By Timothy J. Mullaney The past month has been rotten for Internet investors. Stocks have been hammered since second-quarter earnings showed Web outfits growing pretty much as they had promised -- a change from their habit of slightly besting quarterly projections. The carnage has been just as severe in the Real World Internet Index, a group of Web stocks we picked in 2002 to help ordinary investors play the Internet without undue risk. Ten of the stocks in our portfolio as of the close of trading Aug. 9 tanked after second-quarter reports -- in one case, after a competitor's report.
Is it time to bail out of Net stocks? Some analysts think so. On July 30, Merrill Lynch (MER) cut the weighting of Internet stocks in its model technology portfolio, citing weak earnings surprises and deteriorating momentum in stock prices. Even Google, the search engine whose upcoming IPO was a hotly awaited bellwether for a recovering market, is under fire. "The Internet will take it in the chin for a while," says Steven Milunovich, global technology strategist at Merrill Lynch. "Tech investors are getting more risk-averse."
BAD RAP. The fundamentals suggest a more promising outlook, however. Just last week, Forrester Research raised its e-commerce forecast, predicting U.S. online sales of $227 billion in 2007, up from earlier projections of $204 billion. Forrester expects e-commerce in the U.S. to grow 14% annually through 2010 -- three to four times faster than the economy. Meanwhile, growth in Europe is predicted to average 33% annually through 2009.
Another plus: Net stocks' valuations aren't as high as urban legends insist. The 20 stocks in our newly updated index trade at an average of 32 times this year's forecasted profits. That's twice the composite price-earnings (p-e) multiple of the Standard & Poor's 500 -- but it's still way down from the 38 p-e our index had in March. Yahoo! (YHOO) and eBay (EBAY) still trade at 83 and 64 times earnings, but most companies' stocks are priced for much less aggressive growth. And valuations are offset by the fact that the average Internet marketing and media company is expected to boost profits 40% in 2004 and 39% next year, according to Piper Jaffray analyst Safa Rashtchy. Profits for companies in the S&P 500 are expected to grow 10%.
So the answer isn't to bail out -- it's to invest smart. The Real World Internet Index -- which we're now christening the BW Web 20 Index -- is intended to help aggressive investors accept the risk inherent in the Web, but balance it by focusing on "real" companies with solid products, services, and profits. Every month, this column will do more than track how stocks in our index trade -- it also will help investors figure out which rallies are sustainable and spot the bubblicious behavior that earned Net investing a bad rap.
NEW BLOOD. Companies only get into the Web 20 if they make money or are cash-flow positive. They don't stay there if they lose money or turn cash-flow negative. And they need to be leaders in using the Web to drive change. Witness how eBay took the idea of a garage sale and used the Internet to create a global marketplace. We cribbed our philosophy from the best: Legg Mason Value Trust, a fund that has beaten the S&P for 13 straight years. Not surprisingly, we like a lot of the same stocks: Web 20 members eBay, Amazon (AMZN), and IAC/InterActive (IACI) are all in Value Trust's top 10 holdings.
Still, it's essential to fix your mistakes. Effective at the close of trading Aug. 10, we're dropping four companies from our Index: low-cost Internet service provider United Online (UNTD), online conferencing software provider WebEx Communications (WEBX), Web advertising-services company DoubleClick (DLCK), and Digital Insight (DGIN), which makes software for banks to run online banking sites. The four were jettisoned not just for poor performance, but because they face strategic challenges and fresh, tougher competition.
The companies we're adding represent some of the fastest-growing niches on the Web. They are:
Aquantive (AQNT): This Seattle-based online ad agency competes with DoubleClick, but it's better diversified. It's also making an interesting play into the fast-growing pay-for-performance advertising market, charging only when an ad actually leads directly to a sale.
Blue Nile (NILE): The online jeweler is taking the diamond business by storm. More than 100 brick-and-mortar stores would be required to duplicate the $129 million in sales Blue Nile handled through a small warehouse last year, jewelry industry analyst Ken Gassman says. Forrester sees online jewelry and luxury-goods sales doubling by 2007.
Infosys Technologies (INFY): While this Indian outsourcing company isn't a classic Internet outfit, the Net makes it possible for it to service clients thousands of miles away. Plus, it has something the Web 20 hasn't looked for in the past -- a 2.6% dividend.
IndyMac Bancorp (NDE): This Pasadena (Calif.)-based bank manages its business through a Web-coordinated network of mortgage brokers and its own consumer site. It was a member of the original index in 2002, but we dropped it last August, betting rising interest rates would hurt its stock. But shares of this highly efficient industry leader have risen 56% since. (Ouch!) We repent, and they're back in.
ROOM TO GROW. Our index has bested the market for most of the last two years, and the biggest gains came from having guts at times like these. The BW Web 20 was first published (under its old name) in August, 2002 -- about two months before Web stocks bottomed out. It jumped 71% in its first year, vs. a 6% rise for the S&P 500. Only since the last revision, in March of this year, has our index underperformed a major market index, falling 11% vs. the S&P 500's 7% decline. Even so, the Web 20 has still beaten the 13% dip in the Nasdaq composite index since Mar. 1, 2004.
Retreats like these are buying opportunities for true Net believers. Back when Internet stocks were busting, Value Trust manager William H. Miller III, which already had a huge stake in Amazon, bought more shares for as little as $6 and change. Miller likes to point out to his staff that lower prices mean better prospective returns, says Michael J. Mauboussin, chief strategist for Legg Mason Funds Management.
Is that still the case? The numbers indicate yes. Even Milunovich says, "I'm not that negative, looking out a couple of years." With less than 7% of U.S. retailing and 5% of U.S. advertising done online, it's early to say the party's over.
BW Web 20 Index
Return Since 03/01/04 (%)
University of Phoenix Online
S&P 500 Index
* Blue Nile return is measured from IPO price on May 20
Dropped from Index, effective August 10: United Online, DoubleClick, Digital Insight, WebEx Communications
P/Es are based on estimates for calendar 2004, except UOPX, which is based on fiscal 2004, ending in August
The BW Web 20 Index is 100 shares of each company, adjusted for any splits after a company was added to the Index. The index includes 200 shares of Netflix, Yahoo, Symantec and EBay
DATA: BLOOMBERG FINANCIAL MARKETS, CBS MARKETWATCH, YAHOO FINANCE. Mullaney is BW's e-Business editor, based in New York