Spare the Burial Rites for Internet Innovators

A <I>Street Insight</I> columnist takes aim at some fuzzy logic about the Internet.
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Editor's note: This column is a special holiday bonus for readers of TheStreet.com, written by James Altucher. It originally appeared on Street Insight April 14. To sign up for Street Insight, where you can read James' commentary regularly, please click here.

Barron's

had a cover story last weekend that I almost didn't want to dignify with a comment. But it does bring up some interesting points -- all of which I intend to rebut.

First, it accuses the Internet stocks,

eBay

(EBAY) - Get Report

,

Yahoo!

(YHOO)

and

Amazon

(AMZN) - Get Report

in particular, of being in a bubble. Then it says what prices these stocks "ought" to be. Then it underlines all of its suggestions with a detailed breakdown of the options expenses on these guys. And finally, it illustrates the point further by pointing out some bargains.

I consider each of the arguments invalid, and explain why below.

Bubble?

To call these stocks a "bubble" after the Nasdaq 100 has gone from 5000 to 1000 seems a little late to the game. In the past few months we've seen articles about gold bubbles, real estate bubbles, etc. Suddenly, a phenomenon that used to happen once every couple of decades (or centuries, depending on how you define "bubble") is now happening in every financial sector every couple of years.

A speculative bubble occurs when the only reason an asset is bought today is because it was up yesterday. There is zero fundamental basis for it. It can be argued that Amazon at $400 was in a bubble. More accurate would be to say we went through an IPO bubble, when IPOs would bounce several hundred percent simply because the last IPO did as well. To call eBay, which has gone from $2 million in earnings to $250 million in earnings in just five years, a bubble stock seems to be missing the point of what's been going on in this economy the past few years.

Some Facts:

Internet e-commerce rose 50% in 2002 over 2001 and similar numbers are expected this year. Paid e-content (online subscriptions, for instance) rose 95%. eBay and Yahoo! were the biggest beneficiaries of these increases. And GDP growth was how much?

We are still in the beginnings of a booming industry that keeps going up in huge strides regardless of what's happening in the economy. It's no accident that e-content and e-commerce are the stock market sectors that are up the most this year.

Google

, which barely existed a few years ago, is now up to several hundred million in revenues and supposedly just had its ninth straight profitable quarter. Where this type of boom ends up, nobody knows.

Valuation:

The

Barron's

article is pretty sure of itself when it specifies valuations where companies should trade. To begin with, over the past 100 years there is essentially zero correlation between price and price-to-earnings, which is a lagging indicator used to measure a forward-looking market. Beyond that, the article goes on to compare the valuations of these companies with

Wal-Mart

(WMT) - Get Report

,

Barnes & Noble

(BKS) - Get Report

, etc. Leaving aside the sheer speed of growth of the industries mentioned above, how about the fact that a company like eBay has gross margins six times that of Wal-Mart and other traditional retailers. Forcing eBay into the little hole of valuation carved out by bricks-and-mortar retailers does not seem fair -- it is still carving out its own sector.

Option Expense:

Barron's

argues strongly that these Internet companies need to expense employee options. Whatever the merits of the argument in theory, in practice it is impractical.

Coca-Cola

(KO) - Get Report

recently abandoned a suggestion made by Warren Buffett on how it should expense its options. Since the traditional method for expensing options, Black-Scholes, does not take into account the nontransferability of the options (among other things), Buffett wanted to come up with an alternative for valuing employee options. Coca-Cola gave up on the effort when it wasn't convinced that the Financial Accounting Standards Board would approve.

Nice to know that

Barron's

has solved all of these problems and determined exactly how much the employee options of these three highly volatile companies should be worth.

Bargains:

Instead of companies that have multiplied earnings by 10,000% over the past few years,

Barron's

searches the Internet for Graham-like companies that have been trading close to cash, losing market share and have a host of other problems. Their picks include the following:

E*Trade

(ET) - Get Report

(which I've actually recommended here) is chained to its refi business.

FreeMarkets

(FMKT)

has not been able to keep pace with its competitors despite enormous increases in b2b commerce over the past year (rivaling the increase in consumer e-commerce).

EarthLink

(ELNK)

offers a commodity that every cable company, phone company and satellite provider is gunning for. As for

AOL Time Warner

(AOL)

, well, call Paul Jaber on that one.

The

Barron's

article is another fine example of its consistent tendency to reward a calculator and punish innovation, creativity and the continual growth in this industry, which has blossomed so greatly in such a short time.

James Altucher is a partner at Subway Capital, a hedge fund focused on deep value and arbitrage opportunities, where opportunities are identified using proprietary software. Previously, Altucher was a partner with technology venture capital firm 212 Ventures and was CEO and founder of Vaultus, a wireless and software company. He holds a B.A. in Computer Science from Cornell and was a Ph.D. candidate in Computer Science at Carnegie Mellon University. Email him at james.altucher@thestreet.com.