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Friday, May 21, 1999

An Investment Opinion
by Warren Gump

Delusional Optimism

I have watched in bewilderment this week as some Internet companies continue to defy the norms of traditional, and possibly even bubble-era valuations. Yesterday, Healtheon (Nasdaq: HLTH) soared to over $100 on news that it finally reached an agreement to acquire privately held WebMD in a merger of equals. That value of this combined upstart is in the $15 billion ballpark. On the same day, eToys (Nasdaq: ETYS) completed its initial public offering (IPO) of 8 million shares for $20, only to see shares close at $77, placing an enterprise value of almost $8 billion on this upstart. That's about $1 billion more than Toys R Us' (NYSE: TOY) $7 billion enterprise value.

Now, I know all the arguments made to justify these valuations. We are entering "a whole new world," where first movers are going dominate business segments. The evolution of the Internet is different because it allows for a global introduction of business operations with relatively low costs. The growth prospects are unlimited. These companies are all going to move into new areas that will justify the current prices. On and on. Certainly, the proponents will argue their cases more elegantly than me. Despite these arguments, I would urge you to be extraordinarily selective when investing in Internet-related stocks.

I have no beef with the belief that the Internet will revolutionize many facets of business. We have only seen the tip of the iceberg in terms of changes to emerge from this new technological infrastructure. Innovation will bring about the ability to do things that are almost unimaginable today. My concern lies in the fact that so many people seem to think that virtually everyone developing a business on the Internet will be successful and the dominant leader of their respective sector.

The allure of getting into a company in its early stages is enormous. Books and articles are littered with true stories of investors who have become millionaires by buying just a few shares of one stock early on and holding as the company developed. You can pick your choice of successful large companies... patient early investors in Coke (NYSE: KO), Microsoft (Nasdaq: MSFT), McDonalds (NYSE: MCD), or Dell (Nasdaq: DELL) have achieved enormous financial gains. We would all naturally like to follow in their footsteps.

One strategy devised by some speculators, encouraged by stratospheric runups in the stocks of so many Internet-related companies, is to pile into any company related to the information superhighway. This reckless abandon, assuming that any company allied to the field will be successful, raises a huge warning flag. Although a select few companies focusing on the Internet revolution will become corporate titans of the next century, many will fall by the wayside and become also-rans. It happens in every emerging industry.

Think about the biotech craze in the early 1990s. Everyone was convinced that these companies would revolutionize medicine. In many ways they were correct. Advances in the field so far have been impressive and much more is on the way. Despite this success, only a few companies in the sector have been superior investments. You do, of course, have stocks like Amgen (Nasdaq: AMGN) that have increased in value 30-fold this decade. A few standouts will always exist. You also, however, have a more numerous pool of investments that have not been so stellar.

For a real loser, you can look at Immunomedics (Nasdaq: IMMU). This maker of products for the detection and treatment of cancer and infectious diseases started the decade at $4 a share. In the excitement over the biotechnology revolution in 1992, the stock reached $17 per share. Today, you can scoop up shares for a tad over $2 a piece. Investors in this company not only incurred a substantial loss, but also lost out on the tremendous gains provided by most other stocks.

Some companies that turn in great operating results end up being lousy investments when market expectations have been driven too high. One need search no further than Centocor (Nasdaq: CNTO) as an example. This company hit $60 per share in early 1992 after posting revenue of $53 million and an operating loss of over $100 million in 1991. Optimism flourished about the company's terrific prospects in the developing world of biotech. Seven years later, the company has grown revenues six-fold and turned its losses into an operating profit of over $40 million. Where, you might wonder, is the stock? About $45 a share. Even though the company has enjoyed terrific financial results, the stock has lost value because expectations were too high.

Years from now, investors will likely reflect on how much money was made and then lost on Internet stocks in the late 1990s. I fear that many extremely successful companies will turn out to be bad investments like Centocor because of the extreme level of enthusiasm investors currently hold for the future. Winning in any business endeavor is not guaranteed, particularly when you're competing using a revolutionary technology. Today's stock prices seems to imply that everyone will be winners, which certainly won't happen.

If you are absolutely determined to place some of your money into Internet stocks right now, I will make one recommendation. Take a few minutes to review the criteria used by the Motley Fool's Rule Breaker portfolio to evaluate investment opportunities. Stocks that pass these barriers will not be immune to marketwide reevaluations of an industry's prospects, but they will be much more likely than the average company to withstand that turmoil.

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