Maureen Burke

Signs of Life in the Internet Sector

Crash and burn, baby! Who will soon forget that memorable moment of self-immolation for the Nasdaq last Spring? The incineration throughout the trading day of April 4 was proof that for every action, there is an equal and opposite reaction - the Nasdaq shed over 500 points at the low point of the day, only three weeks after reaching an all-time high.

Although some of the better-positioned Net stocks have recovered, the sector remains a repository of charred hopes. Most Internet mutual funds and index funds are in negative territory for the year. Their performance relative to the broader market is no longer the subject of giddy chatter among stockholders, many of whom had never seen a decline in the value of their holdings.

Greg McFall, a Chicago-area investor, was tired of being a wallflower at the party. So in March, he bought a small stake in Pets.com (IPET) at about $8 per share. Now IPET is at less than $1 and falling.

"During the past two years, people were constantly talking about how they were making 200% returns," says McFall. "I figured I was missing the boat with my 7% Treasuries. That 7% sure looks good now."

McFall vows to avoid investing in other businesses whose plans call for selling commodity items below cost. Good idea.

With Net issues having a higher perch from which to fall, they have declined more than twice as much as the Nasdaq, while the S&P 500 has made modest gains. There is little difference in performance between Internet funds and Internet indexes. However, mutual funds expense ratios are about a percentage higher than index funds ratios, and some (see chart) have large sales charges. Adding those expenses reduces the performance figures for the mutual funds listed below.

* Front end sales charge aprox 0.5%

Sources: Morningstar.com, SmartMoney.com

Not all Net funds are created equal. Generally, the worst-performing entities are holding B2C e-commerce companies and content providers. The stronger funds have invested in infrastructure areas such as bandwidth capability, database management and storage, and transaction software.

What has caused the stomach-churning volatility in even the highest-quality funds? Eugene Lee, president of the Internet Index Fund (based on the Dow Jones Internet Index), sees an uncertainty over true value in the sector as a factor in the volatility.

"Over time, however, investors will reach a consensus over how to evaluate these new companies and volatility will diminish," says Lee.

Others blame those Internet IPOs. In 1998, there were 42 Net issues, most of them having very small floats and raising $1.96 billion total for the year. With lots of money chasing few shares, the prices soared. In 1999, 289 Internet IPOs raised $24.66 billion. That's a big chunk of change for the equity markets to digest. (Source: Hale and Dorr LLP)

Richard Dukas, senior vice-president at Amerindo Investment Advisors (ATCHX), saw the quality of issues decline as their numbers increased.

"They brought stuff public that never should have been funded," he says.

This concern over the IPO market as well as valuation levels caused Dukas to issue a warning on March 13 that there could be a large correction ahead. Good call.

There is a more discriminating marketplace for IPOs today. Eighty-three Net companies have withdrawn their IPOs so far this year. But there is still room for stellar performances from infrastructure companies, such as Blue Martini (BLUE), an interactive customer relations firm. It started trading at $20 per share on July 25 and now hovers around $60. (Source: Webmergers.com)

How can investors avoid getting burned again? Eli Neusner, senior analyst with MetaMarkets' OpenFund (OPENX), believes e-tailer stocks are finished.

"We see no secular recovery in this area," says Neusner, who looks for upward movement in the infrastructure area. "Bandwidth demand is very robust, as is the demand for silicon. We see no slowdown in the semiconductor area, particularly for communication chips," notes Neusner.

The consensus among fund managers is that certain segments of the Net sector will do very well moving forward, despite continued volatility through the fall. They predict a strong fourth quarter for the infrastructure, B2B e-commerce, and financial Internet sectors. Amerindo has already achieved a 93% return YTD with its new B2B e-commerce fund, which opened less than three months ago (not on chart because of its recent launch).

Over the next five years, Dukas believes Internet stocks will achieve valuations of three to four trillion dollars.

"The rocket has left the silo," says Dukas.

Its trajectory, however, remains unclear. So what to do? Value the opportunities presented by the phenomenal growth of the Internet sector. Understand the businesses in which you invest. And, as John D. Rockefeller said when asked how he amassed his fortune, "Buy low. Sell high." Good advice.