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Attraction to Internet stockslove or smallpox?Will Deener

wwrdeener@aol.com

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 arent lathered up about all Internet stocks, but rather

just a handful that theyve pushed into the stratosphere. But unlike theprevious generation of Web-based companies often run by tinfoil-hat-

wearing 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.

Lets 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 theres asocial 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 & Poors 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.

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A second web-based company that caught my eye was Zillow Inc., which

you may be familiar with if youve 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 its not profitable yet, but its 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 wont 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 professionalprofiles 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.

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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 otherpeople, 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, Im 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.