Just as fires need oxygen to keep them alive, Internet stock performance relied on continued and unbridled enthusiasm for "the concept," because for most companies there was not enough history to create a reality. As enthusiasm about "the concept" diminished with declining margins, increasing competition, interest rate concerns and a host of other factors, the hot air that held up the stocks was sucked out of the market.
Even with the slight rebound we've seen in the technology-heavy Nasdaq, many leading Internet stocks are still down 50 percent or more from their recent highs. We all knew that the seemingly "sure thing" that was Internet investing was too good to last. The reality, however, is that the momentum investing environment of the past afforded too much credit and capital to flawed, weak or immature businesses, and today probably assigns too much risk to the strongest Internet properties.
At least for now the heydays are gone, and Internet investors are on the sidelines, scowling at the Internet companies that failed to accomplish the unachievable: continuing their rise to the moon.
The pessimism that reigns among Internet investors is understandable considering that prominent institutional and retail investors are still licking their wounds from the correction. Internet companies, most trading at deep discounts to their value at the beginning of the year, are madly reworking their business models to accelerate profitability and re-establish their worth among investors.
Although it may seem as if Internet stocks have come crashing back to earth, most remain inflated according to traditional valuation metrics. A close look at companies with projected earnings in 2001 shows that many still trade at substantial premiums to their growth rate, the traditional multiple used for growth stocks. What does this mean?
If the shift in focus toward earnings continues, most Internet stocks still have a ways to fall. Two notable exceptions are Lycos and About.com, both of which are projected to have profits in 2001 and which trade at discounts to their three- to five-year growth rates of 75 percent.
A more disciplined approach to stock analysis, including looking at earnings multiples and cash flows, is merited and necessary. It is not the case, however, that industry blue chips will or should trade based on this analysis alone.
The macro trends in terms of business and consumer usage of the Web, the tremendous number of individual investors active in this sector, and the growth rates these companies are experiencing combine, we believe, to sustain substantial investor interest in the sector. As investors regain their courage, dollars should be focused on the relatively small number of Internet companies that have proven models, entrenched leadership, and significant earnings or earnings potential.
There's an expression along these lines: Idiocy is making the same mistake twice and expecting a different outcome. With so much capital needing to be invested, there's a reasonable risk that instead of making fewer, smarter investments, venture, private and public equity investors just shift their money to another sector--let's say wireless--and the cycle repeats itself. The hot sector has moved from business-to-consumer to business-to-business and now to wireless and infrastructure.
Unless we begin to ask tougher questions, demand more from the business models, and derive a better sense of a company's value, these sectors will be overfunded and overvalued and will lead to the same crash-and-burn outcome witnessed in the business-to-consumer and business-to-business sectors.