This Stock's a No-Brainer

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The Internet may prove to be the greatest human invention of all time. Investing in Internet companies in 2000, however, may prove to have been one of history's greatest follies.

Yet 2000 was a heady year for Internet investment. Guides such as Greg Kyle's 100 Best Internet Stocks to Own showed you "how to get in on this once-in-a-lifetime opportunity." Kyle predicted that there would be 430 million Internet users by 2003, and that by 2005, "consumers will spend $150 billion shopping online."

In fact, those estimates proved conservative. By 2003, nearly 600 million people were online. In 2005, shoppers spent more than $175 billion on the World Wide Web.

Time to cash in
But even though Internet usage blew away expectations, you would have been a big loser if you'd invested in Kyle's 100 best Internet stocks. How much of a loser?

In the fall of 2007, we went spent hours computing the returns figures. Spoiler alert: The results are painful.

Had you invested $1,000 in each of Kyle's 100 Internet names back on April 20, 2000, and held them through September 2007, your $100,000 investment would have turned into -- drum roll, please -- $37,814. That's a total return of negative 62%, and again, that return is through the fall of '07 -- before the current bear market.

You were more likely to pick a company that would go bankrupt (18) as you were to pick a company that simply increased in price (13)!

To the moon!
Even the success stories struggled with their valuations. Shareholders who bought in April 2000 made a small profit (about 10%) when Dow Jones acquired MarketWatch.com. (To further confuse, Dow Jones was later acquired by News Corp. (NYSE: NWS).) Checkfree, now part of Fiserv (Nasdaq: FISV), returned 39% to shareholders since from 2000 to 2007. Shareholders of Wit Capital Group, which became Soundview Technology, found 42% gains when Schwab (Nasdaq: SCHW) acquired their company.

There were, of course, some amazing returns. You would have done quite well buying Verio, which was acquired in 2000 -- Verio shareholders scored a cool 117% in about a month.

But even the big winners can't change the fact that 18% of Kyle's companies went bankrupt. And many of the companies that survived, including Drugstore.com (Nasdaq: DSCM), Sapient (Nasdaq: SAPE), and Quest Software (Nasdaq: QSFT), are down about 50% or more.

What went wrong -- and why
Most of the companies profiled in the book were profitless -- and burning through capital at a rapid rate. Indeed, many of the companies shouldn't have been worth a dime ... let alone billions of dollars.

See, Internet companies at the turn of the century were expected to generate massive cash profits. They didn't. A stock's value is nothing more than an estimate of its ability to generate cash profits over time. Before long, "market share," "network effects," "eyeballs," and "B2B business models" were exposed as Northern California euphemisms for "no cash."

The value of valuation
That's why valuation is such a critical component of investing. As the Internet mess illustrates, taking a top-down investing approach -- starting with the best, fastest-growing industry -- will usually lead to failure. Show us that industry and we'll find you a stock operating therein that's going down in flames.

That's why we advocate a bottom-up investing approach. Start at the company level and work up from there.

It's also why there are no no-brainers in investing. Just to repeat: Although the Internet has been even more successful than Kyle imagined, the stocks he profiled were mostly disasters.

China = the new Internet
When an earlier version of this article was published, we made the case that the lesson of the Internet was as timely as ever -- and not because of the burst housing bubble. Why was it timely? China.

After all, the Chinese government was concerned enough about a bubble to triple the tax on stock trades last summer. According to The New York Times, that move was "aimed at braking what many business executives and economists inside and outside China now see as a stock market bubble."

The Chinese stock index was up 130% in 2006, and another 97% in 2007. According to data from Forbes, Chinese stocks, as measured by the Shanghai and Shenzhen 300 Index, were trading for 52 times earnings last fall -- at a time when the S&P 500 was going for a P/E of 17. And according to Bloomberg, "Domestic [Chinese] investors opened about 49 million trading accounts [in 2007], nine times the total for 2006."

The more things change ...
Not even a decade later, investors assumed that picking the right place to invest trumped picking the right companies to invest in. The lesson has been just as painful this time around -- Chinese stocks fell more than 60% last year, far outpacing even the lackluster performance of our domestic markets. 

While "buying China" was a sucker's bet back then, things are a bit different now. For starters, multiples in China have come way down. The likes of Suntech Power (NYSE: STP) and Solarfun Power (Nasdaq: SOLF) have seen P/E multiples contract.

The recent malaise in the Chinese market means that you can buy into the country's great growth story at the best prices in recent memory -- which is a major reason why our team at Motley Fool Global Gains is making a research trip to Asia for the third consecutive year.

Here's the cool part: You can follow along with our research and notes from the trip -- completely free of charge -- by signing up for the team's live dispatches from the road. All you have to do is enter your email address in the box below to let us know where to send them.