Internet Investing (updated 10 March 99)

Investing in the internet and investing via the internet have become the new investment frontier. The potential impact of this new communications medium on business and society has been reflected in a frenzy of speculation in internet stocks, driving prices to extraordinary levels. Much of the speculation has come through online trading: the internet has enabled the emergence of the 'electronic day traders', who take advantage of the wealth of online data available and the low transactions costs of online brokers to place very short-term bets on stock price movements.

Wilshire Associates, who manage the Wilshire 5000 index, a yardstick that includes all of the seventy-four thousand publicly traded companies based in the United States, calculate that internet stocks were responsible for a fifth of 1998's market gain. The big name internet companies like Yahoo, Amazon.com and Netscape made three or four digit percentage gains that year. And NASDAQ, home of the market's hottest technology stocks, made its third biggest annual gain since being launched in 1971.

Since most internet companies are yet to show a profit, the boom in their stocks has sparked an entertaining debate about they can be valued. Traditional tools are hardly suitable so there is instead talk of such practices as 'monetizing the top line growth'. Jim Seymour in theStreet.com offers a tongue-in-cheek formula: 'There is a very profound, if wildly inexact, kind of algebra at work here: M(omentum) + F(uture, the) = L(ooks cheap today).'

Normally, companies in an early and rapid stage of their growth have difficulties financing it. Requirements for working capital, expense 'burn rates' and the discipline of optimistic forecasts used to attract financing all put pressures on the financial side of rapid growth companies. But not with the internet: growth of customers, not necessarily revenues, seems to bring opportunities for early public issuance of stock (see INITIAL PUBLIC OFFERINGS). Thus companies have the opportunity to 'monetize' the prospect for revenue growth - monetize the top line - even before the growth can be tested as a revenue generator and before profit margins can be estimated.

By early 1999, investors seemed willing to pay virtually any price for internet stocks, causing Federal Reserve chairman Alan Greenspan to warn of a 'lottery mentality'. At the same time, he conceded that investors' enthusiasm for the internet made some sense: 'The size of that potential market is so huge that you have these pie-in-the-sky type of potentials for a lot of different vehicles. And undoubtedly some of these small companies are going to succeed.' But, he added, 'the vast majority are almost sure to fail.'

For the securities industry itself, the internet has helped to democratize the investment process by providing widespread access to even the most specialized data and thus leveling the playing field for individual investors. Many freely available websites display real time stock quotes and chat rooms provide forums for stocks not widely followed on Wall Street. There are now ways of getting information on companies, countries, regions, peoples and cultures that were, until only very recently, totally inaccessible.

High-tech investing guru: Geoffrey Moore

The Technology Adoption Life Cycle, a model developed in the 1950s by Everett Rogers, describes how a new technology gets taken up by consumers. It explains how high-tech markets go through five phases as a new technology is adopted in turn by innovators, early adopters, the early majority of users, the late majority of users and the laggards. Geoffrey Moore, president of the Chasm Group, a high-tech market strategy consulting practice based in San Mateo, California, has extended this concept into marketing in the era of the personal computer and the internet. He adds the key insight that there is no smooth progression between the different stages. He has also applied the idea to the business of investing in high-tech companies.

Moore's first book, Crossing the Chasm, introduces the idea of a gap or 'chasm' that innovative companies and their products must cross in order to reach the lucrative mainstream market. He provides guidelines for adjusting market development and marketing communications strategies to ensure that products are positioned to break into that market. The sequel, Inside the Tornado, explores how to capitalize on the potential for hypergrowth beyond the chasm, an ambition that demands radical shifts in market strategy.

The Gorilla Game, Moore's third book, co-authored with Paul Johnson and Tom Kippola, combines the market analysis methodology of the earlier books with stock valuation models to suggest how to build a solid investment strategy around purchasing and holding the stocks in what the authors call 'gorilla' companies. It is distinguished from more general growth investment books (see GROWTH INVESTING) because it focuses exclusively on high-tech, specifically on product-oriented companies that sell into mass markets undergoing hypergrowth. Moore claims that above average returns can be made by investing in high-tech companies that 'own' their markets and are therefore worth more than traditional Wall Street accounting allows.

Moore's basic story is that the way markets adopt certain kinds of technologies ends up catapulting a single company into an extraordinarily powerful and enduring position. These companies are called gorillas, and the key for successful investors is to learn the difference between gorillas, chimps and monkeys. Gorillas are the companies that come up with the standard architecture, such as operating systems, whereas monkeys offer compatible products. Chimps are companies that tried to be gorillas but their architecture was not selected by the market.

The essence of the game is to buy a basket of stocks in all potential gorilla companies; as the gorilla emerges, sell off the rest of the basket; and hold the gorilla stock for the long term, selling it only when a new technology threatens to eradicate its power. Moore argues that the significant appreciation in gorilla stocks is directly linked to the periods of competitive advantage they enjoy and which far outreach their competitors.

Counterpoint

In 1958, fiberglass boat stocks were the hot thing on the stock market and Dean LeBaron, one of the co-authors of this book, was the world's greatest expert on them. At that time, fiberglass was going to wipe out wooden boats completely: it was indestructible, light and leak-proof, and it had very low maintenance. Furthermore, from the standpoint of the builder, you could pay about $300,000 for a mold, $50 for what you out in it, and stamp out as many boats as you liked. Fiberglass fit the leisure-time theme of the late 1950s; it fit the manufacturing notion of high fixed costs and low variable costs; everything was right. And of course, there were not very many fiberglass boat stocks: Glassbar, Glasstron and American Molded Fiberglass were the big names.

Today, internet stocks may be the equivalent of fiberglass boat stocks. Yes, the arguments are strong. Yes, there are high fixed costs and very low variable costs, and the technology does some wonderful things and fits into some major themes. But who remembers the fiberglass boat stocks now, forty years later? And who may remember the internet stocks of today, forty years or even four years from now?

Another more recent analogy for the internet industry might be the experience of the emerging markets in the early to mid-1990s: there is the same excitement of discovery, with the glamour of seemingly unbridled growth and almost infinite demand. Investors were attracted to emerging markets because little was known about the risks or any of the eventual outcomes. This is not so now: we are going through a period of increasing maturity and sobriety (see EMERGING MARKETS).

The internet, on the other hand, is at the stage of emerging markets a couple of years before the Asian crisis, with enthusiasm that seems completely unchecked. Portal websites, for example, seem to be important, but it is hard to imagine that this will continue to be the case when consumers are able to comparison shop easily. The internet seems to be emerging markets all over again and it may follow exactly the same path. We are on the upside now.

As Marc Faber has pointed out, the most dangerous moment in any market boom is when fund suppliers stop paying attention and take on trust the value of the assets they are funding just because everyone else is doing it (see MANIAS, PANICS AND CRASHES). Whenever it is expensive to monitor the value of assets but the opportunity costs of missing out on an investment appear too high to resist, a switchback effect occurs: investors stop monitoring the underlying value of the assets and look for reassurance in momentum and herd behavior.

Getting a real understanding of how internet technology will develop is very difficult, and many investors seem not to be looking very hard at the revenues of companies whose stocks they are bidding up. Indeed, many seem to believe that picking a few winners in a bull market, especially risky high-tech stocks, is a certificate of brilliance in investing. What will happen if and when markets turn down? Will online brokers be able to trade large volumes of stock in what are thin markets?

Ed Yardeni also has a skeptical view of internet stocks. He writes: 'The New Economy is now the Yahoo Economy, where even the sky is no longer the limit. The outer limits are somewhere out there in cyberspace. GM and IBM were once market leaders. Now the internet stocks provide the leadership. The new theory of relativity posits that website accessors, not earnings, matter. As the custodian of yardeni.com, I should be a big supporter of this theory. Maybe I should even consider an IPO. However, while I am cyber-savvy, I'm also old-fashioned. I was taught that stock prices should equal the present discounted value of future earnings. In my opinion, the internet is fundamentally deflationary, which is fundamentally bad for earnings.' (see POLITICS AND INVESTING).

Where next?

The internet is becoming increasingly deeply embedded in our daily lives. Some of its fastest growing uses are the commercial, wholesale and retail transactions of e-commerce. These are empowering consumers in a number of ways: advertising can be customized and directed at people who will actually find the products interesting; the purchasing convenience is tremendous; and comparison shopping becomes easy.

Intelligent mobile agents or 'bots', a new form of computing ideally suited to the heterogeneous nature of the internet, will become increasingly important. These are programs that act independently on our behalf. For example, a bot searching for airline tickets from virtual travel agencies on the internet can match preferred dates, price-range, class of travel and other features of the journey, without having to come back to us for approval. Bots equipped with some negotiating skills can be used to schedule meetings, participate in online auctions and trade in financial markets.

Library research used to depend on proximity to a well stocked set of library shelves. And then it was dependent on your research resource skills - how good you were at retrieval, sorting, copying and summarizing. Not now. It is possible to assign a bot a research task, which it will tirelessly pursue one hundred and sixty-eight hours a week, no fringe benefits required. And, in theory, you could have many, many bots - and perhaps a bot to manage the bots.

Once someone becomes moderately adept at research and commerce on the web, a web addict is created. At that point, it is difficult to imagine going back to the conventional practice of looking for something through the Dewey decimal system or actually to walk - or drive in the case of the United States - to a store. Bots may also diminish the importance of branding, which we are accustomed to thinking about in a world where information is scarce. With the internet, information is not scarce - overwhelming perhaps, but not scarce - and the power of brands and portal websites may be reduced.

What is more, with new technology like agents, it may be increasingly difficult for companies to get the 'lock-in' competitive advantages that the gorilla game strategy demands unless you are a builder of the net or your customers are other businesses. And the empowering nature of the internet may well threaten the margins of even those companies with large market share. This explains why it is possible to be very enthusiastic about the potential of the internet but skeptical about the high valuations of internet stocks.

So is the internet primarily a spoiler of profits in industries or a net builder of profit for its industry and a breeder of new industrial applications? We can see some of the areas that it will spoil: brokers are being replaced by online financial services; e-shopping is taking over though curiously, it is not producing any more profits for the vendors; and mail is being threatened. We do know that some new industries will come, but we cannot really see what they are. It may well be that the ease of entry into the internet is so great that none of the companies will make any money by it. After all, we compare the internet with the printing press and we know that the printing press put an awful lot of monks and scribes out of business.

It seems likely that investing online will continue to expand enormously and go far beyond the speculative world of the day traders. But what impact will it have on traditional financial services? Wall Street's brokers, for example, are facing a considerable challenge as they try to deal with online discount brokers.

Bill Miller comments: 'I think the online market is like the discount business - it just further segments the market; it doesn't replace traditional trading or brokerage. Sort of like TV to the movies, then VCRs, etc. Online traders are most like traditional discount customers, which is why Schwab is so successful at it. The do-it-yourself market is big and growing in a lot of industries, but it rarely if ever totally displaces those who want to pay for service and advice. This is different from, say, book retailing, where the best customers of Borders are the best potential customers of Amazon. The best brokerage customers, equity-oriented wealthy families who use margin are not the profile of the E-trade customer, whose demographics are entirely different. They may merge in a generation or so, but by then only the most dimwitted brokers will not have been able to adapt.' (see ACTIVE PORTFOLIO MANAGEMENT).

Paul Farrell, mutual funds editor of CBS MarketWatch, takes a different view: 'The Wall Street Establishment is like a medieval priest caste, believing that they have some kind of divine right, some superior insight, some special access to the God of The Markets. No wonder the online investing revolution scares the devil out of Wall Street, why they hate do-it-yourself investors, the new breed of investors has no loyalty, isn't dependent on Wall Street, and does not believe in the Myth of Wall Street's Special Wisdom.'

Farrell continues: 'Bottom line: Wall Street's brokers are about to become the monks of the new millennium, thanks to the online investing technologies, especially the new fund supermarkets. By the year 2000, over 25% of all sixty-five million mutual fund investors will have online investing accounts. They are emerging as a critical mass that will control the market, transferring power from Wall Street to Main Street where the allegiance is solely to the computer, the internet and their own inner spirit.'

In June 1998, the self-styled 'magazine of the digerati', Wired, launched what it called an index of the new blue chips: 'in the spirit of the intrepid Mr Dow, we are launching the Wired Index. Our aim is to do for the information age what the Dow did for its predecessor: track the growth of the companies that are building the new economy - not just the usual high-tech suspects, but a broad range of enterprises that are using technology, networks and information to reshape the world.'

The magazine continued: 'Traditional financial tools are less and less effective in an economy defined more and more by intangibles. In creating the Wired Index, we looked instead for fast learners - companies already exploiting the new realities of a digital, networked world. Their fundamental qualities are: globalism (exploiting worldwide markets and open systems); communication (building brands and mindshare; networking); innovation (creating and utilizing new ideas; speed and agility); technology (using new tools to maximum effect; adaptation); and strategic vision (understanding how to be in the right place, and stay there).'

Governments try mightily to regulate the internet. Some pornographic material gets into the hands of minors and some to the citizen of countries like Singapore where it is offensive. Some governments try to tax e-commerce. And others, like the US government, seem to think the internet superhighway should be regulated on general principles. The early days of internet growth seemed driven by non-monetary goals of accomplishment. Now that money is such a component of net company planning and with shareholder expectations high and government rule-making seemingly ready to grab hold, will the internet be more useful than we have seen? It hardly seems likely yet to date, every forecast has been broken, on the upside.

Read on

In print

Stephen Eckett, Investing Online: Dealing in Global Markets on the Internet
Geoffrey Moore, Crossing the Chasm: Marketing and Selling Technology Products to Mainstream Customers
Geoffrey Moore, Inside the Tornado: Marketing Strategies from Silicon Valley's Cutting Edge
Geoffrey Moore, Paul Johnson and Tom Kippola, The Gorilla Game: An Investor's Guide to Picking Winners in High Technology

Online

fisher.ecn.bris.ac.uk/staff/ecnv - website of Nir Vulkan with research on the economic implications of agent technology and e-commerce stocks.
wired.com - website of the Wired Index, run in real time
www.gorillagame.com - the website of the book
www.imagination-engines.com - a website that illustrates what a bot will do. www.thestreet.com - a good source of information and entertaining writing about the stock market
www.yardeni.com - Ed Yardeni's website