This Stock's a No-Brainer

The Internet may prove to be the greatest human invention of all time. Investing in Internet companies in 2000, however, may prove to be 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?

It almost pains us to tell you.

Had you invested $1,000 in each of his 100 Internet names back on April 20, 2000, for a total investment of $100,000, you would have had -- drumroll, please -- $37,814 through October 2007. That's a total return of negative 62%.

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

To the moon!
Even the success stories struggled with their valuations. Despite having lived up to its promise of becoming the premier cyberstore, Amazon.com returned just 68% from April 2000 through last October. Discount brokerage Ameritrade (Nasdaq: AMTD), which merged with TD Waterhouse in the intervening time frame, returned 46% to shareholders.

There were, of course, some good returns. You would have done quite well buying Verio, which was acquired in 2000 by Japanese wireless firm NTT DoCoMo (NYSE: DCM). Verio shareholders scored a cool 117% on that deal 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 CNET Networks (Nasdaq: CNET), Akamai Technologies (Nasdaq: AKAM), and AOL (now Time Warner (NYSE: TWX)), are down 60% 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 a company's 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 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
Somehow, these lessons seem as timely as ever (and we're not talking about the burst housing bubble). Exhibit A: investing in China.

Moreover, the Chinese government was concerned enough 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."

It might look familiar: The Chinese index was up 130% in 2006 and another 97% last year. According to data from Forbes, even after a tough start to this year, Chinese stocks, as measured by the Shanghai and Shenzhen 300 Index, still go for 28 times earnings -- compared with just 20 times earnings for the S&P 500! 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 assume that picking the right place to invest trumps picking the right companies to invest in.

While "buying China" is a sucker's bet, there are more than a handful of attractive opportunities in China. One way to find them is by using bottom-up fundamentals analysis, with an eye on political and currency risk and a grasp on valuation. The other is to keep up with our research at Motley Fool Global Gains.    

Our recommendations aren't no-brainers, but we're confident that on average they won't yield negative 60% returns. And even better, you can see them for free with a 30-day guest pass. Click here for details on this special offer.

This article was first published Sept. 28, 2007. It has been updated.

Neither Brian Richards nor Tim Hanson owns shares of any company mentioned. Amazon and Time Warner are Stock Advisor selections. CNET and Akamai are Rule Breakers recommendations. The Fool's disclosure policy does a lot of spelunking.