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YOUR MONEY | INVESTING 201

Some See Information Highway as Road to Riches, Others as Road to Ruin

This is the third lesson in Investing 201, a 10-part series that looks at changes in the investing landscape that have occurred over the last few years. Lesson 3 focuses on Internet stocks. Next week: Online investing.

May 16, 1999|KATHY M. KRISTOF

In Lesson 1 of this series, we looked at how fundamentals dictate stock prices. Now it's time to forget all that so we can talk about one notable exception: Internet stocks.

Many of these companies have no earnings, management experience or other fundamental indicators of value. What they have is potential--and stock prices that indicate no limit.

"Dot-com" stocks have risen so far so fast that many experts say we've entered a mania, a moment when market math temporarily goes out the window. When sanity returns, valuations will plummet, laying waste to the millions of unsophisticated investors who bought Net stocks without questioning their true worth, says Michael Murphy, editor of the California Technology Stock Letter and author of "Every Investor's Guide to High-Tech Stocks & Mutual Funds" (Broadway Books, 1998).

"The Internet is two different things," Murphy says. "In the real world, it is a fundamental paradigm shift in how we do business. In the financial world, it's a bubble."

Or not.

Another contingent of market professionals says Net companies are so fundamentally different from businesses that rely on bricks and mortar--buildings, branch offices and retail outlets--that their high stock valuations are reasonable.

Even Internet bears say the rush to buy is not completely irrational. While past market manias saw investors snapping up tulips at ridiculous prices in 17th century Holland, for example, underlying the current fever is a belief that the Internet will change the world. Tulips have no long-term economic value, but the Net transcends time and space and makes it easier to reach customers, communicate and transact business. Prices may be steep, but some companies will inevitably prosper and make their investors rich.

How expensive are Net stocks? Most stocks sell for 10 to 30 times their current-year per-share earnings. In market speak, that's their "multiple." These days, many Net stocks are fetching hundreds of times their projected earnings.

"Is a 90 multiple--or a 300 multiple--for America Online too much? No," says Alexander C. Cheung, manager of the Monument Internet Fund, citing the company's zooming profit growth. "Amazon.com is only a 4-year-old company. Can we use the same methodology to measure Amazon as Barnes & Noble or Wal-Mart? No."

Yet experts agree that plenty of Internet stocks won't survive. Cheung, for example, figures that at least half of today's Internet fliers will be bankrupt in five to 10 years.

Which are the right companies--and which are the wrong ones? It's hard to say.

Consider the debate about Amazon.com, the Internet-based seller of books, records and tapes. While the company's sales are soaring, so are its losses. In 1998, Amazon lost $124.5 million, compared with $31 million in 1997. And this year's figure could be even bigger, since the company lost $61.7 million in the first three months.

Still, investors have been pouring money in. During the last year, the stock price has soared from about $13 to an all-time high of about $221. It has since settled in the $140 range, but that still gives this money loser a market capitalization--the value of all shares outstanding--above $20 billion.

Why are investors so eager to buy this stock when other companies are more profitable?

As Cheung puts it, "You have to look at the business model--not just the business."

Amazon has 8 million customers. That's a big increase from a year ago but still just a fraction of the roughly 125 million users of the World Wide Web. And, of course, the number of Web users is expected to continue growing at a blistering pace.

If Amazon's growth mirrors that of the Web, it will have 25 million customers in three years and sales of $2 billion, Cheung projects. But Amazon doesn't plan to grow merely at the same pace as the Web. One reason the company is losing so much money is that it aims to be a "killer retailer," such a recognized name that when people think books, they click to Amazon. The company is spending a small fortune on advertising and customer service to gain a loyal following.

Meanwhile, the company is expanding its offerings in an effort to leverage its name and infrastructure into more sales. If the strategy works, Amazon could become wildly profitable.

"When you cross that line, earnings could increase exponentially," Cheung says. "With a normal retailer, the profit margin is 2% to 4% of sales. But if you can do it without the brick and mortar, you can expect 5% to 6%."

Others question whether Amazon will ever see a profit.

Virtually anyone with a computer, some programming expertise and a connection with publishers can compete for book buyers, notes Alan F. Skrainka, chief market strategist with Edward Jones in St. Louis. Thus, the easiest way to gain market share when you're selling a commodity, such as books, CDs or even stock trades, is to cut your prices. That's good for consumers but rotten for profits, and ultimately it's bad for shareholders, he says.

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