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?
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 the fall of 2007, even before the current bear market. That's a total return of negative 62%.
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!
And that's despite some successes. AXENT merged with Symantec, and a $1,000 investment there would have been worth more than $4,600 by last fall. Auctioneer king eBay would have doubled your money over the same time.
But other 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 fall. Discount brokerage Ameritrade, which merged with TD Waterhouse in the intervening time frame to become TD AMERITRADE (Nasdaq: AMTD ) , returned 46% to shareholders.
Even the big winners can't change the reality that 18% of Kyle's companies went bankrupt. And many of the companies that survived, including Akamai Technologies (Nasdaq: AKAM ) and AOL (now a part of Time Warner (NYSE: TWX ) ), are down more than 60%.
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 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 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.
"Buying China" was a sucker's bet back then, but things are a bit different now. For starters, multiples in China have come way down. The likes of AgFeed Industries (Nasdaq: FEED ) , China Digital TV (NYSE: STV ) , and China Security & Surveillance Technology (NYSE: CSR ) have seen P/E and P/B multiples contract rapidly.
And although stocks like these may still look expensive compared with their American peers, 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 our team at Motley Fool Global Gains recently undertook a research trip to Asia.
If you'd like to see our team's top ideas from that trip, we offer a 30-day free trial without obligation to subscribe. 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 eBay are Stock Advisor selections. eBay is also an Inside Value pick. Akamai is a Rule Breakers selection. The Fool's disclosure policy does a lot of spelunking.