripled in the past month. Propelling the shares higher: a strong Christmas selling season, which helped the pre-eminent E-commerce site post triple sales in the fourth quarter to $250 million. Following a 3-for-1 split, the stock hit $199, or $600 on a pre-split basis. Last week, it closed at about $140. Share prices of eBay, Yahoo!, Inktomi, and several others significantly deflated as well. But is that an indication that the bubble is popping or merely that the pin has been inserted? In a sign that Internet fervor was very much alive despite a week of extreme volatility, Marketwatch.com, a Web-based financial news service, went public on Friday at $17 and soared to $105.
No place to hide. Internet mania isn't just a speculative sideshow. It is seeping into the "real" stock market, where at least 100 million American households have invested. It is hard to overstate the impact of all this on market psychology. As more and more people tell tales like Patterson's about making a bundle, old-fashioned nostrums, such as doing your homework before investing, increasingly strike investors as a waste of time. "People are buying real stuff with their winnings, like Corvettes and giant houses," says Michael Burry, a neurology resident at Stanford University who invests for the long haul, not the quick buck. "It's hard to go to cocktail parties and look at that, and continue to stick to your guns."
One after another, the rules of safe investing are being overwhelmed. Momentum investment–or buying something just because it is going up–has been taken to new levels. Meanwhile, hype is becoming routine, and buying on rumor is emerging as standard procedure. Valuations seem to be losing touch with any underlying reality. When it comes to Internet companies, the quaint notion of judging a stock price by comparing it with a company's earnings (the price-to-earnings ratio) doesn't work because many haven't made Dime 1. Indeed, Amazon has accumulated losses of $85.9 million; Inktomi's losses total $36.3 million.
At their current stock prices and profitless prospects (no one knows when Amazon will make its first profit), investors are betting that the managements of each of these companies will execute their strategies with "absolute perfection," says Bruce Smith, an Internet analyst at Jeffries & Co. That just doesn't happen in the real business world. Adds Smith: "There is easily a risk that these stocks can go down 50 to 70 percent."
What keeps luring investors into the game, of course, is the conviction that at least some of today's Internet companies will be tomorrow's blue chips. But it's unlikely that all or even most of them will survive, let alone prosper. That's the lesson of previous waves of new technologies that have hit the American economy.
Trying to identify winners is what the Internet chase is all about. 'There's a distinction between people speculating on secondary and tertiary stocks and the people who are investing in the category leaders," argues Thomas Evans, CEO of Marina del Ray, Calif.-based GeoCities, the largest site for personal home pages on the Web.
Problem is, no one can predict with any certainty which leaders will survive and which won't. The best-positioned company, in the view of many Wall Street analysts, is America Online, which was added to the S&P 500 late last year. "The only Internet company to have already achieved blue-chip status and whose stock will likely be worth a lot more than it is today is AOL," says Merrill Lynch Internet analyst Jonathan Cohen. "They control the online population with 17 million subscribers and will be very, very difficult to stop."
Culture change. Internet mania is being driven partly by a profound shift in the culture of investing. With a computer and modem that together cost about as much as a fancy TV set, investors today can gain access from their living rooms or office desks to virtually all the information their brokers have. Some 100 online discount brokers have sprouted in the past five years to accommodate do-it-yourselfers. At an average of $15.75 a trade, online brokerage commissions are now about 70 percent below what they were three years ago.
Increasingly, individuals sit by computers all day, whether at work or at home. There may be some 5 million of these financial wildcatters who buy and sell stocks online, and their activity now accounts for nearly 10 percent of the stock markets' daily trading volume, up from about 5 percent a year ago, according to Bill Burnham, an analyst at Credit Suisse First Boston in San Francisco.
Many of these amateurs are the so-called day traders, jumping in and out of the hottest stocks. By the close of trading, they often have sold off all their positions, only to take up the quest the next morning. "People can trade these days like they were a big institution," says John Markese, president of the American Association of Individual Investors.
But even though do-it-yourself investors have powerful trading tools at their disposal, they may not be as Street smart as they think. Many message board and bulletin board discussions at Silicon Investor, Yahoo!, and AOL have the feel of a college dorm bull session. Some investors may not understand the arcane world of futures, options, and warrants. "Goodbye, cruel world," one trader, using the name RudeMF, informed a Yahoo! Finance message board earlier this month. RudeMF said he had shorted 600 shares of Yahoo! and 1,000 shares of Lycos. But the shares surged instead, wiping out his investment of $80,000.
Newcomers are also vulnerable to stock manipulation schemes, particularly when shares are being flipped many times a day by pros who can move massive amounts of money into–and out of–thinly traded equities. Another technique for separating fools from their money is the pump and dump. In that scam, manipulators praise a stock with seemingly genuine announcements or commentary, even while they sell their own shares.
Facing the music. Sometimes newbies get hurt because they make their investment decisions solely on the basis of public announcements and filings gleaned from Internet sites. Take the case of K-Tel, based in Minneapolis, which sells music CDs over the Internet as well as through other channels. The company made a series of announcements in November 1998 that its music would be sold on Playboy magazine's home page and on Microsoft Network's Home Shopping Page. The stock soared from below $5 to nearly $40.
What the company didn't disclose was that Nasdaq was threatening to delist it because it had fallen below minimum requirements for tangible net worth and total sales. When word of that got out, the stock price fell back to around $11, where it is currently trading. Investors who went along for the ride up lost money, and a class action suit has been filed on their behalf accusing K-Tel of withholding important information. Company President Lawrence Kieves denies any wrongdoing and says the company is back up above Nasdaq's minimum requirements. "We have a strong fundamental business," says Kieves.
Day traders can also get burned when insiders sell out. The shares of most initial public offerings are dominated by management and early venture-capital investors. At a company like online auction house eBay, for example, only 9 percent of the company's total 37.2 million shares are publicly available, according to Morgan Stanley. After an IPO, the insiders have to observe a "lockup," or waiting period, before selling any of their shares. When that period expires and insiders unload large numbers of shares, the stock price can fall sharply. The expiration of a lockup period seems to be at least part of the explanation for the big losses in Broadcast.com's stock one day last week. It's not clear that insiders sold–it may be simply that major investors feared they would do so. In any event, buying an Internet highflier without understanding lockup periods is risky. Both eBay and GeoCities have lockups that expire in February.
Should you make the leap into the Internet frenzy? The choices for individual investors depend, as always, on their own financial circumstances. No one should be playing with the equity in their homes or a nest egg that is essential to their retirement or children's college education. And buying on margin is simply too risky for the vast majority of small investors.
For those who realize the risks involved, one tack is to take out your initial investment once you are ahead and play with the house's money. If you hit it right the first time, don't think you're smart–just lucky.
Indirect Net plays. Another relatively conservative approach is to buy the bigger stocks like Microsoft, Intel, Cisco, Dell, Gateway, and MCI WorldCom, which have a piece of the action but are not purely Internet players. MCI, for example, carries a large percentage of the Internet's traffic on its backbone telecommunications system. A surge in the shares of those sorts of companies drove the Nasdaq sharply higher on Friday.
The average investor might also consider one of the handful of diversified Internet funds. One of the best performers has been the Munder NetNet fund, with $430 million in assets and 57 companies in its portfolio. "People are looking for a diversified way to get at this sector," says co-manager Paul Cook. His fund has begun paring back its exposure to AOL, Yahoo!, Amazon.com, and other pure Internet players, adding slightly less volatile stocks in their place. "It's kind of the chicken's way out," says Cook.
For investors who still want to make pure Internet plays, it's important to look at the fundamentals–ranging from the business plan to the company's management team. A few good sites on the Internet itself are CNET.com, internet.com, and hotwired.com, because they track what's happening with each Internet stock.
Investors who ask some basic questions, while avoiding exotic financial instruments, stand a better chance of identifying ultimate winners and avoiding being the ones left holding the bag. The pros also strive to diversify their holdings so their exposure to pure Internet players like Yahoo! and Amazon does not dominate their portfolios. NetNet's Cook is taking a closer look at stocks that many investors wouldn't automatically associate with the Internet, like Office Depot and the Gap. He thinks those two retailers will use the Net to rev up already booming sales and profits.
And the next time there's a correction, smart investors will take note of which white-hot Internet stocks fare best. Some of these strategies may sound old-fashioned. But even the Net hasn't changed the basic rules of safe investing.
With Fred Vogelstein
HYPE AND DOLLARS
What's an Internet firm worth?
Imagine you were some Wall Street honcho with $30 billion to plop down for a corporate takeover. You would want, of course, to get as much value for your money as possible. So should you buy a sexy new Internet company or a similarly sized, "offline" firm, as the digital cognoscenti refer to non-Internet businesses?
Compare Amazon.com with, say, Colgate-Palmolive, the venerable maker of Ajax, Fab, and other household products. Both have market capitalizations of between $20 billion and $30 billion. But unlike the highflying–but not yet profitable–online bookseller, boring old Colgate posted an after-tax profit over the past 12 months of $820 million. "You could spend $50 billion on an Internet company and not get a company as good as Colgate," says Robert Sanborn, portfolio manager of the $7.2 billion Oakmark Fund in Chicago.
Or how about spending $70 billion? AOL and Fannie Mae are both hovering around that market cap level. But the mortgage company had after-tax earnings of $3.3 billion during the past 12 months vs. $168 million for AOL. Not to mention both Colgate and Fannie Mae are trading at price-earnings ratios under 40 compared with 500 or so for AOL and, well, practically infinity for Amazon. Sure, they're not as exciting as the Net plays, but they do have real earnings and businesses that are somewhat predictable–in the good sense of the word. Hey, if they added dot com after their names, who knows? They might even be bigger than Microsoft.–James Pethokoukis
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