If there's such a thing as a mutual-fund ownership bubble, eBay ( EBAY) is experiencing one.

The San Jose, Calif.-based online auctioneer stands alone among Internet companies in living up to the most optimistic expectations, including better-than-expected third-quarter earnings posted in October. The company's performance has been amply rewarded by Wall Street and Main Street investors: eBay shares, while volatile, have soared more than 800% since the company's 1998 IPO and are up 109% since the beginning of 2001.

Not surprisingly, mutual-fund managers looking for decent returns have piled up on eBay during the past ugly year. The number of large-cap funds reporting a stake in eBay in the latest quarter more than doubled to 291 from 142 in the year-earlier quarter, according to research conducted by Morningstar for TheStreet.com. While surely some fund skippers were led to the company by in-depth analysis, a lot of the new eBay stakeholders are engaged in good old-fashioned performance chasing.

Therein lies the problem, which has consequences for eBay stockholders and fund investors alike: The fund world's rush into eBay has helped bid the company's shares, hovering around $70, up to a triple-digit price-to-earnings multiple, essentially pricing it beyond perfection.

"This is a great company, but a very expensive, overvalued stock," says David Kathman, the Morningstar stock analyst who covers eBay. "I put the company's fair value at $47."

Given eBay's remarkable operating performance during the past few years, fund managers' love for the stock can be understood. The company has posted average annual earnings growth of 132% over the last three years, and average revenue growth of 106%. The company projects sales to soar to $3 billion by 2005, from $749 million in 2001, and many analysts say eBay is likely to meet that target.

Bidding Up eBay
eBay is now in 21% of all large-cap funds
"eBay is one of our favorite business models -- it's well-managed and growing nicely," says First Albany analyst Youssef Squali. "The issue is valuation."

Squali, who says he has fairly aggressive earnings and revenue growth projections for eBay, puts the stock's 12-month price target at $68 -- below yesterday's close of $70.75. "They would have to beat growth targets by a fairly wide margin to justify its current price."

While valuation remains the big cloud on the otherwise sunny horizon for eBay, some critical analysts have pointed out a few potential challenges that "should keep eBay up at night," borrowing from the title of a Forrester Research report from last month. Among other things, Forrester voiced concern about how eBay's enterprise-seller program -- in which IBM and other big companies unload excess goods -- would affect its legions of small sellers, who might theoretically migrate to another auction site.

eBay watchers disagree on the likelihood of such a migration, but other concerns loom as well. " AOL Time Warner and Amazon.com are moving into eBay's turf," Squali says. "I don't want to say it's all downhill from here, but it's going to be increasingly difficult for eBay to maintain their market share."

While most eBay watchers have confidence that CEO Meg Whitman will continue to navigate the ever-changing Internet landscape successfully, many say the stock is due for a pullback. "It's hard for me to envision the stock going up very much from here," says Morningstar's Kathman.

Chasing Performance

Enter mutual funds. Fund ownership in eBay has steadily climbed since the company went public in 1998, in the face of considerable volatility, as the auction site emerged as the most profitable Internet company. The company, with its remarkable business model and clean balance sheet, became the de facto "safe Internet play." As the bubble burst in mid-2000 and the markets slumped in 2001 and 2002, more and more funds took shelter in eBay. In the past three quarters, the number of large-cap blend funds reporting a stake in eBay nearly quadrupled from 37 to 147.

Premium Blend
eBay also is in 26% of all large-cap blend funds
Source: Morningstar

While the increased fund ownership can signal broad confidence in a company's ability to execute, huge changes often signal two unpalatable fund-industry moves: performance-chasing and "window dressing."

"Funds clearly engage in momentum investing, which leads a stock to become richly valued," says David K. Musto, an assistant professor at University of Pennsylvania's Wharton School. Window dressing -- when fund skippers buy and sell securities ahead of public disclosure dates, to show winners in the portfolio and hide the loser bets -- "does happen, but it's more difficult to see. They're trying to do it behind the scenes."

However, it has negative implications for fund and stock owners, says Mercer Bullard, fundholder-rights activist and founder of Fund Democracy. "It happened in 1999 with Qualcomm," when the stock soared 2,619%. The stock surged higher in the final months of the year as skippers jockeyed to get in on the year's hottest stock, only to shed 60% of its value during the next six months.

"Window-dressing gives the appearance that the fund was investing in a company that was doing well," Bullard says. "A stock that is the subject of window-dressing will have a significant drop, but no one knows exactly when it is."

Because most mutual funds disclose their holdings either twice-yearly or quarterly, it's difficult to tell if funds have continued to rush into eBay since the third quarter's end. However, so far in the fourth quarter, eBay's shares have climbed 34%.

Enter Janus

Several funds, according to the most recent statements, have bought into eBay during the past year. The most notable addition is Janus Twenty, the concentrated offering from Denver fund shop Janus Capital Management. The Twenty fund purchased 5.4 million shares of eBay, according to its most recent report -- a semiannual disclosure for the period ended April 30. "eBay, a new holding, came in at the 12th-largest holding at last count, about 2.5% of the fund," sayd Brian Portnoy, who tracks the Janus fund family for Morningstar.

Indeed, as of Sept. 30, Janus funds owned 5.27% of eBay, making the fund firm the largest institutional holder, according to institutional-ownership tracker Lionshares.com. The firm owned 16.1 million eBay shares, valued at $1.14 billion based on Tuesday's close.

However, the firm had sold 1.8 million shares, or 10% of its stake, before Sept. 30. In recent years, Janus, known for making concentrated bets on certain stocks, has gotten burned by falling stocks such as Nokia, Enron and AOL Time Warner -- unable to move nimbly out of its massive stakes as attempts to pare its holdings continued to pressure the stock.

Scott Schoelzel, fund manager of Janus Twenty, couldn't be reached for comment on this story. However, in the April statement, he said eBay "has the potential to evolve into one of the great consumer-branded franchises."

Portnoy notes that Janus' annual disclosure report is due later this month; eBay stock investors and Janus fund holders should both keep an eye out for it. If Janus has added to its stake, any selloff in the new year could crimp the fund. And if Janus shows signs of unspooling its sizable holding in eBay -- if it hasn't already -- that will surely put downward pressure on the highflying stock in 2003.

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