Just because you see a punch coming doesn't mean it won't hurt. Internet investors have learned this year just how true that is: The key benchmark for Internet stocks, the Amex InteractiveWeek Internet Index (IIX), is down 9.5% for 2006. It's actually not a huge shock: On Jan. 9, then-First Albany Corp. Web analyst Jason Avilio launched a much-discussed report that said a run in the second half of 2005 left Web stocks overpriced, even with the Net economy growing six times faster than the rest of the U.S. The stocks began tanking the next day.
The bad news: That meant BusinessWeek's BW Web 20, a portfolio of blue-chip Net stocks, has had the toughest six months of its four-year run. The Web 20 fell 3.9% between Feb. 21, when we did our last semi-annual review and made adjustments to our model portfolio, and Aug. 15. That's not bad for the environment: It beat the NASDAQ composite by 1.6 percentage points and cruised past the Amex Net index's 9.5% loss. But both the Dow Jones Industrial Average and the S&P 500 beat us—and that's only happened once before, when the S&P beat the Web 20's 6% drop by two percentage points between February and August, 2004. So even though we said in February the short term would be tough, it's still a shock.
Things ought to be different now, since the Web economy hasn't slowed down and valuations are much more in line. The BW Web 20, which includes 100 shares of each stock adjusted for splits, now averages a multiple of 30 times this year's forecast earnings. That's down from 38 in February and the lowest price-to-earnings ratio in memory. It is still more than the market's 15 p-e. But if you factor in the projected growth for the companies (dividing the p-e's by expected long-term profit growth), the average Web 20 stock is actually cheaper than the S&P 500. Even Standard & Poor's analyst Scott Kessler, a conservative type, recently raised his rating on Google, which represents 32% of the value of our portfolio, to buy. "Some of them look very compelling on a valuation basis," Kessler says.
Indeed, one big fund that invests a lot like the Web 20 is adding to its bets. Bill Miller's Legg Mason Value Trust (LMVTX) has $2.6 billion of its $19 billion in assets in Google (GOOG), Yahoo! (YHOO), eBay (EBAY), online travel agency Expedia (EXPE) and IAC/InterActiveCorp (IACI)—all Web 20 companies.
Legg Mason Opportunity Trust owns $200 million of shares in online video-rental service Netflix (NFLX)—another Web 20 regular. Value Trust is down 10.4% for the year, putting its decade-plus streak of beating the market every year in peril. But it added shares of IAC and Expedia in the first quarter. "At this point, values are squashed down so far that Internet companies trade at parity with old media multiples," Value Trust analyst Randy Befumo says.
STILL, GROWTH GALORE. Here's why that's smart: While Internet stocks were falling this year, the Internet economy is growing as fast as ever. Online advertising spending in the U.S. rose 38% to $4 billion in the first quarter (second-quarter data isn't out yet, says the Interactive Advertising Bureau). In comparison, online advertising increased 26% in the first quarter of last year. Second-quarter online retail sales figures aren't due from the Commerce Dept. until Aug. 17, but first-quarter sales rose 25%. "Investors could be anticipating some slowing if consumer spending slows—but I think we'd be talking about a few years out," says Mark Zandi, chief economist of Moody's Economy.com (MCO).
That has translated into pretty solid earnings for most Net companies. When the Web 20 fell 6% between February and August 2004, there was an obvious reason—10 of the 20 companies then in the portfolio missed second-quarter profit estimates. This year, only two did—online ad agency Digitas (DTAS) and online bill-payment processor Checkfree (CKFR). (Expedia missed its first quarter before recovering in the second.) Slightly lowered guidance or soft revenue slammed companies like Yahoo and Netflix even though they made their bottom-line numbers. And eBay, which makes up 8% of the index, struggled with execution issues, digesting its $2.6 billion Skype acquisition and fighting off competition in Korea.
Our strategy in February was to deal with Avilio's argument by adding some stocks with lower price-to-earnings ratios. Some new names with low p-e's worked well. For example, J2 Global Communications (JCOM), the parent of eFax.com, rose 12%. Others, like Digitas (down 38%), didn't. Its ratio of 22 didn't protect the Web 20 committee—read, me—from a bad second quarter and client defections including Best Buy (BBY) and FedEx (FDX). Lesson: A low stock price is one thing, good value can be another.
THE NEW PLAY. This time, we're worrying less about valuation and concentrating on names that reflect how the Web is changing. Because our existing companies are mostly doing well, we're tinkering less, changing only three names instead of the more typical four or five. Out go Expedia, Digitas, and Websidestory (WSSI), whose software helps Web retailers analyze customer's click patterns to help boost sales. Expedia and Digitas leave because of their earnings misses, while Websidestory is dropped because the Web analytics market is relatively small. Between them, Websidestory and archrival Omniture (OMTR) will post about $130 million to $150 million in sales this year.
We're adding three names that represent soon-to-boom Internet markets. The first is Akamai (AKAM), whose services let companies make their Web sites work faster and more smoothly. In particular, Akamai's the choice for companies that want to distribute video online—a huge emerging market. Talk to Netflix CEO Reed Hastings about expectations that his company will one day deliver movies online rather than by mailing DVDs, in competition with players like Apple (AAPL)and Yahoo, and he says offhandedly that "we're all going to use Akamai." The 20 has already missed a huge run in Akamai, whose stock bottomed out at 75 cents a share in the dark days of 2002. But even at 49 times this year's estimates, there's still enough growth to make this $40 stock a decent bet.
The Web 20 already has one bet on the rising role of Web technology in health care, and we'll add another by tapping Idaho-based Nighthawk Radiology Services (NHWK). Like medical-records software maker and Web 20 member Quality Systems (QSII), Nighthawk is a bet that technology can make health care more organized and safer. Its service lets U.S. hospitals beam late-night CT scans to Nighthawk centers in Switzerland and Australia, where they can be read by specialists without rousting local doctors out of bed.
CEO Paul Berger says the next step is to get small and midsized radiology practices to use Nighthawk for specialized orthopedic scans and other non-emergency daytime tests. The $16 stock trades at 25 times this year's estimates of 63 cents a share; the company beat second-quarter forecasts and raised guidance for the year. Like Google, its name has become a verb: To use telemedicine for radiology help is now called "nighthawking."
THE THINKING. The last pick, Softbank, is a bet on the Net's growth in Asia. Investors have done well in plays like Chinese online travel agency Ctrip (CTRP) and Indian tech outsourcer Infosys (INFY). Softbank is a profitable, highly diversified play on Asia's Internet economy, with stakes in dozens of companies spanning Net access, wireless services, media and e-commerce. Among the best: A controlling stake in Yahoo Japan.
If the last four years have taught us anything about Internet stocks, it's that they clobber strong markets while holding their own when things are tough. The bet remains straightforward: For strong Web companies, you pay a price-to-earnings multiple two to three times the market's, in exchange for expected growth rates five or six times higher. That is, without question, a bet that carries certain risks. But over time it is likely to be a correct one.
THE NEW WEB 20
Blue Nile (NILE)
Ctrip International (CTRP)
Digital River (DRIV)
J2 Global Communications (JCOM)
Nighthawk Radiology Services (NHWK)
Quality Systems (QSII)
TD Ameritrade (AMTD)
New additions in bold. The Web 20 includes 100 shares of all companies except Ctrip (200), J2 Global (200), eBay (400), Infosys (200), Quality Systems (200) and Yahoo (200), all of which have split since being added to the model portfolio.