By Andrew Leckey
No investment has so teased investors with dreams of a lucrative future as the Internet. Its cruel history of making some rich while sending others to the poorhouse could make you wish for a reboot of your brain.
In what other industries do dramatic earnings gains regularly trigger stock declines because they missed expectations that were projected even further into the stratosphere?
Changing technologies can turn a dynamic breakthrough into a breakdown. Internet firms desperate for a "new new thing" aggressively acquire competitors to pocket bright ideas and products.
Whenever a portion of the industry gets hot, as Internet advertising has this year, competitors move quickly. That's why Microsoft Corp., Google Inc., Comcast Corp. and Yahoo Inc. have all expressed an interest in buying a stake in Time Warner Inc.'s America Online unit.
Internet stocks represent the uncertainty and volatility of speculation, but they aren't going to disappear, because consumers and investors are hooked.
"Think about the fact that your teenage son will never buy a car without researching it first on the Internet, or that most Americans will never buy another house without first taking a virtual tour," said Allison Thacker, co-manager of RS Internet Age Fund (RIAFX) in San Francisco. "Our lives have completely changed in the past five years and that change is here to stay."
RS Internet Age Fund is up 14 percent the past 12 months and has a three-year annualized return of 40 percent, but its five-year annualized decline of 5 percent provides a reality check. The Internet drives this fund's stocks. Some of its money was moved out of hardware and software stocks following their price run-ups, shifting even more dollars to the "pure" Internet companies.
"A lot of Internet companies invested their money back into their core businesses this year," Thacker said. "Because investors want to see an expansion of profit margins, it has been a difficult year for many Internet stocks."
Some have boomed. Among Thacker's winners in 2005 are Internet search/advertising giant Google (GOOG), which has gained 54 percent; flash data storage company M-Sys Flash Disk Pioneers Ltd. (FLSH), up 32 percent; advertising/software firm ValueClick Inc. (VCLK), up 23 percent; and power management/security component maker 02Micro International Ltd. (OIIM), up 17 percent.
High growth rates and lofty price multiples make Internet stocks both exciting and terrifying. The trick as always is to try to buy dominant businesses at a fair value.
"Despite all that was made of the Internet bubble, the fact still remains that some real business was actually created during that time," said Scott Devitt, vice president of equity research at Legg Mason in Baltimore, who covers Internet stocks. "Some of these companies, such as eBay, have exceeded the capitalizations that they had during the bubble."
Just because an Internet stock goes down doesn't necessarily mean it will snap back. Some declines are justified.
"There is a heck of a lot of risk associated with each and every Internet stock, and money can be lost quickly even when a company's earnings results appear to be good," said Scott Kessler, Internet software and service analyst at Standard & Poor's in New York, who keeps his recommended list in this category limited. "Investors must research every stock they're interested in buying, no matter how favorably analysts may have talked about it."
Many Internet products and services are readily available to investors to be examined right along with earnings, revenues and stock charts.
"If you're considering an Internet stock, make sure that you fully understand how its model works and always be sure to test the product to see if it has any flaws," said Frank Gristina, senior analyst in consumer Internet stocks for Avondale Partners in Nashville. "A lot of valuations of Internet stocks are being done on earnings multiples today, which leaves less uncertainty than before the bubble when they were being valued on sales multiples."
There's a "renaissance" under way in online commerce, Gristina said. The segment got a bad reputation when poor business models were exposed in the bursting Internet bubble, but there's more sophistication now, with companies doing a better job of advertising and advancing orders directly to the suppliers, he said.
Stock of Yahoo (YHOO), the popular global Internet brand that has extensive services, tools and marketing, is recommended by Devitt and Kessler and is a major Thacker holding. Its stock is down 10 percent this year.
The online DVD movie rental service Netflix Inc. (NFLX), up 133 percent this year, and the pet pharmacy PetMed Express Inc. (PETS), up 31 percent, are recommended by Gristina.
Online auction giant eBay Inc. (EBAY), whose stock has declined 31 percent in 2005, and online diamond and jewelry seller Blue Nile Inc. (NILE), up 19 percent, are Devitt recommendations.
Kessler likes some stocks whose prices have disappointed.
His picks include diversified Internet/telecom/music download firm VeriSign Inc. (VRSN), down 38 percent; online games provider Shanda Interactive Entertainment Ltd. "A" (SNDA), down 44 percent; server-based computing firm Citrix Systems Inc. (CTXS), whose stock has been flat; and digital audio content provider Audible Inc. (ADBL), down 58 percent.
But be warned: All Internet stocks are guaranteed to give you a jolt from time to time.
Editor's Note: Andrew Leckey is a regular contributor to The Bull & Bear Financial Report print version.
