Lately, I have been getting two types of questions from friends who are not in the
investment
business. The first goes something like this: "Are you worried about a crash in
Internet stocks?"
implying that a precipitous fall is likely in the future. The second is: "Know of any
hot web stocks I
should buy?" with the implication that all a company has to do is add
".com" after its name to be a
sure winner.
While it is comforting that these polar opposites are not being posed by the same
individuals, they
do highlight how divided the investing public is on the question of the correct valuation
of high-tech
companies. So let's address some of the confusion about today's stock market.
Why are some analysts worried about the values of Internet stocks?
The first problem is that many long-term valuation standards are difficult to apply to web
stocks.
Two typical benchmarks of value are the price-earnings (P/E) and price-to-book-value
ratios.*
However, few Internet companies are currently profitable, so in most cases a
price-earnings ratio
cannot be calculated. Moreover, Internet companies use relatively little capital
equipment, and
whatever tangible assets that are needed (office space, computers) can be rented, so the
appropriate level of the price-to-book-value ratios is hard to determine.
The main difficulty in assessing an appropriate value for web stocks is that although we
know this
industry is growing rapidly and will continue to do so, precisely how rapidly is anyone's
guess.
Clearly, the huge gains in these stocks over the past year suggest that the average
investor feels the
prospects for continually large growth have improved. But whether the companies are worth
the
current values is difficult to assess. Any slight change in the growth projection of a
stock will
dramatically affect its price estimate. That is why web stocks have been so volatile over
the past
year.
What is the major risk of buying a web stock?
If in the near future an Internet company does not achieve the growth in revenues that
analysts
expect, those analysts will downgrade its long-term growth estimates, which will lead to a
severe
reduction in its stock price. The fall can be precipitous and quick. And the effect can be
spiraling, as
a severe stock price decline can make the public lose confidence in the company, which
will lead to
even more disappointing revenues in the future.
Could I eliminate risk by diversifying across many Internet stocks?
Diversification will certainly help, but it will not eliminate all of the risk. Much of
the price movement
of a stock is based not only on its own results, but also on the results of other web
companies. If
Yahoo announces revenues that are less than what was projected, analysts will assume that
Amazon
and other Internet firms will also likely fall short of their targets.
Does this volatility in Internet stocks affect the rest of the market?
Yes it does, directly and indirectly. Many companies not entirely focused on the Internet
have a
substantial portion of expected future revenues dependent on "e commerce".
Hence, a decline in
Internet stocks will affect that portion of their business as well. Moreover, many
analysts expect the
Internet to improve overall economic efficiency, so its growth is considered good news for
the
economy. That also means that disappointments in the growth of the web are shared by the
overall
stock market.
It is also important to consider that there are other aspects causing increased volatility
in the market.
Concerns about stability in emerging markets, worries about inflation and interest rates,
and fears of
a potential slowdown in economic growth are causing stock prices to rise and fall
dramatically.
Is this the first time we have seen market conditions like this?
No, in two respects. First, occasionally, sectors of the stock market have grown in value
and
become quite volatile. In the '60s manufacturing firms were hot (remember The Graduate's
"plastics,
Ben, plastics"). In the '70s we had oil stocks and then electronic stocks (the late
'70s version of
".com" was "tron", with the joke being that a firm could increase
value just by adding "tron" to its
name). In the '80s it was biotech stocks. Earlier in the '90s it was health-care-related
stocks. Some
of those rapid rises were justified (electronics) and some weren't (health-care).
Second, realize that this level of overall market volatility has certainly been
experienced before. In
fact, if anything, the 1995-1997 period was very remarkable because of its lack of
volatility, which
makes the movements of the past year appear to be more extreme than they actually were.
So, Scott, tell me what to do.
First of all, I don't suggest dumping all of your Internet stocks. However, this is not
the time to be
over-weighting your portfolio with web stocks either. Not because I think they will go
down, but
because they will be much riskier than the rest of the market. Broad diversification is
usually your
best strategy during a volatile market.
Second, you should stick with your long-term investment strategy. While I feel that the
stock market
will have above-average risk over the next year, in the long-term it will settle down. And
it will likely
settle into values that are higher than today's stock prices. The problem with pulling
money out of
the market during a potentially risky era is that you are never quite sure when to put it
back in. In
early 1994, fears of inflation and rising interest rates caused the market to become more
volatile,
leading some investors to exit the market. Many of them did not come back in. Since that
time, the
value of the average stock has nearly tripled. It is nearly always a mistake to alter
long-term policies
in reaction to short-term factors.
*The price/earnings ratio is the price of a share of stock divided by the current earnings
per share of the
company - a high ratio indicates investors believe earnings will grow, and vice-versa. The
price-to-book-value
ratio is the stock price divided by what the balance sheet (accountants) says the company
is worth - a low ratio
indicates that investors think the firm's assets have been overvalued in its financial
statements, and vice-versa.
 Lummer's
Logic Archives
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook. He
wants to know what's on your mind, so feel free to send him your questions about the stock
market! He'll answer as many as he can in his weekly column.
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