Web Stocks The New Rules

Kiplinger's Personal Finance Magazine, April, 2000 by Steven T. Goldberg

COVER | AVOID DOT-COMS and still profit from the Internet.

NO SIGN ADORNS the beige, lows-lung building in a Sterling, Va., industrial park--Exodus Communications would just as soon you didn't know it exists. Armed guards check for unfamiliar license plates in the parking lot. Inside, other guards watch from behind bulletproof glass and patrol the corridors. ID cards are required to open doors, and really sensitive areas are equipped with electronic palm readers, which admit only people the machine recognizes.

The security is designed to keep thieves and mischief makers from wreaking havoc on Web sites that process bank transactions, credit card purchases and sales of everything from business equipment to toys and books. Yahoo!, SportsLine and the Weather Channel are just a few of the dozens of companies whose Web sites are housed in the carefully controlled and constantly monitored bunker--which looks like nothing so much as a dog pound for computers, with floor-to-ceiling black-wire caging around each company's hardware.

Inside the cages are the guts of the Internet. Sun Microsystems and Dell Computer servers sit on metal shelves. So do Cisco Systems routers and switches. About half the servers run Microsoft Windows NT software; the remainder use archrival Unix. Open the computers and you'll see Intel Pentium microchips and motherboards, Western Digital hard drives and 3Com network-interface cards. The Web-server software is from Netscape and Microsoft. Oracle runs most of the databases. Backup software comes from Veritas, Legato and EMC.

While none of these firms is an Internet company, all of them are what Kevin Landis, manager of the Firsthand funds, calls "arms merchants" in the intensifying Internet-business turf wars. Everyone who sets up a Web site needs to buy equipment from some of these companies--and perhaps to rent space or buy technical assistance from Exodus or one of its competitors.

That this facility has barely been open a year is testimony to the Internet's geometric growth rate. Internet firms are involved in a land grab, each trying to stake out and defend a niche on the World Wide Web. "This is a real estate war," says Peter Pevere, chief financial officer of Commerce One, which helps businesses sell to other businesses over the Internet. "It's sort of like we're trying to fly the plane and build it at the same time."

Here's where you come in. In the past, investing in Internet stocks often seemed like casino gambling--you made your bets with little to go on because the profit potential of so many companies remained cloudy. Now some clarity has emerged:

* Accept that the Internet is here to stay. It will have a huge impact on how this nation does business. And its companies should be part of your investment portfolio.

* Know your tolerance for risk. If you can't stomach owning the stocks of money-losing Internet companies--many of which may eventually go bust--stick to stocks of big tech companies that benefit from the Internet.

* Concentrate on stocks that will profit mightily from the Internet without being the Internet.

With the Internet's growth so rapid, opportunities for profit are enormous. Of course, everyone knows that already. The Robertson Stephens Internet index was down 7% through early February, but it returned 156% last year and 297% in 1998. Historically, stocks in Standard 8: Poor's 500-stock index have sold at about 14 times annual earnings and two or three times sales. Although most Internet companies are losing money, many trade at 100, 200 or even 1,000 times annual sales.

Should you shun such stocks altogether? History is replete with cautionary tales. In the early 1980s dozens of companies tried to grab control of the mushrooming PC industry. None succeeded. Today's dominant companies--Dell, Compaq and Gateway--didn't flourish until after computer stocks nose-dived in 1983-84.

In the late 1960s jet airlines and color televisions caught investors' imaginations. But airline stocks are longtime poor performers, and not a single U.S. company makes TVs anymore. Radio transformed the nation much as the Internet is doing today, but RCA, the biggest radio company in the 1920s, took 30 years to regain its pre- 1929-crash price.

The run-up in Internet stocks reminds John Brennan, CEO of the Vanguard funds, of skyrocketing Japanese stocks in the late 1980s, which subsequently plunged and are still selling at about half their peak 1989 prices. Says George Vanderheiden, who recently stepped down as manager of Fidelity Advisor Growth Opportunities fund: "There's a huge supply of these companies, and only a handful of them will survive." Even the most ardent Internet bulls expect a shakeout in which stronger companies acquire or knock off weaker ones. "There are hundreds of companies in any industry, and then there will be four, and then two," says Charles Lax, partner in a venture-capital fund.

But Alexander Cheung, manager of Monument Internet fund, argues that "if you continue to own the best companies, they will survive and eventually become bigger." Others say valuations must simply be ignored. "It's too big an opportunity not to bet," Phil Summe of Chase Capital told an Internet-stock conference in Boston. "If you don't make colossal bets now, you'll be sitting in your rocking chair when you're 90 and ask, `How did I miss the biggest opportunity of my lifetime?' These companies are going to be the Fords and GMs of the future."