Chapter One: It's Not Too Late

The Revolution You Can't Afford to Miss

There are lots of bad reasons to invest in the Internet. Among them is the notion that Internet investing is a road to a quick buck. Internet stocks, according to this logic, may or may not be around forever, but it doesn't matter. Their volatile trading patterns mean that the nimble investor can make a fast profit regardless of the long-term outlook. The fancy name for this is momentum investing: the practice of buying a stock for no other reason than that it's moving higher. But don't be fooled; investing has little to do with it. In its most extreme form -- day trading -- momentum investing involves jumping in and out of stocks over the course of a few hours, barely pausing to find out their names, in the hope of making a lot of money off of moves of just a few points. Momentum investing gained a broad following during the tech-stock craze of 1999 but became a lot less popular during the tech-stock sell-off of 2000.

This book has an altogether different approach. It's premised on the notion that the Internet is here to stay but the spectacularly volatile way Internet stocks have traded in recent years isn't. Already, the once-frenzied rush to invest in anything remotely connected to the Net has ended as a growing number of formerly high-flying dot coms have gone bust. Yet more than a few companies continue to sport billion-dollar market values despite having no profits, meager sales, and heavy competition. Couple that with fickle investors who repeatedly shift from one subsector and business model to another, and investing in Internet stocks has become the most exciting -- and terrifying -- investment theme in years. Millions of investors have thrown billions of dollars at Net stocks in hopes of reaping huge rewards. Some have. Others have lost their shirts.

If all that turmoil has you sitting on the sidelines of Internet investing, don't worry, you have plenty of company. Yet there's no need to be paralyzed. This book is aimed at investors who know the Internet is changing the world but haven't determined how to use that knowledge in their investment portfolios. It has three underlying principles:

1. The Internet is for real (but that isn't true of every Internet company).
   
   
2. It isn't too late to become an Internet investor.
   
   
3. The "secrets" of investing in the Internet are the same secrets of making any investment: do your homework, know what you're buying, invest for the long haul, and don't buy stocks that will keep you awake at night.
   
   

Here's the bad news: Among the hundreds of Internet companies that have gone public in recent years, most will flame out. Two of the most prominent Internet stock analysts, Morgan Stanley's Mary Meeker and Merrill Lynch's Henry Blodget, predict that as many as three quarters of the dot coms that have gone public within the last couple of years will cease to exist within the next couple. Their revenues and profits won't materialize, their stocks will plummet, and they'll either wither slowly on the vine, go out of business, or be sold. It's already happening. Remember ToySmart, Living.com, and Boo.com? Jeff Bezos, the thirtysomething founder and chairman of Amazon.com -- the largest of the Web-only retailers -- cheerfully jokes that his firm is "famous for losing money," warning prospective investors that Amazon "is not yet a lasting company" and may never become one. "The track record of innovators is not good," Mr. Bezos frequently intones.

But that doesn't mean the Internet itself -- or every Internet company -- will suffer a sorry fate. Quite the opposite. A few dot coms that today seem like the most speculative of bets will almost certainly rank one day among the greatest success stories in the history of business. Investors fortunate enough to get in early on these future giants will be richly rewarded. Many other companies, meanwhile, will become more modest successes, even if they don't live up to the hype of their early days. The tough part of all this, it goes without saying, is sorting the long-term winners from the losers. That's where this book is designed to help.

The Living Dead

Already, the proverbial separation of the wheat from the chaff is well under way. Consider theglobe.com, a business founded by two twenty-five-year-old Cornell graduates as an on-line meeting place for people with similar interests. One of the earliest examples of such "community"-oriented Web sites, theglobe.com went public in late 1998 in one of the most spectacular initial public stock offerings in history. Its stock, priced at $9 a share, opened at $90 before settling back. But theglobe.com never came close to regaining those first-day highs, and by late 1999 -- barely one year after its IPO -- the company had issued its first formal warning that its quarterly results wouldn't meet expectations. In early 2000, the two founders resigned as co-chief executives. And although, as of early 2001, theglobe.com remained in business, it continued to lose money and its stock was clinging to life at pennies a share.

Another example: Value America, one of the early darlings of Internet commerce, was founded on the intuitively appealing idea that the Web eliminates the need for retailers to carry inventory and, to the contrary, means they can offer customers a limitless selection of products. With financial backing from blue-chip names such as FedEx and Microsoft cofounder Paul Allen, Value America launched a flashy coast-to-coast advertising campaign, tantalizing consumers with rock-bottom prices for everything from toasters to toothpaste. But Value America's promise also faded quickly. The hugely expensive marketing effort failed to draw many customers; those who came were disappointed with uneven service (a symptom of the same inventoryless model that made the company so attractive to investors); and the razor-thin profit margins hadn't a prayer of stanching the firm's hemorrhage of capital. By early 2000, Value America had announced drastic plans to scale back its advertising, curtail its product offerings, refocus its sales efforts, and fire half of its staff. A few months later, it had filed for Chapter 11 bankruptcy protection, hoping to reorganize and reemerge with a new business strategy.

A third example: TheStreet.com, a Web site devoted to financial news and content, was created by a high-profile money manager (James Cramer of the Cramer, Berkowitz hedge fund) and a high-profile publisher (Martin Peretz of The New Republic), staffed by veterans of some of the nation's most respected news organizations, and backed by such established names as The New York Times. But after a promising start, TheStreet.com also faltered. Despite high-quality content, it failed to attract enough paying subscribers, resorting first to free promotional giveaways to drive subscriptions and ultimately scrapping the paid-subscription model almost entirely. A management shake-up and a public pledge by Mr. Cramer to take stock options in lieu of a salary failed to do much for the company's stock, which following an early pop has remained a lackluster performer. In early 2000, TheStreet.com confirmed that it had hired an investment bank to "explore alternatives," and later that year the company laid off part of its staff and closed its European operations.

Theglobe.com, Value America, and TheStreet.com are all examples of companies that, although unprofitable as businesses and unsuccessful as investments, refuse to die. They linger on -- the living dead of the new economy -- clinging to the hope that they'll either be bought or their luck will improve before they run out of money. Ironically, these three companies are among the fortunate ones. They arrived on the scene early enough and garnered enough publicity that they were able to capture investors' imaginations, raising so much money through both private and public rounds of financing that they are able, for now, to remain in operation, though each of them continues to bleed red ink. In the meantime, hundreds of other, lesser-known firms in similar circumstances have been forced to merge, sell their operations at bargain-basement prices, or shut down. They are names destined to be forgotten amid one of the greatest technological revolutions -- and speculative bubbles -- the world has known.

The New Elite

But for all these failures, a few companies have already achieved stunning successes unimaginable just a few years ago. In 1999, eBay -- the on-line auctioneer that allows millions of ordinary people to conduct business with one another in a global flea market -- purchased the century-old Butterfield and Butterfield auction house, the first significant example of an Internet-age company overtaking, and subsuming, an old-world rival. A few months later, Internet service provider America Online -- a fifteen-year-old company written off by some as doomed just a couple of years earlier -- acquired Time Warner, the world's largest media conglomerate and owner of some of the most prestigious brands in television and print. And then there's Yahoo!, the giant among so-called Internet portal sites. A company with no real-world assets to speak of, founded by two graduate students on leave from Stanford University, Yahoo! was added to the Standard & Poor's 500 stock index in late 1999, just six years after its founding. Though it has repeatedly disclaimed any interest in doing so, Yahoo! has at times been cited as a potential merger partner for venerable behemoths in the traditional media ranging from News Corporation to the Walt Disney Company. In contrast to the living dead, these three firms are examples of the economy's new elite -- companies with hugely promising business models that dominate their competition to an extent rarely seen in the annals of American business.

The Big Picture

More broadly, the Internet as a repository of content, a medium of communications, and a mode of commerce will become ever more entrenched in our daily lives. Worldwide, the number of people using the Net is expected to top half a billion in 2004, up from about half that level in 2000 and from less than 40 million as recently as 1996, according to International Data Corporation. And some studies suggest that those numbers are conservative, because they assume that Internet users will rely only on personal computers or Internet-ready TV sets and don't take into account newer, cheaper, and more ubiquitous Internet access devices such as cellular phones and personal digital assistants. Already, the Web has utterly reshaped the way many of us shop, study, and conduct business. Don't feel like heading in to the office anymore? In 1999, according to Forrester Research, nearly a third of North American households were linked to the Net with the express purpose of allowing someone to work from home. Don't feel like doing the grocery shopping? In 1999, $513 million worth of groceries was sold on-line, up from $90 million just three years earlier. And Forrester expects that number to hit nearly $17 billion by 2004. So complete and so rapid has this transformation been that more than a few commentators have worried that we're becoming a nation of hermits, content to while away our lives in the isolation of our own homes, interacting with the outside world solely via mouse, keyboard, and telephone. "The more hours people use the Internet, the less time they spend with real human beings," Stanford University political scientist Norman Nie told The New York Times. "When you spend your time on the Internet, you don't hear a human voice and you never get a hug." A study by Mr. Nie found that of those Americans who spend more than five hours per week on-line, 13 percent spend less time with family and friends and 8 percent attend fewer social events. Perhaps not surprisingly, a 1999 Roper Starch poll commissioned by America Online showed that 66 percent of Americans surveyed would prefer an Internet connection to a telephone (23%) or a television set (8%) if stranded on a desert island.

Even as it reshapes our personal habits, the Internet's unprecedented ability to heighten business efficiency -- by eliminating the need for costly physical infrastructure, improving awareness of prices, and increasing the flow of information generally -- is rippling through the world economy. For corporations, this will mean less pricing power but also lower overhead, raw material costs, and manufacturing expenses. For consumers, the net effect (pardon the pun) will be not just greater convenience but also cheaper prices -- or at least a slowdown in the rate at which prices rise.

Federal Reserve Board Chairman Alan Greenspan is one of many noted economists who have repeatedly cited the advent of the Internet as one of the most significant aspects of the high-technology revolution. That revolution, Mr. Greenspan says, has fundamentally changed the way the global economy operates, improving efficiency, increasing productivity, and helping to hold inflation in check. Mr. Greenspan is willing to take this argument only so far, however. He notes, for example, that other factors have at times acted as inflation stimulants -- including the occasionally incredible values of Internet and technology stocks that make investors feel richer and thus spend more money. But other economists take the argument much further, suggesting that the Internet and other advances have practically eliminated inflation in the United States by holding down the cost of raw materials, and by making it hard for retailers to raise prices. The Net, after all, is the ultimate tool for comparison shoppers, with whole businesses devoted to helping e-shoppers find the lowest price for any product with just a few keystrokes. "The Internet is more important than the Fed," writes economist Larry Kudlow of ING Barings and CNBC.com. "Easily accessible low-cost information and increased competition, the hallmarks of Internet economics, will contribute substantially more growth with significantly lower prices. Think of it as deflationary growth, a classic consequence of long-wave technology cycles. This is the new paradigm of the information economy."

There is, of course, a downside to all these positive developments. For all those new businesses that have sprung up out of nowhere, for all the convenience the Net has meant to consumers, for all the efficiencies it has created for companies and the inflation-fighting effects it has had on the economy -- the Net has also endangered countless old-world companies and threatened to displace millions of jobs. In some cases, those businesses that are jeopardized simply have little reason to exist in a Webified world. Once consumers can search for the cheapest, most convenient airline tickets, car rentals, and hotel reservations with just the touch of a few buttons, for example, why use traditional travel agents? Once publishers and record labels can distribute books and music on-line, on demand, why would anybody want to rummage around in traditional bookstores or record shops? Once individuals can put their basement clutter up for sale before a global audience, fetching unthinkable prices for otherwise worthless tchatchkes, why would they ever want to rely on traditional newspaper classifieds? This, in a word, is disintermediation: the act of removing the middleman. The tremendous commercial power of the Net -- to heighten convenience, improve efficiency, and keep prices low -- derives precisely from the fact that it is the greatest disintermediator the world has ever known. It threatens to do to thousands of businesses and their employees what the electric refrigator did to the iceman.

As with previous technological revolutions, however -- from the advent of electricity to the invention of the microchip -- those companies that survive will ultimately be strengthened. Thus, companies from General Motors to General Electric -- if their efforts at Webification are successful -- could in theory get better prices on thousands of component parts that go into every product they make, while improving the efficiency of their just-in-time manufacturing systems by having computers automatically monitor inventories and reorder supplies as needed. The result should be fatter profit margins -- assuming that GM and GE are able to maintain some degree of pricing power over their customers. But even if they aren't -- because the same Internet that allows them to comparison shop for cheaper widgets allows their customers to comparison shop for cars and dishwashers -- these companies will nonetheless be better off for embracing the Web early and will gain an advantage over rivals who don't. The Net "is the final nail in the coffin of bureaucracy," says legendary GE Chairman Jack Welch. "It's taken the company by storm. It's exciting, it's faster. Business will never be the same again."

The Internet and You

All this said, the Net is also a barrel of misconceptions. It isn't just four or five years old, for example. It's been around for nearly thirty years -- though it's only recently become a means of doing business (more on this in a moment). "Internet companies" aren't just newly fledged, profitless enterprises run by technogeeks fresh out of college. There are some of those, to be sure, but there are also plenty of mainstream, very large, and very profitable companies that are central players in the Internet. And the Internet hasn't redefined investing. Despite all the Net lingo about things such as "eyeballs," "stickiness," and "virality," the key "metric" -- a term that is itself Net jargon for "measurement" -- remains, as it has for centuries, corporate profitability. Rest assured, no company without profits can exist indefinitely. Finally, and most important, the Internet isn't nearly as risky as you and many other investors may think. The Internet is such a mainstream phenomenon that the riskiest investment strategy may be avoiding it rather than embracing it.

Just how the Internet and all the companies associated with it fit into your personal portfolio is something that only you can determine. You can, for example, choose to play with the fast money that tries to determine which sector or subsector of the Net will be the next hot theme. Stocks in whatever sector that is will be extremely volatile; initial public offerings of companies in the category will skyrocket in a matter of minutes. The gains to be made are spectacular. But so are the losses. If you choose to take part in that mad scramble, don't call yourself an investor. You're a speculator, and you are playing a very risky game.

At the other end of the spectrum you can be content to pay little attention to the Internet or Internet stocks. Invest your money for the long haul in index funds, and relax secure in the knowledge that as the Internet grows to encompass virtually every aspect of the domestic and global economy you'll be along for the ride. Already, for example, the Standard & Poor's 500 stock index sports two very prominent Internet companies -- AOL Time Warner and Yahoo! -- and dozens of other companies in the index, while still classified as "old-economy" firms, are rapidly remaking themselves to take advantage of the efficiencies the Internet offers. Take this approach, and I can guarantee you won't make the kind of fabulous profits that the speculators are after. But you almost certainly won't suffer catastrophic losses either. If the Internet is indeed ushering in a new era of prosperity and productivity, a diversified portfolio of U.S. and foreign stocks will reflect those improving economic circumstances.

Then there's the vast middle ground between those extremes, a rich array of stocks and mutual funds that let anyone tailor a portfolio to suit his or her own needs. Somewhere amid all those offerings is where I figure you'll want to be. I'm assuming that you know the fundamentals of investing: the importance of a diversified portfolio, the costs of commissions and taxes, and the essential metrics (there's that word again) of stock evaluation: revenues, profits, and price-earnings ratios, for example. If you don't feel completely comfortable in that arena of stock evaluation, don't worry. I'll explain a lot of that as we go along. If you're new enough to investing to be uncertain about concepts such as diversification and the impact of costs on returns, you probably should stop here and go find a good explanation of what investing is all about. And if you want to play at either of the extremes I mentioned earlier, you can stop here, too. This isn't a text about gambling, and if you're just buying index funds you certainly don't need the information in the remainder of this book (though, of course, you may find it interesting). But if you want to take advantage of the Internet in your own portfolio, read on.

A Little Background

Although what we know as the Internet entered our consciousness in the 1990s, the Net was born nearly three decades earlier as part of a federal cost-cutting program. At the time, computers were massive, room-sized machines costing millions of dollars each and used mostly for government research, although a few universities owned them, too. Many of those universities obtained their computers through government grants. That led a federal bureaucrat at the Advanced Research Projects Agency (ARPA) to the conclusion in the late 1960s that the government could save lots of money by enabling universities to share computer power among themselves. It was a radical notion, given that the technology didn't yet exist for two computers in the same room to talk to each other, much less to share information with other computers hundreds or even thousands of miles away. Solving that problem became a challenge that, by some accounts, rivaled the effort to put a man on the moon. And in fact, at around the same time that Neil Armstrong was stepping onto the lunar surface, the first crude messages began passing back and forth among computers in four locations in California and Utah. By 1970, the first East Coast branch of this new computer network was established in Cambridge, Massachusetts. And gradually, the ARPANET, as it became known, expanded to include dozens, and later hundreds, of locations all across the country. In 1973, computers in England and Norway were connected. And while the system was first used to perform complex research, it very quickly became a means of communication as well, with the first e-mail messages transmitted by the early 1970s.

The immense efficiencies inherent in sharing computer power at long distances touched off the creation of dozens of other computer networks around the country, at universities, government agencies, and even some companies. Each of these networks operated differently from the others, with different computers speaking different languages. The result: a cacophony of small networks that couldn't share information with one another. And that problem touched off yet another quest for a solution, one that was solved by the mid-1980s, when technology was created that allowed the different networks to communicate with one another. The product of this "inter-networking of networks": the Internet.

During this entire time, the Net remained a text-based medium, with nothing in the way of graphics and few practical applications beyond communications and computer and mathematical research. It was extremely user-unfriendly, with only the most computer-savvy of individuals able to figure out how to use it. But those advances, too, came quickly. In 1990, a computer scientist in Switzerland created the World Wide Web -- a system of addresses and common standards that simplified the way users of the Net could find one another. The Web also allowed computers on the Net to pass information back and forth using an agreed-upon set of rules, so that the information looks the same no matter what type of computer is accessing it. From that point on, developments piled one on top of the other. In 1992, led by then-Senator Albert Gore, Jr., Congress passed a law that opened the so-called Information Superhighway for uses beyond research and education, helping to foster the growth of commerce on this exploding medium. In 1993, several graduate students at the University of Illinois invented the first "browser," a piece of software that makes it little more than child's play to navigate the Web and view information graphically.

Within a year, the browser software created in Illinois -- initially called Mosaic but later renamed Netscape Navigator -- was the basis of a company, Netscape Communications, and the trigger that led to the Internet's spectacular growth. Netscape went public a year after that in a hugely successful initial public stock offering that ushered in the age of Internet stock euphoria. In 1994, a Wall Street denizen named Jeff Bezos became one of the first to realize the commercial applications of this fast-growing new medium and set out to capitalize on them. His on-line bookstore, Amazon.com, was launched in 1995. It went public in its own hot IPO just two years after that and within a few years became a place to buy virtually anything on-line -- not just books, compact discs, and videos, but also toys, toasters, and even chain saws. Hard on its heels followed the creation of hundreds of other Internet businesses: book stores, toy stores, drug stores, wine shops, sporting goods stores, pet supplies stores, and on and on. Thus the Internet was transformed from a communications medium into a medium for commerce, and Internet stocks became -- overnight, it seemed -- the hottest form of investment in anyone's recent memory.

Is It My Eyes, or Are These Distinctions Blurring?

In the earliest days of the Internet as we know it today -- that is, about seven years ago -- there were Internet companies that either did business on the Net or helped make it possible for others, and there was everybody else. But that distinction has faded considerably since and will be essentially meaningless in a few years. The borders between what is and what isn't an Internet business are rapidly blurring as more and more companies, both old and new, do business on the Net. Some use the Net mostly to simplify and streamline their back-office processes, such as purchasing. Others use it as an additional channel for communicating and doing business with customers, just as they would the telephone or a physical store. A few do business mostly or exclusively on-line, but they are, and will remain, a minority. Many of the dot coms that began life as Web sites have started to open physical locations, to team with bricks-and-mortar counterparts, or in some other way to develop tangible, physical embodiments of their virtual selves.

Examples abound of how the world of Internet companies and the old economy are blending. Take, for example, Amazon.com. There isn't any question that it's an Internet company. It sells products exclusively on-line and operates no "real-world" bricks-and-mortar stores. But it also owns millions of dollars worth of physical inventory, stockpiled in cavernous distribution centers around the world -- complete with conveyer belts, forklifts, and thousands of employees. And it has a joint venture with Toys "R" Us, under which Amazon sells and distributes an inventory of children's products selected, and owned, by Toys "R" Us.

Then there's eBay. It, too, is unquestionably an Internet company. It does business mostly on-line, owns no inventory, and its person-to-person auction business couldn't have existed before the Internet. But eBay also owns a real-world auction house, Butterfields, that has been around for more than a century.

Now consider AT&T. It is the country's largest long-distance phone company, as well as its largest cable television provider, with tens of thousands of employees and a massive physical infrastructure that stretches from coast to coast. But its network is also one of the largest carriers of Internet data traffic (the Web's circulatory system), and it controls the nation's largest high-speed Internet access service. It may not be a pure Internet play, but the Internet is a huge and growing part of its business. Indeed, the decline of Ma Bell's core long-distance business and the rise of the Net are key reasons behind the company's dramatic restructuring and breakup, announced in late 2000 and expected to occur over several years.

Finally, look at General Motors, which builds and sells cars and trucks, one of the most inventory-intensive and labor-intensive industries around. But GM is also a part owner of what is expected to become one of the world's largest on-line purchasing exchanges, and it will soon buy most of its billions of dollars worth of supplies over the Net. It's far from a pure Internet play, but there isn't any question that the Internet will play a critical role in the company's future.

All this probably sounds a little confusing, and the last thing I want to do is confuse you. So if you're willing to accept that the distinctions between what is and what isn't an Internet company are a bit arbitrary, I will, for the purposes of this book, define an "Internet company" as one that derives most of its revenue from transactions completed over the Net or whose business is predominantly and inextricably related to the Net. But I'm not going to ignore the many companies that, while not deriving the bulk of their revenues on-line, nevertheless stand to benefit in some notable or significant way from doing more of their business on the Net or, more indirectly, from the explosion in other companies doing business on-line.

The aim of creating these distinctions -- and there are more detailed distinctions yet to come -- is to give you the tools you need not only to analyze various companies as potential investments, but also to allow you to analyze your own investment portfolio. Only by understanding the broad categories, such as Internet companies and non-Internet companies, and more detailed categories among the Internet companies, will you be able to control and achieve the proper exposure to this new investment opportunity. Believe me, too much exposure to the Internet can be just as dangerous as too little.

Categories and Subcategories

Wall Street tends to group Internet stocks into three broad categories:

• Business-to-consumer (known as "B2C") companies aim their products or services at individual customers such as you and me.
  
  
• Business-to-business ("B2B") companies sell their products and services to other companies.
  
  
• Infrastructure companies (sorry, no catchy nickname) focus on building the physical components of the Net.
  
  

We'll use that basic system in this book, although you should understand that, like the differences between Internet and non-Internet companies, the distinctions between these subcategories can become blurry, too. Most infrastructure companies are, in some sense, B2B companies as well, since their customers are other companies, not retail consumers. Some companies cross several boundaries. AOL Time Warner, for example, is partly an infrastructure company, since as an Internet service provider it operates a large telecommunications infrastructure that is part of the Net's physical backbone. But AOL is also a B2C company, since it aims most of its products and services at consumers and operates a consumer-oriented "portal" that serves as the virtual gateway to the Web for tens of millions of people. Yahoo!, meanwhile, is predominantly a B2C company, since the vast majority of its services are consumer-oriented. But it is increasingly targeting the business of helping other companies build and operate Web sites in exchange for a fee or a percentage of sales.

Despite the increasing blurriness of all the categories, you can tell a lot about the challenges and opportunities facing an Internet company by determining which category it falls under. An infrastructure company such as Cisco Systems, for example, has a smaller number of potential customers than a B2C powerhouse such as Amazon.com. As a result, Cisco has a lot less reason to invest in a massive, coast-to-coast advertising campaign to build its brand name than does Amazon. On the other hand, Amazon isn't actually building machines, nor does it have too much to fear from new technological innovations that could put it out of business; but this is a very real threat to Cisco. As a result, Cisco has more reason to invest in research and development than does Amazon. On the revenue side, Cisco's customers are buying a relatively small number of big-ticket items from the company, and those items can't be found in too many other places; Amazon's customers, on the other hand, are buying a relatively large number of small-ticket items from the company, and those are things they could probably find at many other stores. Thus the competitive situation of the two companies' respective markets and the resulting profit margins on the items they sell look different and must be analyzed differently. Those differences will become much more apparent in subsequent chapters.

Copyright © 2001 by Stephen E. Frank