Editor's note: This is Part 1 or a two-part series. Check back next week for Part 2.
Fact: Over the last 12 months, TheStreet.com's Internet index of 21 leading technology stocks has risen 16%, significantly outperforming the 4% appreciation for the Dow Jones Total Market Index.
Fact: The three hottest stocks in this Internet index have been:
, up 146%,
Research In Motion
( RIMM), up 141%, and
, up 56% for the last 12 months.
Fact: Believe it or not -- Internet stocks can decrease in price. The three worst performing stocks in the index,
( AVCT) and
, actually lost 23% of their value during the same period.
What explains the difference?
If you believe McKinsey's just-published article in its quarterly, "Eight business technology trends to watch," the answer is simple. Winning companies don't just use technology; they create new ways of doing business.
In the spirit of stirring up dialog about which are the best stocks for 2008, here are the eight trends as outlined in the McKinsey article and my comments on near-term valuations for Internet stocks:
The first four trends fall under the theme of managing relationships.
1) Distributing co-creation. According to McKinsey, the Internet and related technologies can give companies radical new ways to harvest the talents of innovators working outside corporate boundaries. This trend refers to the way companies co-create with partners and strive to be more productive.
This brings to mind the Blackberry, which revolutionized productivity, and of course the company that makes it, Research In Motion. Between marketing programs with large telecoms, new products and the potential for more Asian market growth, this company's ability to grow through subscription services looks unstoppable.
RIMM shares have only partially reflected the success of the Blackberry franchise. Admittedly, the stock of this company trades at 33 times the consensus estimate for next year's earnings. This is almost double the 17 times multiple for the average stock in the Internet index, but this is no average stock. The company generates $550 million to $600 million of free cash flow per year and grows top-line revenue at a rate of over 60% per year. So it's natural to expect Blackberry to continue to merit a premium valuation in its business and in the financial markets in 2008.
2) Using consumers as innovators. This trend focuses on the consumer of the product or service vs. the internal contributors to the production process. The consumer-driven view requires new economic models and management processes. Online social networks were born from this trend.
For those who think that social networks are only for the "under 25" crowd and other political activists, not for investing, take note of the
$240 million investment in privately owned Facebook in October. This high-profile transaction valued Facebook at $15 billion. The equity stake demonstrated that Microsoft was serious about its goal to invest multibillions over the next five to 10 years for companies in online advertising, search software service and hardware devices.
Microsoft shares sell at 15 times 2008 earnings estimates and 17 times 2009 estimates. These are average levels, and investors seem to be discounting near-term upside surprises from this new focus until earnings materialize. While it's true that the online business is less than 5% of sales, remember the company pulls in $5 billion in free cash flow each quarter from its existing businesses. Expect more value creation for MSFT in 2008 and maybe as a new year's resolution you can forgive MSFT for Vista.
3) Tapping into a world of talent. The McKinsey article extends the "factors of production" concept to outsourcing. As much as technology permits companies to decentralize innovation through networks or customers, it also allows them to parcel out more work to specialists, free agents and talent networks.
From an investor's perspective, stocks like the $25 billion market-valued
normally hit the radar as the first name to buy whenever someone mentions outsourcing. But this overlooks the smaller Monster Worldwide, with a $4 billion market value. Quite honestly, with a 26% price decline over the last 12 months, MNST looks like the "Dog of the Dot Nets."
But Monster has a leading position in global online recruiting, solid free cash flow of $200 million per year and a very healthy balance sheet. Factor in the margin improvements from a restructuring and awesome revenue gains in the U.K. recruitment market and this starts to look like a potential winner for 2008. Value investors should take note of this one.
4) Extracting more value from interactions. As a result of all this outsourcing, the nature of work is changing. A growing proportion of the labor force in developed economies engages primarily in work that involves negotiations and conversations. Knowledge, judgment and ad hoc collaboration -- all tacit interactions. By 2015, McKinsey expects employment in jobs primarily involving such interactions to account for about 44% of total U.S. employment, up from 40% today. Europe and Japan will experience similar changes in the composition of their workforces.
The difficulty of monetizing interactions, such as in the health care arena, can be illustrated by looking at
. This company provides health information services and at one time spun out 20% of
WebMD Health Corp.
, a fast growing portal business. It now aims to rejoin it through a merger.
After reporting a weaker-than-expected third quarter, the consensus estimate for HLTH 2008 earnings per share were again revised downward. The consensus now expects 78 cents for 2008, an increase of only 5% over the 2007 estimates. Given its weak growth outlook, this stock does not look like a candidate for an analyst recommendation anytime soon.
So here we have two stocks to buy now (RIMM and MSFT), one that might be interesting if you are patient (MNST) and one that only a patient would love (HLTH).
Read more tech trends for 2008 in part two.
Rudy Martin is the director of research for Fundpickr.com Ratings.