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Tech Industry

Playing the Internet stocks game

Despite the recent pre-announced shortfalls of bellwether technology companies like Compaq Computer and Motorola, technology stocks have been strong across-the-board this year.

    Despite the recent pre-announced shortfalls of bellwether technology companies like Compaq Computer (CPQ) and Motorola (MOT), technology stocks have been strong across-the-board this year.

    Both the Dow Jones Industrial Average and the Nasdaq indices are hitting new highs (8,848 and 1,829, respectively) and investor confidence seems to be strong. This, however, is in sharp contrast to the beginning of last year, when pre-announcements by Intel (INTC) and others sank the Hambrecht & Quist Technology Index 18 percent from its first-quarter high on January 22. Tech investors should recall that during the March and April bloodletting of last year, Internet stocks displayed their natural volatility and dropped a devastating 29 percent during the same time-frame. For many, this was a difficult lesson in the increased risk and volatility of playing the Internet stocks game.

    The behavior of the broader market is vastly different this year. Internet stocks are again more volatile than their technology counterparts, but this time, the volatility is working on the upside. While the H&Q Technology Index is up 26 percent from its low on January 12, 1998, the H&Q Internet Index is up a whopping 41 percent--in just over ten weeks!

    The following chart maps the performances of the different indices: the Dow Jones, the Nasdaq, H&Q's Technology Index, and the H&Q Internet Index. Besides the fact that all of them generally move "up and to the right," notice the H&Q Internet index relative to the others.

    As you can see, H&Q's Internet index, and hence Internet stocks, mapped to the swings of the other indices, mapping closest to the Technology Index but at a greater amplification (i.e. the swings were more severe than with the other sectors). However, I think a major breakthrough has occurred since the first of week of March, with Internet stocks de-coupling themselves from broader technology issues.

    Net stocks

    If you look at the chart during March, certain dips in the H&Q Technology Index were not matched by dips in the H&Q Internet Index. This lies in sharp contrast to the same time last year, when the H&Q Internet Index simply mirrored the broader dips of the technology sector. This dynamic is significant because it demonstrates an increasing adoption of Internet stocks by institutional investors, who typically prefer to have their money invested in safer, more established technology stocks. After a year of maturation--not to mention stock appreciation--Internet stocks are definitely making their way into the larger institutional funds.

    It would seem that investors may have come to realize that swings in technology adoption and hardware inventory levels are having only a limited amount of impact on the adoption and growth of the Internet. In fact, amid recent shortfalls in the tech sector, Internet issues are starting to look less risky.

    Realistically, should Pentium inventory levels, or levels of PC shipments, significantly affect the performance of Internet companies in the near term? I would say probably not much, depending on the sector. The fact of the matter is, the Internet is growing at its own pace, and is growing much faster and more furiously than the pace of technology adoption. The Internet is still in its infancy, and, as a result, should not be strongly affected by the cyclical nature of the tech sector. Unquestionably, PC prices are of some relevance to Internet penetration into the home, but it's a long shot to infer that technology cycles are the determinant of the performance and the rate of adoption.

    What are the determinants for 1998? I encourage you to look at my last column for some of the metrics that H&Q's Internet research division views as critical. As for the direction that Internet stocks will go this year? Well, clearly, if there is an overall market correction, then the Internet sector--like all other sectors--will take a beating.

    An important way to look at the Internet, however, is as its own economy. Investors increasingly need to start evaluating Internet stocks based not only on the fact that they belong to the Internet sector, but also on the fact that they are companies competing (albeit with different approaches) in more traditional industries.

    In other words, investors need to start thinking about the performance of Internet stocks not only in terms of how they compete within their own segment, but also in terms of how their performance and the overall performance of traditional sectors are doing. I suggest considering the following questions--How is the professional services segment as a whole? What are the growth expectations of the travel sector? How is consumer retailing doing? What are the growth assumptions underlying advertising growth for the next few years?--before making any Internet investing decisions.

    Dan Rimer offers his Internet insights regularly in Marketwise.