Explaining the Dot-Coms, Part 2

In the second of two articles on Internet businesses, Cramer explores the meaning of Media Metrix numbers and Net valuations.
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Editor's Note: Don't forget to check out Part 1 of this two-part series.

And once the companies came public we used another flawed matrix,

Media Metrix

, to measure how much to pay for the stocks. In the world of television, the

Nielsen

ratings make sense. The television companies have no way of telling who is watching, so the advertisers demand an independent analysis, even one as flawed as Nielsen. If a television program has big ratings, it can command a high dollar amount per minute.

For the Net, however, the Media Metrix numbers at best are an irrelevance and at worst tell entirely the wrong story to Wall Street.

Let's take

TheStreet.com

, because I know that best. We have our own numbers that are far more accurate than what Media Metrix can ever give us, as does every other sophisticated site. These numbers are the numbers that matter because, unlike the ratings systems, they are not a guesstimate, but are the actual viewer data.

More important, unlike the television business, advertisers don't pay you more for higher Media Metrix numbers. In fact, despite the oblivious fund managers who should know better, Media Metrix numbers don't count in the real Net world at all. No advertiser gives a hoot about these ratings. They care about qualified eyeballs and the demographic of the reader. In other words, they don't care about the number of eyeballs, which Media Metrix measures inefficiently; they care about

what heads the eyeballs are in!

The few Web-savvy advertisers out there would much rather reach fewer, wealthier people because they are trying to build Web brands, not generate massive click-throughs. (Oh, don't act so surprised. Do you think that

Coke

(KO) - Get Report

expects you to order a Coke by pressing a Coke ad in a magazine? Do you think

General Motors

(GM) - Get Report

expects you to buy a Chevy from an ad in

Money

magazine? That's not what advertising is about, and those companies that don't yet advertise on the Web haven't only because their ad agencies are staffed with people who tend to be offline worshippers. These longtime golfing relationships take forever to crack!)

That's why charging for a product, if the readers will pay the freight, is so important. It makes sure that the advertisers reach only the qualifieds, without having to pay for the unqualifieds. That's what advertisers truly seek. It is why a "free model" works more like a newspaper giveaway than like network TV. It attracts the wrong demographic -- or worse, no measurable demographic at all.

The result became a stock market that was chaotic in its valuations, seizing on whatever URL got marketed next by offline brokerages. As long as new money, as judged by trading volume from the

Knight/Trimark

cohort, continued its geometric growth, this "pop" method of evaluation worked well in excess of where people in the industry thought it would.

Until a few weeks ago, when it seems that the market underwent a remarkable change. The pipeline of deals got so filled that the institutions, which had played along with the "poppers" because the IPOs generated great flip returns, got nervous. They stopped putting in for 10% of the deal to get their sliver.

Meanwhile, the Net trader ranks stopped growing. Some of that had to do with the unfortunate spotlight the media threw onto daytraders after the terrible Barton

tragedy. Some of it had to do with the release of definitive studies that put the lie to the daytraders' stellar records.

Some of it had to do with a change in the margin rules that gave these buyers less power.

But what I think did the most damage was a bending of the rules by hedge funds. You aren't supposed to be able to short the stocks of new companies until 30 days after the companies go public. They aren't supposed to be marginable until then, and you can't legally short nonmarginable stocks.

Nevertheless, trading institutions figured out that nobody got in trouble that anybody knows of for shorting these unseasoned stocks, and they began to lean on them in a way that meant instant profits from the day these dot-coms went public. (No, I don't do this; I play by the rules as I was taught them.) But I can't blame people for not playing by the rules. These dot-coms, including ours, were bid up to unrealistic levels, levels that left a lot of people hurt.

That's not what this process is supposed to be about. It is not meant to disillusion new investors. It is meant to raise capital in a realistic fashion. In fact, I think the rules should be changed, and short-sellers should be allowed to offer stock any time an IPO goes to a 100% premium. It would make for a much more honest process and give the underwriters a modicum of control over the process by creating supply.

So where are we now? We are only in the scaleback and delay phase of the current deals. The venture capitalists and the brokerage houses don't really intend right now on leaving billions on the table. They will try to force the market's hand by bringing out sidelined merchandise with each little window that opens. We haven't had any real cancellations yet, just enough to be able to rebuild liquidity. The dogs will be made to eat the food.

Of course, the selloff has been phenomenal. Any dot-com merchandise that came since the window got thrown open with

theglobe.com

(TGLO)

last November now bounces up softly on analyst recommendations and then down hard with any tick up in interest rates (that's the institutions selling on that matrix) or on release of new underwritings (that's the public selling the old to bring in the new).

There is dot-com detritus every where you look. The only stocks that are really working are those that benefit from the dollars the newly minted dot-coms threw off: the tech companies that make dot-coms go and go faster.

Of course, those companies are already so overvalued that they will never reach their market-cap potential, but nobody cares because they are where the action is. (The action being defined as companies that can blow the earnings estimates of the underwriting firms because of much stronger-than-expected demand since the IPO.)

The rest of the stocks are either searching for consolidation, hoping for nonunderwriting coverage to spur new buying or giving up on their stocks and just focusing on building the business until the money runs out.

It turns out that business on the Net is just as tough as business off it.

Those sites that rely only on the hoped-for advertising that comes from being free are getting the same kind of rates that Penny-Savers get. Those that thought that they didn't have to have bricks and mortar needed it anyway (hence

Amazon's

(AMZN) - Get Report

monster build-up of warehouses.) Those that are just using the Net the way a company uses an 800 number (the ones that lured my unsuspecting daughter in the first

part of this piece) will eventually have the same kind of margins that catalog companies have: crummy ones. And everybody is just hoping for a big Net Christmas to reignite things.

So we bump along with periodic short-covering Net rallies like we had last week, and then selloffs when more deals come or rates go back up. We wait for more homes to go on the Net and for more and faster rollout of DSL and cable modems.

Whom does this environment favor? To me, it favors the most entrenched players and those that can convince the market that they are more than just a catchy URL seeking advertising. It favors those companies that can build recognizable brands that can then be leveraged into dollars by creative managements not blinded by dot-com-itis, which is the belief that if you get great Media Metrix numbers, everything good will come. It won't. You will run out of money long before that happens.

Hence, we stay long

Yahoo!

(YHOO)

and

AOL

(AOL)

, winners in the real world because they have executed in true business fashion, taking their brands to profitability.

And we ignore virtually everything else.

The one thing that has changed though, and that makes this investing climate for the incumbents better than a year ago, is that the notion of someone today coming up with a bookstore for the Net is finished. The idea that someone can get backing for a new furniture or toy company on the Web has become outlandish. The belief that another

Bezos

can start something from scratch that can be a multibillion-dollar company six months from now has dimmed.

That's great for those that have done it, and very bad for those trying to do it now. They will simply be lost in the clutter that is my daughter's double-u, double-u, double-u chart.

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund was long TheStreet.com, Yahoo! and America Online. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

jjcletters@thestreet.com.