CNET también está disponible en español.

Ir a español

Don't show this again

Tech Industry

How to invest in the Internet

Some of the public companies in the Internet sector will turn out to be huge successes over time, while some will turn out to be built on smoke, mirrors, hope, and hype. While day traders can profit from transactions in both types of companies, serious long-term investors should think about differentiating between the two.

After a month or two of uncertainty, investors once again appear to be completely convinced that there is an enormous pot of gold at the end of every Internet company's rainbow.

This unbridled enthusiasm for all things Internet certainly makes the analyst's job temporarily easier, because investors are much more pleasant to deal with when they are making money. However, truth be told, there was something more comforting about the skepticism of last month than the current euphoria.

We're still very early in the development of the Internet as a consumer information and e-commerce network. Some of the public companies in the Internet sector will turn out to be huge successes over time, while some will turn out to be built on smoke, mirrors, hope, and hype. While day traders can profit from transactions in both types of companies, serious long-term investors should think about differentiating between the two.

There are several important considerations Internet investors should factor into their decision-making processes. A few are generally accepted, some are controversial, but all are critically important.

For starters, the Internet is all about size. Bigger really is better, and the big get bigger faster. Despite all the dollars being spent on banner ads and sponsorship deals, Internet companies must admit that word-of-mouth recommendations from current users are by far the most effective way to attract valuable new customers. Since bigger companies have more "mouths" to spread the word, they have a self-perpetuating advantage.

Bigger companies also have an economic advantage, because there is a larger customer base over which to spread fixed costs. This is the classical "economies of scale" argument.

Another advantage of bigger companies, and one that's more unique to the Internet, is what industry sage, Ethernet inventor, and 3Com founder Bob Metcalfe has dubbed "The Network Effect."

The Network Effect theory states that the value of the network increases by the square of the number of incremental "nodes" on that network. For example, EarthLink not only collects incremental subscriber revenue from each individual customer, but also can "sell" each of those customers to sponsors and advertisers anxious to maximize the number of eyeballs that will see a specific ad message. Again, bigger definitely is better.

Another key consideration investors should note is that, at the end of the day, the value equation will favor content over distribution. Currently, Madison Avenue and Wall Street get excited about growth in the number of unique users and in the "reach" percentages of specific sites. But while these so-called metrics are easy to calculate, they really aren't helpful in trying to determine the value of a given site. While those advertising on television can get a reasonable estimate of customers likely to see an ad by studying reach and ratings, the Internet offers no such assurances.

For example, viewers watching Ally McBeal are highly likely to watch the beginning, middle, and end of the show, and are reasonably likely to see the commercial advertisements in between. By contrast, visitors to a particular information hub online, such as a portal, may well only stop in to check a portfolio or visit a chat room. There is no assurance that they will see, much less notice, a particular advertisement.

I believe that advertisers increasingly will be drawn to sites that can prove a certain degree of customer loyalty, as opposed to sites that only can claim to have a large number of pass-through visitors. If this proves an accurate assessment of the marketplace, the key question then becomes: "How do you build loyalty?"

The answer is with proprietary content. On the Internet, content can be defined within a wide range of information such as personalized start pages or portfolios, chat rooms with a "community" of returning participants, and articles that either appear only on the Web or are repurposed from print publications. I believe that advertisers continually will favor sites that can offer this range of information to their "members." The resounding success of The Street.com and AOL's recent deal with Time Warner to be the exclusive provider of People Magazine content online provide evidence that, already, content is taking on a more kingly role on the Internet.

Lastly, it's simply silly to value customers based on page views. On the one hand, an increase in page views could mean that more customers are spending more time on a given site, and are seeing more of that site's content. This is information that should warm advertisers' hearts. But on the other hand, an increase in page views could mean that more customers are having more trouble finding the information they seek, and hostile customers generally are not well-disposed to noticing ads.

Page views are easy to manipulate, and actually don't impart much information about a site's economic prospects. Web sites and the stocks that represent them should be valued as a function of the total number of customers, the profitability of each customer, and the cost to sign on a new, loyal customer. While these numbers are a bit obscure today--they require an analysis of the run rate of revenues per customer, gross margin per customer, and sales and marketing expenditure per customer--they ultimately will be the measures that most accurately determine which of the current batch of companies will be winners, and which will end up as footnotes or case studies for the business school classes of tomorrow.

Despite wild volatility and hard-to-stomach valuations, a number of stocks in the Internet sector are poised for greatness. Others, however, aren't. My strong recommendation to investors is to be rational above all, taking as many factors as possible into consideration. I also advise investors to remember that stock price appreciations and company valuations that appear to be too good to be true most likely are. Just ask the folks who bought Theglobe.com at $87.