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Surviving the Net stock bubble

Unlike with other famous bubbles, the Internet bubble is riding on rock-solid fundamentals, perhaps stronger than any the market has seen before

The leading Internet stocks, which are up an average of threefold to sevenfold since September, always have seemed outrageously expensive, and now they are arguably the most expensive stocks in history. Despite all talk of "regression to the mean" and "irrational exuberance" these stocks just keep going up.

Given the extent of that upward trajectory, I'm comfortable labeling the current Internet stock phenomenon a "bubble," assuming that the term signifies enormous, manic increases in price without corresponding changes in the fundamental outlook. But because bubbles tend to burst, I continue to think that investors should actively manage the risk inherent in their Internet portfolios--taking profits until direct exposure to the sector becomes more appropriate.

Unlike with other famous bubbles, however--the South Sea company, tulipmania, and the biotechs of the early 90s come to mind--the Internet bubble is riding on rock-solid fundamentals, perhaps stronger than any the market has seen before. Underlying the crazy price increases are the foundations of what could become the early 21st century's leading growth companies, a group that in my opinion will include America Online, Yahoo, and

So while the October-to-January run-ups have been crazy, the urge to invest in the companies that have seen the biggest pops is not. Just because the Internet stock phenomenon looks like a bubble, it isn't a given that the bubble will burst.

At CIBC Oppenheimer, I continue to recommend that investors develop a coherent Internet investment strategy, whether it be offensive or defensive, direct or indirect. The Internet is much more than a technology trend. It is what might well be described as a global megatrend, one that will affect--positively or negatively--dozens of industries throughout the world economy.

As with other, smaller trends or events (Y2K, for example), some companies and stocks are positioned to benefit from the changes, while others are positioned to get socked in the jaw. The end result of the Internet on the stock market, in my opinion, will be a significant redistribution of market value. And based on the speed with which the medium is developing, that redistribution may happen sooner than people think.

I am not recommending that investors rush out and chase Yahoo to the moon, however. I believe, rather, that they should take time to analyze, industry-by-industry, what might be called the "Internet effect"--and develop a plan for reallocating capital to account for it.

For investors interested in investing directly in the growth of the Internet, I believe it is important to make some conclusions about what is fueling the sector's extraordinary valuations and whether that force is sustainable over the long term. In this month's column, I will address the first issue. Next month (assuming the stocks haven't tanked in the meantime), I will offer some thoughts about what investors might expect over the long term if this short-term "bubble" actually does burst.

The main driver of the Internet stocks is an imbalance of supply and demand. The price of any good or service is determined not by its inherent "worth," but by the law of supply and demand, and good Internet investments are in short supply and great demand.

Metaphorically speaking, if you want to live in Manhattan, you have to pay mind-boggling Manhattan prices. Similarly, if you want to invest in the stocks of companies that appear to be on their way to becoming the leading growth companies of the early 21st century, you unfortunately have to pay mind-boggling prices for Internet stocks (at least for now).

Because the valuations of America Online, Yahoo,, and other Internet leaders long ago reached levels that are hard to justify through traditional fundamental analysis--and yet have continued to appreciate--it seems a mistake to try to arrive at a precise "fair" multiple to put on them. No one knows what the stocks are really worth, and by attempting to determine this, a great number of smart investors have missed golden opportunities.

Instead, I believe investors should take as a given the scary proposition that the Internet stocks are the most expensive in history, and from there try to figure out whether the risk of owning them is justified by the potentially greater risk of continuing to miss them from here on in.

There are plenty of good reasons to invest in Internet stocks. As a global megatrend, along lines of the printing press, gasoline, the telephone, the computer, and electricity, the Internet will have a significant impact on multiple sectors of the world economy. Unlike a mere technology trend, which renders prevailing technologies obsolete and, in so doing, creates an opportunity for vendors of new technologies to quickly build large businesses, the Internet is changing the way people and companies communicate, research, buy, sell, distribute goods and services, and, importantly, spend leisure time. As a result, it is not only creating the opportunity for new businesses to get big fast, but it is introducing change and competition into a wide range of mature industries, including media, retailing, technology, telecommunications, financial services, transportation, healthcare, and energy.

All this translates into an enormous supply of investment dollars. Investment capital--and, with it, market value--tends to migrate toward growth and away from stagnation, and the Internet is clearly creating vast opportunities for growth (the pure-play Internet companies are among the fastest-growing in history). Moreover, investment capital also tends to migrate away from fundamental risk, and for entrenched industries and companies too stubborn or distracted to notice the writing on the wall, the Internet represents significant risk. So in offering fundamentals that appeal to two major types of investors--those that seek to put their money where the growth is, and those that seek to move it out of harm's way--good Internet investment opportunities are attracting a great supply of investment dollars.