Inside the Internet bubble

Kiplinger's Personal Finance Magazine, Nov, 1998 by Steven T. Goldberg

Think your stocks have been volatile lately? Imagine being in Tammy DiCaprio's shoes. With three children age 11 and under, DiCaprio doesn't have much money to spare. What she does have, she plows into stocks--but not just any stocks. "I only invest in Internet stocks," says DiCaprio. "I'm a big believer in the future of the Internet stocks--their potential is unlimited." An investor only since October of last year, the Chesapeake, Va., woman bought Amazon.com, Lycos and Yahoo! She sold all three at handsome profits, paid a few bills, and put the remainder of the money into America Online and GeoCities, which are now her only stock holdings.

AOL rocketed from $64, the price at which DiCaprio started buying it in March, to a peak of $141 in July. Then, even faster than it had soared, AOL plunged to $85 in September. GeoCities did even worse: DiCaprio bought it at $38 in mid August, and after rising to $51, it plummeted to $21.

While DiCaprio and her husband, Phillip, both 34, have some money in diversified stock funds, Internet stocks (primarily AOL) represent three-fourths of their investments. "This is all the money that I have except what we need for our basic living expenses," says Tammy. "We really need it. I can't lose it, because that would be a big hit for us." Phillip is a Navy petty officer, while Tammy works from home for AOL. "Everything I've always heard is, invest in what you know," she says, "and what I know is the Internet."

Before the unnerving plunge last summer, DiCaprio said of her Internet investing: "This has been fun for me, but I get real nervous because I haven't been on the losing end of a stock purchase, and I know I will be eventually."

Eventually came sooner than she expected. By mid September she said she was "thinking of selling GeoCities if it gets a bounce. I'm surprised at how much it lost." But while admitting to some panic, DiCaprio remains bullish on AOL. "If I had more money, I'd probably buy more AOL right now because I don't think it'll be this cheap for a long time."

While her single-minded devotion to Internet stocks is unusual, DiCaprio is far from alone in seeing a huge potential in Internet stocks--especially because they're down so far from their highs. The average Internet stock fell 43% from the July 6 peak through August 31. Even with the sharp decline, most Internet investors have been richly rewarded--so far. But the fact remains that most of these stocks as of mid September remained absurdly overvalued by any commonsense measure.

The real upward move in Internet stocks began toward the end of 1997 and the start of 1998. In fact, an index of Internet stocks compiled by Hambrecht & Quist is up 85% this year through September 8, even after the summer's hammering. Despite a flurry of initial public offerings, only about 40 publicly traded companies make the bulk of their revenues from the Internet--a supply-demand imbalance that has been a boon to Internet-stock prices.

But even with the dramatic sell-off, substantial doubts exist about the prices of many Internet stocks. Either their earnings are nonexistent or the stocks trade at stratospheric multiples of earnings. For example, AOL trades at 83 times projected 1999 earnings per share of $1.23, according to First Call. Yahoo! trades at 203 times 1999 estimated earnings, or 66 times 1998 revenues. By contrast, stocks on Standard & Poor's 500-stock index sell at an average of 21 times estimated 1999 earnings.

Seeking ways to value stocks that have no earnings, Internet analysts have taken to ranking them based on their revenues per share--or on the number of customers they have, or even on the number of visits from computer users to their Web sites. But no matter how you look at these stocks, their prices still appear unrealistically high. Whereas the average stock in Standard & Poor's industrial index sells for 1.7 times sales, online bookstore Amazon.com, which doesn't expect to turn a profit until 2001, goes for 12 times sales. Similarly, search engines Infoseek, Excite and Lycos sell at 12, 15, and 17 times revenues, respectively. The prices are so high that many experts have called the Internet-stock craze a mania--an irrational willingness among investors to bid up stock prices to absurd levels.

"Gravity is going to win this one in the end--it always does," says Nick Moore, a technology analyst at Jurika & Voyles. "This is a real bubble, and it's going to pop. People are excited about something that's really new, that looks as if it's going to be really big. But by paying the wrong price, you can turn a great business into a lousy investment because these stocks are going to be like falling knives." The drop in Internet-stock prices doesn't end the danger, he warns. "When these things start to go down, they usually end up undervalued before they stop falling. Have you ever seen a balloon that's half popped?"

You've seen this before

Investors with even short memories shouldn't be surprised. Just seven years ago, in 1991-92, biotechnology stocks were the rage. Many such companies had no earnings to speak of, and drug research consumed money voraciously. Eventually, the sector crashed, and only in the past few years has it begun to revive as more biotech drugs have been approved for sale.