Stock Models Revisited: Lessons From the Internet Era

More than a year ago, I wrote the following words in one of my columns: "Especially this year, which we predict will be a shakeout year for many Internet companies, investors have to scrutinize the balance sheets and cash flow statements of their investments and limit their investments to those with the deepest pockets."

That column, "Practical Models for Sifting Through Stock Ideas," was published on Feb. 11, 2000. As the Internet indices continued to soar through April 1, 2000, aggressive investors might have thought that I didn't "get it." But as we now know, my call was just a few weeks early.

As the 1999-2001 period was a particularly volatile one for Net stocks, it seems like a good time to review the models I described in that article and to discuss the stocks I'm buying now.

Innovators/Adopters/Laggards Model

This model tries to determine which products will die out and which will become universal by tracking the behavior of consumers with different interests. Innovators want to be the first on the block to own a Tivo, while laggards haven't upgraded their stereo from LPs to CDs.

Among businesses, even laggard companies have adopted Internet strategies because to not do so would leave them without a very cost-effective marketing and distribution platform (like trying to run a business without phone service).

Consumers, however, are in the late innovator/early adopter stage with respect to the Net, held back by the difficulty for most individuals of obtaining high-speed access (either DSL or cable modem). Three years from now, however, we expect 90% of U.S. households will have high-speed access. Unlike CB radios, the Internet is here to stay.

To look at an earlier product cycle, in the early 1980s, any investor could make money simply by opening up a PC and buying the stocks of whatever companies provided the components inside. In 1984, for instance, there were about 36 disk drive manufacturers with huge price-to-sales ratios (forget about earnings). By 1984, however, most of these companies had crashed and burned, along with their stock prices. PC makers like Osborne, Sinclair, Commodore, KayPro and Zenith simply disappeared. However, investors in the next wave of PC-related companies, including Microsoft (MSFT - commentary - Cramer's Take), Compaq (CPQ - commentary - Cramer's Take) and Dell (DELL - commentary - Cramer's Take) made fortunes. These companies were privately held until 1986 (1988 for Dell).

Among Internet stocks, we're trying to figure out which of the survivors are worth investing in, and also keeping an eye out for new companies that have learned from and can capitalize on the failures of the first generation.

In February 2000, the companies we held in our client portfolios were Amazon.com (AMZN - commentary - Cramer's Take), America Online (AOL - commentary - Cramer's Take), Broadcom (BRCM - commentary - Cramer's Take), Cisco (CSCO - commentary - Cramer's Take), CMGI (CMGI - commentary - Cramer's Take), DoubleClick (DCLK - commentary - Cramer's Take), eBay (EBAY - commentary - Cramer's Take), EMC (EMC - commentary - Cramer's Take), Macromedia (MACR - commentary - Cramer's Take), Oracle (ORCL - commentary - Cramer's Take), RealNetworks (RNWK - commentary - Cramer's Take), Sun Micro (SUNW - commentary - Cramer's Take) and Yahoo! (YHOO - commentary - Cramer's Take). Some of those positions have since been eliminated, as I'll discuss below.

The Salmon Swimming Upstream Model

This model pretty accurately describes the fate of most Internet-related companies over the past year. Thousands of salmon enter a river, but only a handful arrive at the spawning grounds, and the same holds true for companies in any new industry. To get a daily obituary report of Net companies, you need only subscribe to the Silicon Alley Daily.

Applying this logic, we've sold CMGI outright (we thought its incubator approach to investing in the Internet would be successful, but we were wrong). DoubleClick and RealNetworks remain in our portfolios because we regard DoubleClick's ad placement and RealNetworks streaming technology as integral to the whole Web experience, but both companies are facing extreme financial pressures and may end up being acquired.

eBay, though, operates one of a handful of businesses that exists only on the Internet and does not have to worry about "bricks-and-mortar" competition. Although the stock price is hardly cheap -- it's trading just 19% off its 52-week high set last June -- we continue to add eBay to our client's portfolios.

When Highways Are Being Built, Buy Cement Companies Model

We've held Sun Micro, Oracle, EMC and Cisco for years -- these companies are each No. 1 in market share in their respective segments and provide the guts of the Internet. While their stock prices fell an average of around 65% from September 2000 through March 2001, that still left us with triple-digit gains, and we continue adding these positions in new accounts.

Currently, there is a glut of hardware (you can buy Cisco routers on eBay, for example) as the assets of failed dot-coms are auctioned off. Cisco recently took the unusual step of writing down its entire inventory. A year from now, though, we expect Cisco to experience a huge surge in orders as the current generation of technology becomes obsolete.

Macromedia also falls into this category. The company continues to consolidate its position as the No. 1 developer of Web site tools, and is profitable and cash flow positive.

The Enabling Model

In my earlier column, I mentioned Dell and Federal Express (FDX - commentary - Cramer's Take) as two companies that had successfully "enabled" their existing infrastructure with Internet technology. Another example is Lands' End (LE - commentary - Cramer's Take), a catalog retailer that is the leading clothing seller over the Internet.

At this point in time, any pure Internet retailer that has to build a purchasing, marketing and fulfillment operation from scratch will most likely lose to established brands. (Kozmo.com, the home delivery service, prepared and distributed a paper catalog that, ironically, reached consumers after the service closed down for good.)

Amazon, which has struggled to build successful retail businesses beyond books and CDs, may well find more profit in enabling other companies to build successful Web businesses -- for example, last year's alliance with Toys R Us (TOY - commentary - Cramer's Take) to run its toy retailing Web site, or its recent agreement to operate the Borders (BGP - commentary - Cramer's Take) bookstores Web site.

The End-Game Model

When I wrote the February 2000 article, I was still trying to understand the ramifications of the AOL Time Warner (AOL - commentary - Cramer's Take) merger. In hindsight, I recognize that this was one of the great business moves of 2000, giving AOL a leg up in content creation and distribution at what turned out to be a take-under price for Time Warner. Because America Online is a destination rather than a commodity access service for 29 million subscribers, AOL can raise prices even as other access providers are facing bankruptcy.

Meanwhile, I still like Yahoo! as the No. 1 portal service. Although Yahoo!'s revenues have stumbled with the decline in online ad sales, I see great potential in Yahoo!'s shopping service, which allows consumers to search for the same product across multiple vendors, buy at the cheapest vendor and pay using the "Yahoo! Wallet," thus avoiding the need to re-enter address and billing information each time.

The Commoditization Model

In addition to the models I've already discussed, here's an additional one to help you avoid companies we don't think have a chance. A commodity is a product with generally uniform characteristics. In a competitive market, its sale price generally converges on the cost of production.

Oil and copper are typical traditional commodities, but we would argue that memory chips and automobiles are commodities of the modern economy. NorthPoint, a provider of commodity DSL service, recently went bankrupt, and Covad (COVDE - commentary - Cramer's Take), another DSL provider, hasbeen advised that its stock is undergoing review for delisting by NASDAQ. Companies that provide commodity services such as Internet access and telecommunication services (this includes most of the fiber-optic infrastructure companies) should be avoided unless they are the low-cost provider in their segment or the No. 1, 2 or 3 company in their industry in terms of market share.

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David Edwards is a portfolio manager and president of Heron Capital Management, Inc., a New York investment management firm. At the time of publication, his firm was long Sun Microsystems, Cisco, EMC, America Online, Amazon, Dell, FedEx, Broadcom, DoubleClick, eBay, Macromedia, Oracle, RealNetworks, Yahoo! and Microsoft, though positions may change at any time. Edwards appreciates your feedback; send it to him at [e-mail].