FOOL PLATE SPECIAL: An Investment Opinion
Blodget Downgrades the Internet

This morning, Merrill Lynch analyst Henry Blodget downgraded 11 Internet stocks, including eBay, DoubleClick, and Safeguard Scientific. The trouble is that most of these stocks have already fallen severely since the crack-up of the pure-play Internet sector this past spring. Here's another tale of an analyst predicting something that has already happened.

By Bill Mann (TMF Otter)
August 7, 2000

Today is the day Henry Blodget, Merrill Lynch's (NYSE: MER) star sell-side analyst, broke the Internet.

Not really. But Blodget, who made his name by throwing an audacious call on Amazon.com (Nasdaq: AMZN) in 1998, followed through on his saber rattling over the last half-year with a mass downgrade of the entire business-to-consumer e-commerce sector. He has, over this time, stated that some 75% of the sector's companies would be unable to survive the inevitable shakeout and consolidation as hundreds of cash-bleeding immature startups try to make the transition into operating entities.

So today "Mr. Internet" followed through, warning that the 100% revenue growth of the past could not continue into the future, and downgrading 11 companies in the sector. Of these, eBay (Nasdaq: EBAY), 24/7 Media (Nasdaq: TFSM), and Safeguard Scientific (NYSE: SFE) are currently cash flow positive. The remainder, DoubleClick (Nasdaq: DCLK), barnesandnoble.com (Nasdaq: BNBN), Buy.com (Nasdaq: BUYX), eToys (Nasdaq: ETYS), iVillage (Nasdaq: IVIL), Pets.com (Nasdaq: IPET), Quokka (Nasdaq: QKKA), and Webvan (Nasdaq: WBVN) are not.

Blodget stated that "the tide is no longer rising fast enough to lift all boats," a reference to his belief that most pure-play Internet companies are going to fail or be consolidated in the future due to slowing business, poor economics, and increased competition. Blodget also turned his back on the company that made him, cutting his estimates and rating on Amazon.com two weeks ago.

There are a few interesting things here. Looking at Mr. Blodget's record, it becomes quite clear that he completely missed the current downturn in his ratings of the companies he covers. Even with the recent downgrades, he still maintains "buy" or "accumulate" ratings on all but two of the 28 companies he covers. And of the companies he did cut this morning, his recent advice has been almost universally bad. The Foolish investor shouldn't care about "near term" price appreciation (i.e. less than one-year), but for someone whose influence is predicated upon his ability to make such calls, Blodget's record of late is abysmal.

For example, Blodget put a "near-term buy" rating on Pets.com on March 8th, when it was trading at $7 1/2, just after its Merrill Lynch-underwritten IPO. Today that company is trading at $1 5/32, 83% lower. Barnesandnoble.com has fallen 75% from its high, Buy.com 45%, and iVillage 75% -- all in a time when Blodget was warning of weakness in the sector without touching his rating on these stocks.

But analysts, just like everyone else, are really not that good at predicting short-term movements, so Blodget should be given some slack there. What is more troubling is that he failed to publicly change his ratings on a group of companies that are squarely in the cross-hairs of the larger factors he cites for upcoming industry weakness.

The other strange thing was his comment that the downgraded companies may be at seasonal bottoms and thus present a good buying opportunity, and that current setbacks may not be predictions of future weakness. Allow me to translate: "Now that these stocks have dropped 50% or more, I'm going to downgrade them, even though they might turn around soon." In farming they call this "closing the barn door after the cow gets out." In finance we call this "navel-gazing," or trying to look at where stocks have gone to figure out where they're going.

These prognostications are of no help whatsoever to investors. Rather than being predictive at all, they are responsive. The analyst sees that a stock price has dropped and then cuts it. This is the polar opposite of how an investor should approach the stock market. A superior business model that has been hit needlessly by the market is the perfect buy. Of the companies in the list above, there are a few that qualify. It just goes to show that the best predictions are ones made on events that have already happened.

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