October 7, 1999

One thing that always interests me when it comes to mutual fund companies is how they try and downplay the importance of total return. For me, that's the most important issue, the total return of the mutual funds I own (Total return includes taking in account the expenses charged by the fund company to manage the fund.). Everything else is a distant second, issues like availability of research and so-called 24 hour phone service. The same is true with individual stock investing, that is, how much money you make or lose is the most important issue (Which includes taking in account spreads and broker commissions.). Everything else is a distant second, issues like are you a long-term investor or short-term investor, are you using a growth approach or value.

I mentioned this because if you are making money in the internet sector that's what really matters and everything else is secondary. However, I do think small internet investors should understand that when it comes to general investing rules, the internet sector is breaking all of them.

Wall Street Analysts are changing the rules to justify the ridiculous valuations that investors have put on the stocks in this group. And as usual, the financial news media is going right along with Wall Street's lead. We all know why Wall Street and the financial news media are supporters of the internets, it's all about making money, and Wall Street is making a ton of money off internet IPOs, internet secondary offerings and off the trading of internet stocks in general. Some of the money made by Wall Street firms does trickle down to the financial news media.

I personally, wouldn't be too concerned about the overvaluation of the internet sector if it wasn't for one huge problem...Wall Street and its sheep mentality. Unfortunately, the odds are growing every month for a meltdown in the internet sector and if there is a meltdown, then Wall Street Institutions will do what they always do when there's a panic, and that's to sell everything, internet related or not. Even if you are not invested in the internets, you could still have heavy losses.

To try and explain why I think the internet sector is overvalued, I'm going to talk about Yahoo and about Yahoo's third quarter report. I think Yahoo is perfect for this because it's the industry leader and just reported 'great' third quarter earnings. It's not like I'm going to be talking about the worst stock in the sector.

Like I said before we all want to make money...and most of us don't care how we make it, in the internet sector or not. Well, so far Yahoo's current investors are showing $50 billion on their balance sheets. Why is it that investors are willing to pay the $190 a share for Yahoo which gives Yahoo a $50 billion market cap? The reason, rather they realize it or not, is because they are betting Yahoo, overtime, can earn that much money. Just how much time will it take Yahoo to earn that much money?

Next year (00) Yahoo is expected, by the Wall Street Analysts, to increase their earnings from 1999 by 56%. Since Yahoo is used to 'blowout' numbers, let's say they are going to increase their earnings by 100%. If Yahoo increases its earnings for next year over 1999 by 100%, Yahoo will earn $145 million dollars next year. If we assume they will continue to have gains of 100% year after year, it will take Yahoo 5 years to earn $50 billion and Yahoo will be making almost as much money per year as Microsoft currently does. Yahoo having earnings growth rates of 100% per year, year after year, and making almost as much as Microsoft is very unlikely. Adding this to the fact that I am assuming during the next five years, Yahoo's stock stays where it is now. If the stock were to double just one more time in the next five years, its market cap would also double. That is, Yahoo investors would then be holding $100 billion on their balance sheets and already Yahoo would have to earn another $50 billion. Note too, that Microsoft's profit margin is over 40% and Yahoo's is less than 15%. Microsoft is, in my opinion, very close to being a monopoly with very few competitors, whereas, Yahoo has tons of competitors. Granted with investors giving Yahoo so much investment capital, Yahoo can buy other companies and maybe that's what it plans to do. Whatever Yahoo does decide to do, it needs to include making money and lots of it if it's ever going to support their current stock price with some tangible value.

Off the subject of Yahoo, but keeping with the internet sector, last Monday a merger was announced between Preview Travel (PTVL) and Travelocity.com. From PRNewswire October 4, 1999:

"About Preview Travel, Preview Travel is a leading online travel site with nine million registered members and reported gross bookings of $200.1 million in 1998 and $166.7 million in the first half of 1999. Preview Travel is America Online's primary partner, offering integrated travel content and services to AOL's 18 million subscribers. It also has relationships with Excite, Lycos, Snap, and USA Today, and has established itself as a leader in online media sales."

Look at what they have to say about Preview which is typical for an internet company. They talk about registered members, but nothing about how much money they make off those nine million registered members. They talk about gross bookings, but nothing about what their profit margin is on those gross bookings. They talk about all the relationship that Preview has with so and so, but nothing about how much money they make off those relationships. But of course, investors in most internet companies don't care about earnings, earnings are something that come later, right?

So far, Preview Travel has had 14 continuous quarters of reported losses, losing 64 cents a share in 1996, losing $1.03 a share in 1997, and losing 1.93 a share in 1998. It diffinetely seems like all those registered members, gross bookings, and business relationships are really paying off for Preview Travel.

From Yahoo finance I see under the business summary section in Preview's pofile report, "For the six months ended 6/30/99, revenues rose from $5.5 million to $12.9 million. Net loss from continuing operations rose 42% to $12.9 million." That is, the increase in revenues of $7.4 million made no additional money for the company, in fact, the increase in revenues cost the company $4 million dollars. With a profit margin of -121%, Preview, in my opinion, has proven, yes they can add members and add increase gross bookings...by paying for them.

Since the merger was announced on Monday, Preview stock is up about 22 points. That 22 point relates to an increase in market cap of $304 million dollars. Again, internet investors are right there throwing more money at a nonprofitable company and seem to have no care in the world about if and when the company will ever make any money.

One thing the internet sector has going for it is capital. Investors are giving a ton of money to this sector. No doubt, the internet is a great tool, but is it going to be able to return the billions of dollars back to investors? The only way the internets can do that are by earning money themselves, and so far, which is already 3 years into it, the vast majority of dot coms aren't making any money at all. But what the heck, let's give them another 3 years are see if they can't turn things around.

ADDENDUM (October 8, 1999)

Today, on CNBC I heard, from the minutes of the last Fed meeting, the Fed stated it will be proned to raising interest rates if the stock market goes up too much. As far as what the Fed means by goes up too much is anybody's guess.

It's interesting how the Fed loves to contiune to talk about the overvaluation of the stock market when the stock market clearly has as many undervalued stocks as it does overvalued stocks. And if the Fed is worried about the stock market which generally means you are talking about the S&P 500, why doesn't the Fed state they are especially concerned about the internet sector. I am not saying I think the Fed should stick its nose in the stock market, what I am saying is if they are going to talk about the stock market and valuation, why don't they get more specific. The S&P 500 has a PE of 35 and price to book of 9 and if that concerns the Fed, then why isn't the Fed especially concerned about the internet sector when the so-called industrial leader, Yahoo has a PE of 464 and a price to book of 61 with the vast majority of other internet stocks at more ridiculous valuations than Yahoo?

ADDENDUM (November 9, 2000)

"The $1.7 trillion dot.com lesson

Index of 280 Internet stocks is down $1.7 trillion from its 52-week high by Staff Writer David Kleinbard November 9, 2000: 5:24 p.m. ET

NEW YORK (CNNfn) - Call it the $1.755 trillion dot.com investing lesson.

It's hard to think of a publicly traded Internet company that is not down at least 75 percent from its 52-week high and that hasn't trimmed its expenses or laid off workers. While industry groups have always drifted in and out of favor on Wall Street, it's rare to see an industry evaporate as quickly and completely as Web stocks did.

CNNfn.com asked the market data and research firm Birinyi Associates of Westport, Conn., to calculate the market value of the 280 stocks in the Bloomberg US Internet Index at their respective 52-week highs and their current market value. The combined market values of the 280 stocks had fallen to $1.193 trillion currently from $2.948 trillion at their peak, a loss of $1.755 trillion, most of which occurred between March and September of this year.

The Bloomberg Internet Index contains Web retailers, Internet infrastructure firms, Web advertising companies, Web portals and makers of networking equipment. Some of the largest losses on a dollar-value basis came from networking equipment giant Cisco Systems (CSCO: Research, Estimates), which has lost $210 billion in market value from its peak; the Internet incubators CMGI (CMGI: Research, Estimates) and Internet Capital Group (ICGE: Research, Estimates), which have lost a combined $100 billion from their apex; the Web portal Yahoo! (YHOO: Research, Estimates), which shed $102 billion, and America Online (AOL: Research, Estimates), which is worth $92 billion less than at its highest point.

Of the 280 stocks in the index, 79 are down 90 percent or more from their 52-week high. Another 72 are down 80-89 percent. Only five are down less than 5 percent.

'It's not a correction ­ it's a crash,' said Fred Wilson, managing partner at Flatiron, a New York-based venture capital firm dedicated to investing in the digital economy.

The collapse of the Internet bubble, perhaps one of the largest financial fiascoes in U.S. history, came after a three-year period, starting in January 1997, when investors would buy almost anything even vaguely associated with the Internet, regardless of valuation. Investors ignored huge current losses and were willing to pay 100 times expected earnings in fiscal 2002. They were goaded by bullish reports from sell-side securities analysts  and market forecasts from IT research firms, such as IDC, Gartner and Forrester Research."