Finding Hidden Value on the Web

Ever since I began compiling the BW Web 20 Internet-stock portfolio in 2002, I've watched Ryan Jacob and the Jacob Internet Fund (JAMFX) with interest. It's one of the few pure-play Internet mutual funds, and it has had ups when Web stocks are hot and downs when they're cold (see BW Online, 3/13/06, "Climbing Jacob's Ladder"). Lately, Jacob has been on a tear, with his $125 million fund up 13% this year and 50% for the last 12 months.

The 36-year-old fund manager, who became a media star in the late 1990s and began his own fund in late 1999, just before the market cracked, tends to pick smaller names than I put in the Web 20. On its face, his list looks a little junky, as if it were packed with tinkertoy companies that aren't going to make any real impact. Its top five holdings are CDC (CHINA), WebMethods (WEBM), (SOHU), Google (GOOG), and Yahoo! (YHOO). Other big holdings include Napster (NAPS), online poker site Partygaming, and iVillage (IVIL), which will soon be acquired by NBC Universal.


  In person, Jacob makes a convincing case that he's pursuing low-profile value plays. Of his top 25 holdings, he says 10 of them were picked because of value -- often, as in Napster's case, because a large part of their market value is accounted for already by cash on the balance sheet. The other 15 are the type of more conventional growth plays you might expect from a Net fund. "We've tried to incorporate some value along with growth so that what happened to us in 2000 and 2001 doesn't happen again," he says.

The dot-com bust taught him to take profits and cut losses faster. "In a volatile market, I'm not sure buy-and-hold is the way to go," he says. He's not always right -- no one is -- but a five-year record with annual returns nearing 14% makes him worth hearing out. Here are five investments or themes Jacob is playing now.

1. He's buying Google and Yahoo.

For most of the Web's existence, the highest multiples have gone to the industry's leaders, like eBay (EBAY), (AMZN), and Google. That's no longer true, Jacob argues, as mid-cap stocks like aQuantive (AQNT) and Netflix (NFLX) have grabbed higher multiples. With Google trading around $371, at 39 times this year's estimated profits of $9.45 a share, Jacob likes it. "People think we should be more worried about Google than we are, but no one is close to their market position," he says. "Google was our biggest mistake in 2005 -- we didn't have enough."

Isn't he worried about click fraud, an issue that has concerned analysts such as Stifel Nicolaus' Scott Devitt and Scott Kessler of Standard & Poor's (see BW Online, 4/6/06, "The Pass-It-On Click Scam")? Not so much, he says, because the auction pricing model of search advertising corrects for any click fraud fairly efficiently.

Besides, it's far from clear what percentage of clicks on search-related ads actually comes from competitors or criminals seeking to drive up an advertiser's costs by clicking thousands of times on an ad, forcing the advertiser to pay for the hits without any intention of buying anything from the merchant. "If it were that bad, advertisers would know it wasn't working," he says. He argues that the rapid growth of both companies suggest that advertisers, who can measure the cost-effectiveness of search ads in detail, are still finding it attractive enough to bet on.

2. Napster can make it this time around.

The onetime peer-to-peer song-downloading service was run into bankruptcy in 2001 by music companies who alleged it enabled piracy. Since then, it has been revitalized as a source of legal downloads people pay for, as well as sample listens supported by advertising. In that business, Napster is a distant follower to Apple Computer's (AAPL) iTunes site. And Napster is still losing money. (Both of those facts are reasons why Napster isn't in the Web 20.)

Jacob began adding Napster this year, and has 3% of his fund invested in it, because it has about $103 million in cash and short-term investments and a market cap of $167 million. It has attracted about 600,000 subscribers to premium pay services, and its ad-supported model launched May 1. Napster has also slowed down its cash-flow burn in recent quarters, which Jacob hopes is the last big step before moving into profitability.

"It's a niche because they only address the 25% of the business that's not Apple," Jacob concedes. "But in a deep-value situation, my downside is limited." He reasons that Napster will get acquired if it can't get profitable enough to stay independent.

3. He's bullish on the Chinese Internet.

Jacob knows all the reasons the ChinaNet scares many investors: unpredictable earnings, even more unpredictable actions of the Chinese government, and fast-changing business models that can make hot stocks like online game seller Shanda Interactive Entertainment (SNDA) or help-wanted site 51job (JOBS) into dogs overnight. ("Shanda kicked my ass," he admits.)

Jacob still has three ChinaNet stocks among his top six holdings, and he has recently been buying (BIDU), the Chinese search engine. Why? "There's no question the growth is there, and we think all these companies will benefit," he says.

He likes CDC because its $500 million market cap is backed up by $200 million in cash. He's impressed by the company's stake in a Web media and gaming business he figures is valued at about $350 million on the Hong Kong exchange. CDC also has an enterprise-software business, built on acquisitions in fields such as enterprise resource planning and customer-relationship management that the market appears to be valuing near zero, Jacob says. Although those software businesses aren't huge performers, together with CDC's other assets they're undervalued, he says.

Jacobs thinks a spinoff of CDC's software business, which the company says is now under consideration, should highlight the value and catalyze a stock rise. "Both businesses are marginally profitable, and the Web media business is growing rapidly," he says. "Something is not being valued."

4. He likes small-cap software.

"On the growth side of our portfolio we're most positive on Internet advertising and media, but on the value side we find the most interest in small-cap software," Jacob says. That leads him to names like Webmethods (WEBM), which he likes because its $500 million market cap is backed up by about $135 million in cash. Webmethods, which makes business-integration and optimization software, also turned profitable in the fiscal year that ended in March, and analysts think it will earn 38 cents a share this year. That puts the stock's price-to-earnings ratio at 24 even before backing out the cash.

5. Finally, don't fear a Bubble Redux.

Jacob scoffs at the notion that the Web industry has entered an early stage of Bubble II, given the media frenzy and me-too venture investments in social networking sites such as or blogs, and the occasional attempt to take financially shaky companies like Vonage or Alien Technology public.

"You can argue the multiples, but it's a completely different situation," he says. "The companies are growing at a nice clip, and the margins and the operating leverage are there." The real bubble is elsewhere, he slyly jokes. "We're not getting much attention because we don't own gold or zinc."

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