Attraction to Internet stocks love or smallpox?

Will Deener
Published: 15 September 2013 09:19 PM Updated: 15 September 2013 09:19 PM

Investors are in love with Internet stocks again, which is something I thought I would never see again following the dot-com collapse of more than a decade ago. Actually, investors aren’t lathered up about all Internet stocks, but rather just a handful that they’ve pushed into the stratosphere. But unlike the previous generation of Web-based companies — often run by tinfoil-hatwearing lunatics out of their garages — these are serious companies with workable business models and excellent prospects for growth. The problem is that their stock prices have advanced too far ahead of their projected earnings. In other words, their stock price-to-earnings ratios are ugly, meaning absurdly high. Let’s start with Yelp Inc., an online guide that helps people find the best places to eat, shop and play. Also, local folks offer reviews, so there’s a social component to this company. Yelp, which currently trades around $63 a share, is up 130 percent since early June and sports a p/e ratio of a head-spinning 269. To put that in perspective, the Standard & Poor’s 500 index carries a price-to-earnings ratio of about 15 and is up only 3.3 percent since June. Yelp, which went public at $15 a share in March 2012, has yet to show a profit, but its revenue is expected to grow an enticing 46 percent next year. Investors are attracted to the stock because that kind of revenue growth is hard to come by. “In this environment where large multinational corporations have difficulty growing revenue, this company is projecting substantial revenue growth,” said Mitch Zacks, senior portfolio manager of Zacks Investment Management.

A second web-based company that caught my eye was Zillow Inc., which you may be familiar with if you’ve ever searched the Web for housing or rental property. Zillow offers home price estimates, profiles and all kinds of other information to prospective homebuyers and renters. This stock is up 255 percent this year and 100 percent since June to about $96 a share, giving it a p/e ratio of 176. Zillow came public in July 2011 at $20 a share, and like Yelp it’s not profitable yet, but it’s enticing to investors because of strong revenue growth that eventually should give way to profits. Investors, speculators and hedge funds have piled into these stocks basically on the belief the companies will grow into their stock prices. That could happen, but historically buying high-priced stocks is a dangerous game. Even buying stocks with p/e levels in the 20 to 30 range is dicey, and chances of success diminish as the valuations move higher. “Generally, over long periods stocks with p/e levels above 60 make poor investments,” Zacks said. That is not to say those stocks won’t move higher in the short run of, say, three to six months, but over five years or longer chances of success are diminished. But the exorbitant p/e ratios notwithstanding, the issue that Zacks has with both of these companies is that competitors can easily intrude into these sectors. “Companies with high p/e multiples like this generally have two things in common,” he said. “They have strong growth in revenue, and secondly there are barriers to competition. But here there is nothing to prevent someone from duplicating what Zillow and Yelp are doing.” By the way, both of these stocks are heavily shorted, meaning a lot of investors expect their prices to drop. A third stock that also occupies what I would call this social media cult sector is LinkedIn Corp. Its 238 million members share their professional profiles and knowledge online. LinkedIn stock has advanced more than 50 percent since June to nearly $250 a share, giving it a p/e ratio of 113. This company went public in May 2011 at $45 a share. Unlike Yelp and Zillow, LinkedIn is highly profitable and has doubled its earnings from 2011 to 2012 and is well on its way to doubling them again this year.

It has more than $1 billion in annual revenue now, which is about 10 times greater than Yelp. Of the three stocks, LinkedIn probably stands the best chance of growing into its steroidal stock price, Zacks said. “Its network of more than 200 million people is really valuable,” Zacks said. “It grows exponentially because every member connects with many other people, and it would be almost impossible for a competitor to create a similar network.” Still, Zacks said he would avoid LinkedIn as a long-term investment. Observing how people have fallen in love with these stocks, I’m reminded of a famous Woody Allen line that goes something like this: I was nauseous and tingly all over; I was either in love or had smallpox. Investors in these companies perhaps just have smallpox.

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