Weighing the pros and cons of Net stocks

Case-and-point, companies with the least amount of revenue are trading at the greatest multiples on a relative basis. But even more shocking is that in certain cases, these same companies are fetching greater a market capitalization than their peers, who claim a better performance track record.

We have spiraled to a point in the markets where the unknown is significantly more rewarded than the known, and the unquantifiable is far more attractive than the quantifiable.

Follow this line of thought: I will pay more for a car shop that has just opened its doors, and is adding customers at a faster rate than the car shop that has been servicing cars for a couple of months, and has actually proven a strong ability to grow and build a business. Such is the world of the Internet stock.

So given how quickly the online world moves, here are four issues that investors should scrutinize when weighing an investment in an Internet company.

One, overall opportunity. If the opportunity is limited, it is not an Internet stock.

Two, the quality of the management team. Given the unprecedented competitive pressure on the industry, every investor should be convinced that a company's main players will not only be good enough to continue to steer the company on the right course at warp speed, but also be able to face and conquer unpredictable obstacles along the way.

And thirdly, the business model. Contrary to what we may desire, business models that generate the bulk of the revenue up front are the wrong business models. The correct business models are those that are associated with the growth of the Internet. In other words, while it may seem counter-intuitive, a company that has high up-front revenue and little deferred revenue is significantly less attractive as an investment, than its inverse.

Most importantly, a slowdown specifically related to a company's operations, or a related market slowdown, is a key metric to spur investor flight. It's difficult to justify holding onto any Internet stock that sways from linear growth when the group is trading at such rich valuations. Of course, it is unrealistic to expect that the growth curve won't flatten over time--but I stress that it will be gradually over time.

If I were to create a company, my company would concentrate on creating new businesses. As soon as a market shows itself to have some legs, I would create or spin-off those new companies--a pure play in this sector--and take it public. I then would continuously acquire companies that are pure plays with limited operating histories in their sectors, but that are well positioned to capture growth in new markets.

What this implies, is that companies that fetch the highest market capitalization will be the ones that redefine themselves and continuously attack new markets.