FOOL ON THE HILL: An Investment Opinion
Dot-coms Discover Profit?!

Internet companies have suddenly been shunned by the market due to their uncertain prospects and their lack of profitability -- precisely the same factors that made them so popular for 18 months. Philip Fisher spoke out against companies that openly tout their successes and clam up about their failures, while Warren Buffett has stressed the need for companies to resist going along with the crowd -- two traits that many of the dot-coms sorely lack as investors are now seeking substance over appearance.

By Bill Mann (TMF Otter)
August 23, 2000

Philip Fisher has some sage advice for people who are invested in Internet stocks. I know, I know, he's old school and not very exciting. Fisher never traded in and out of companies. He's done boring things like buy Motorola (NYSE: MOT) in 1955 and held it ever since (I'll give you a hint -- he did quite well on that particular trade). What could someone who began his career just before the Great Depression teach us about investing in modern technology companies with product cycles measured in hours?

Quite a bit, actually. In Fisher's "15 Points to Look for in a Common Stock," a chapter in Common Stocks and Uncommon Profits, we have what is arguably the supreme methodology of determining true excellence of a company.

Fisher's Point 14 is applicable in the aftermath of the collapse of many Internet stocks. It reads simply:

Does the management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?

The "institutional imperative"
Warren Buffett takes it one step further by determining if companies resist the "institutional imperative." These are slightly different concepts, but they're cut from the same cloth. Essentially, Fisher is exhorting us to recognize that even with the best, most innovative companies that tactical mistakes happen on occasion. A company that pushes its failures under the rug should be considered less worthy an investment than a similar company that openly addresses its weaknesses and seeks to address them. Similarly, Buffett believes that companies that take on a strategy just because it is in vogue or to keep pace with competitors, will never be anything but inferior investments.

I'll give you a perfect example of the "institutional imperative." For the last few years the majority of retail e-commerce companies have played the tune of rapid expansion over all else, infracting the most basic laws of fiscal management in the process. It seemed any expense that built the brand was considered a sound investment. For example, more than 20 unprofitable, relatively unknown Internet companies spent $2 million per 30 second slot to advertise during the Super Bowl this year. One of those companies is already out of business.

The rule on the street was to get big and get known fast, and the rationale was that there was an infinite supply of investor and venture capital cash for those companies that differentiated themselves and their brands. Almost every retail Internet company that I can think of bought into this theory and spent their investors' money like there was no tomorrow.

And for a bunch of them, there now is no tomorrow. So you have companies that spent millions trying to create a name for themselves as operating companies that are now "reinventing themselves," or "refocusing," or "exploring strategic options." I guess these companies' managements are not really in a position to stand up and say "we really screwed up," but essentially that's what you've got. Maybe the best marketing move drkoop.com (Nasdaq: KOOP) did was to go broke, because it bought the company a brand awareness level that other dot-com's spent millions trying to achieve.

The thing is, almost every company in this space screwed up the same way at the same time. I have only been able to come up with two (I'm sure there are more) retail Internet commerce companies that did NOT overspend to grow: eBay (Nasdaq: EBAY) and Yahoo! (Nasdaq: YHOO). Every other company, from Amazon.com (Nasdaq: AMZN) to now-defunct boo.com, to Pets.com (Nasdaq: IPET), Buy.com (Nasdaq: BUYX) and Cyberian Outpost (Nasdaq: COOL) have spent much of their short existences burning through other peoples' money trying to become big before they became profitable. And with few exceptions these companies and their investors are dealing with the consequences of this strategy.

Advertising and concentrating on building customer base and brand worked for the first into the breach: AOL (NYSE: AOL), Yahoo!, Amazon. It hasn't really worked since. Of course, in the great scheme of things, 99% of all pure-play retail Internet companies are still operating, and several may well yet turn the corner. But this will not be due to a strategy of spending themselves into prominence. The Internet is too effective a comparison-shopping tool for brand loyalty to be enhanced by clever or ubiquitous advertising.

Follow the bouncing buzzword
So now we see company after company change from the buzzwords of last year to the ones of this year. Where companies were once speaking of establishing their brands they are suddenly dead focused on profitability. These companies had the opportunity, when they were flush with initial-public-offering (IPO) and venture capital (VC) cash, to develop cash management skills.

Yet they were unable to resist the "institutional imperative" to compete in outspending and outgrowing their competitors. The madness grew to such a degree that managements were willing to walk away from millions, or even billions of cash by underpricing their IPOs so that they could enjoy a successful "pop." The investing community sure helped by focusing on any revenue growth rather than healthy revenue growth, but in the end, companies must be counted upon to provide their own sanity checks.

The e-commerce company that preserved its cash in the heady days of 1998 and 1999 is better off than nearly all of the ones that did not. And I include Amazon in the list of those that did not, though it was actually successful in building its brand. But can Amazon use its brand to price its goods higher than its competitors? Not at all, and therefore its brand does not have the same weight or value that Coca Cola (NYSE: KO) or Nokia (NYSE: NOK) does.

Still, Amazon has the first-mover benefit -- it was a Web destination and brand before some of the walking dead were even on the drawing board. Amazon has turned out to be the Jimi Hendrix of the Internet retailing world -- those that tried to follow and mimic it have mostly found dead-end streets.

So now, even if it is not the most healthy thing for companies, one after another they are chasing investors while hoisting the flag of fiscal responsibility and imminent profitability. Never mind the effect that these changes will have on the top line, the only bright spot for many. Time will tell whether the hole dug by these companies during the salad days was just too deep, or if a drive to profitability will be more than rearranging deck chairs on the Titanic.

But it's fairly clear that the impetus for focusing on profitability was not an internally generated concept. There are simply too many companies declaring themselves chaste for it to be anything but an externally driven vogue. Well, that and a desire to stay in business now that fantasy time has ended. And so, just as big growth and being vertical or viral or B2B or push technology or adding ".com " to your name have been quickly cycling trends, so may this one be until investors become infatuated with some new "concept." And for the most part the majority of these ideas have been skin deep, designed to catch the fancy of the investing public, appearance over substance.

So while the push for profitability may be a sign of companies growing up, if a former big-spending company has changed its tune to meet the needs of the investment community now that it is choosing to be more cautious (a term I'm using loosely) than it was last year, who's to say that it wouldn't switch right back to freewheeling fun when times return? Warren Buffett once said that he is rarely impressed by companies' cost-cutting measures, because it means that they had not engendered a culture of protecting monetary assets from the outset. That's a bold statement.

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