Download Big Gains on Fund's Internet Plays? Eventually, He Says

By EDWARD SILVER

Feb. 17, 1998 12 AM PT

Times Staff Writer

Having seen shareholders reap colossal gains in many of the first Internet-related companies, intrepid investors are staking their claim in this Wall Street gold rush.

For example, Cisco Systems, the provider of much of the equipment for the Internet’s building boom, has climbed from a split-adjusted 37 cents at its 1990 initial public offering to a recent $65 a share. Yahoo, the leader among Internet search-engine companies, has quintupled in market value since late 1996, to about $65 a share now.

However, as in any emerging industry, new Internet firms are a volatile bunch. Shares rise and fall based on rapid shifts in the perception and reality of what’s working and what’s not. While the Internet has mushroomed, profits have eluded many Internet-related companies--and many investors. Caution is advised.

Lawrence York is one of the few money managers who focus specifically on this field. York launched his WWW Internet Fund in August 1996 with his partner, Jim Greene, with the belief that the Internet’s “real-time, any-time” storefront will transform the way we do business.

Certainly, use of the Internet has surged. According to research firm Dataquest, the global population of Internet users climbed 67% in 1997 to about 80 million. For 1998, the forecast is 125 million.

Not surprisingly, with all those keyboards tapping out commercial potential, businesses from all quarters of the U.S. economy want in.

Some provide the technology to develop the Internet; others sell products and services or carry advertising. Inevitably, ads have become a familiar--if not universally welcome--part of the landscape. Indeed, researcher Jupiter Communications reports that the dollar value of advertising on the World Wide Web more than tripled in 1997 to $940 million and is expected to double this year.

The Internet is now a focus of some of high tech’s premier wealth creators, like Microsoft and Intel. Yet the new medium has generated legions of companies whose marketplace is the Web and the Web only.

Business models for Internet ventures are uncertain, and for many companies, revenue is meager or nonexistent.

On the other hand, a mother lode is waiting for some, at least in terms of sales. Amazon.com, the Internet’s leading bookseller, has seen its sales zoom from $8.5 million in the fourth quarter of 1996 to $66 million last quarter. While Amazon.com still is unprofitable, its stock has rocketed to a recent $62 from $18 at its initial offering last May.

York’s job is to try to spot the Internet’s big winners. With $2.8 million in assets, the independent fund is tiny and, with its headquarters in Lexington, Ky., off the beaten path. But York, who has managed money in that location for 14 years, points out that technology has overridden geography. “It’s no longer a function of where you are,” he says, “it’s how you are connected.”

But although York pitches the WWW Internet Fund as a way to get in on the ground floor of a long-term opportunity, early investors have reason to be disappointed.

The fund returned a mere 0.4% in 1997, trailing the average tech fund’s 9.7% gain. The fund also lagged the 30% gain of its Internet-focused peer, Munder NetNet (phone: [800] 4-MUNDER; Internet: https://netnet.munder.com)

Analyst Christine Benz at mutual fund researcher Morningstar Inc. says the Munder fund succeeded in part by casting a wider net in its search for Internet plays. For instance, Munder lead manager Paul Cook made a large and successful bet on Charles Schwab, which has pushed into Internet brokerage.

Another difference that worked to Munder’s benefit: no fear of heights. York sold Microsoft and passed on Amazon.com, believing both to be overpriced, while Cook has ridden both up, up and away. Because the group is so volatile, York figures that in many cases he’ll get another chance to buy highfliers at lower prices down the road.

York’s emphasis on value and patience is almost contrarian in the high-tech world, and it sometimes means buying stocks that have been abandoned by Wall Street. Cases in point: Apple Computer and software developer Spyglass, whose markets have been eroded by powerful competitors, and whose stocks have suffered accordingly.

Speculating on turnarounds is a risky practice in itself, but York feels that the Internet presents opportunities that can turn last year’s losers into next year’s winners.

That is not to say that the fund avoids companies whose prices reflect their success. Cisco and PC kingpin Compaq fit into WWW Internet’s approach not only because they are centers of gravity on the Internet, but also because their stability balances the thrills and spills of the start-ups.

Times staff writer Edward Silver talked with York about his strategy for the fund.

Times: I can think of a few “big things” that fizzled out, from CB radio to 500-channel interactive television. How do we know that the Internet industry is real and will generate profits for investors over the long term?

York: With the Internet, you are looking at an enormously fast-growing mode of communication and distribution that encompasses garage-sized businesses all the way up to major corporations.

If you look at publicly traded Internet companies, just the start-ups that do business only on the Internet, they have created $40 billion in market value in the last three years. It far outstrips the personal computer industry’s growth in its first three years. One of the best aspects of it is that with PCs in maybe 35% to 40% of households and businesses, the Internet industry’s delivery system is already in place. The growth seems to be unstoppable.

Times: But this is still an emerging phenomenon.

York: Yes, it’s in the midst of being built. Like when Henry Ford started making cars, the roads were fairly nonexistent. They started paving roads and laying down asphalt--we are going through the same growing pains with the Internet.

You have got thousands of firms working worldwide to make the superhighway a reality. We have problems associated with congestion and speed, delivery of voice over data, security questions; we are trying to find the right model to pay for it all and develop secure electronic commerce. But you have everyone from IBM to Microsoft and Intel and Hewlett-Packard to new companies like CyberCash and CheckFree working hard to do this--it’s an incredible brain trust . . . .

The development of Internet technology will be an ongoing part of our lives. We think of the Internet is a paradigm shift. Ultimately, we believe it will be as prolific as the telephone.

Times: What are some of the issues that make Internet stocks so volatile and so risky?

York: We invest in many established companies that participate in the Internet, but the pure-play Internet companies are fraught with the most risk. In many cases they are single-product companies, they may or may not have revenues and usually no profitability. The risk is about people buying future concepts and future forecasts of profits. The environment changes quickly, and when it does or there are setbacks for these small companies--well, a stock like that can go up 100% or 200% on emotion and go down on emotion, or threats of competition, on weak results--just about anything. The question is: How do we control this risk?

Times: What’s the answer?

York: First, we diversify the portfolio among what we call mature, midlife and adolescent companies. In the mature group, their Internet business is part of their established overall business. Some of our holdings in that tier are Intel, Cisco Systems, American Express, First Data and Motorola. That’s usually our largest-weighted group. The midlife group are not as established but are well on their way. We own Ascend Communications, Apple, Qualcomm, Intuit, Harbinger Corp., among others. The adolescent tier are start-up-type, young hot companies, we hope. In that group we own CheckFree, Ticketmaster, Edify, Data Broadcasting Corp. and others. The adolescents are pure-play Internet companies, and, of course, they carry the most risk. Cisco is our largest holding at about 5% of the portfolio because of its market-share dominance.

Times: What are your main criteria for placing your bets? This is an area in which price-to-earnings ratios and other measurements aren’t all that relevant.

York: This is an inexact science; you have to do a lot of research. We aren’t overly focused on earnings. Flexible, proactive management is key. When you look at an adolescent company, you have to see if they know how to react to the changes in their industry.

In the long run, the things we look at are are they building market share and building their brand? You don’t have profits very often to evaluate companies, so we do a return-on-assets analysis--this company is generating X revenues versus X operating expenses. So we see who is getting the most bang for their bucks and who is making headway in their market niche.

Another characteristic of this medium is that many of these small companies are delivering services, information, software, and if they succeed in establishing their brand, there’s the promise of huge profitability in delivering those products via the Internet rather than dealing with the overhead of a bricks-and-mortar business.

Times: But some of the most successful brands on the Internet are absent from the fund, like Amazon.com and Yahoo.

York: You try to catch your best profit, but when the levels are ridiculous, you sell. You wait for it to fall back--because it will happen--and you buy it again as long as those elements are in place. We took profits in Yahoo, obviously too soon, but Yahoo should not be valued where it is, nor should Amazon.

Both are strong, well-managed companies with business models that are working, but we don’t own them due to valuation too fraught with peril. With a company like Amazon, one should ask: What are the barriers to entry? If Barnes & Noble had it together, they could wipe out Amazon. Amazon is succeeding in this because they have smarter management, at least Internet-smart.

Times: What’s the next wave in the Internet industry?

York: Electronic commerce is a principal theme for ’98. There will probably be 200% to 300% growth in products and services sold over the Web this year in comparison to last. MasterCard and Visa are developing payment standards, the big banks want to do commerce on the Web, so we see a convergence of efforts to work out security and delivery systems. The convenience of the Internet is going to make the consumer king. Entertainment, information, financial transactions in real time, any time! The consumer is literally going to have it their way!

Times: What are you invested in based on the e-commerce theme?

York: Apple Computer is one. We now see leadership that understands Apple’s strengths, which is the company’s abilities in graphic design combined with the e-commerce software package they inherited from their merger with Next. It’s a risk, but we bought it cheap, at 13, when [former CEO] Gil Amelio resigned. [Apple closed at $19.50 on Friday.]

Among Interent brokers we believe that E-Trade has brand awareness. The stock was cut in half at the end of the year due to fear of small stocks and fear of competition, but it’s got the elements we look for: good alliances, brand awareness, good management. Harbinger Corp. sells software that enables electronic payments between businesses. They just showed good quarterly results, and we expect that growth to continue. The long-term trend is away from paper in favor of electronic documents. We are also excited about Ticketmaster. It is using Web technology not only to deliver tickets to concerts and the like, but information for outings, all kinds of events. So if you’re a golfer, you find out tee times and book the reservation through Ticketmaster on the Web.

Times: What about the blue-chip types with e-commerce agendas? You own American Express.

York: American Express is building their financial-services business and tying it all together through the Internet. They have a mutual fund warehouse, they are buying financial planning and CPA firms and providing these services over the Web.

We [also] love Compaq for e-commerce. One of the exciting things is their merger with [server maker] Tandem, which has good market share in the financial community. And Compaq has survived the PC wars, so it is skilled at dealing with competition. Now that they are merging with Digital Equipment Corp., Compaq is penetrating further into the corporate user base.

Times: VeriSign, which develops technology to make Internet transactions more secure, just went public and, predictably, spiked into the $30s. What’s your take?

York: VeriSign is an important company, their “digital certificates” is one possible solution [to Internet security worries]. VeriSign has strong partners; they’ll definitely get some market share. But there’s lots of competition for this golden egg. There’s going to be a standards war. Hewlett-Packard, GTE, IBM, they all want a piece of it. We are going to do some homework and look at the company’s revenue potential, and keep watching.

Times: Why is this security issue generating such a buzz?

York: Look at it this way: What they’re trying to do is create an ATM-like environment--which is a private, secure network--in a public network, the Internet. Eventually transactions will be commonplace and there will be devices on your keyboard to swipe your credit card or smart card through. You’re going to be loading and unloading money from your Mac.

Times: The search engine companies have been stellar stocks of late. Aren’t they the biggest beneficiaries of electronic commerce as advertising platforms? But they’re trading at huge multiples to revenues, forget earnings.

York: There’s a valuation problem, so we are not invested in them right now. We are looking at Infoseek and Lycos. Lycos has more international exposure; Infoseek has valuable patents on search technology.

Times: What about the Internet service providers? The first wave, like Netcom and UUNet, defied gravity for a while.

York: There are 3,000 or more ISPs in the industry. There’s intense competition and consolidation. That group is interesting because they have a direct link to the consumer. The consumer is going to want to do business on the Internet; the question is, who ends up with them? The ISPs need to become a storefront for the consumer like America Online has with all its content, and many don’t understand that yet.

Times: Does Sprint’s recent investment in [ISP] Earthlink Network play into this?

York: It’s confirmation of the future value of ISPs. The deal gives Earthlink better connectivity, not only by wire but in the wireless world, and Sprint gets access to Earthlink’s customers. I think the connectivity companies will be looking for content. Earthlink is developing content; they have an alliance with Time Warner. I think there will be more of these alliances and mergers.

Times: Is content king on the Internet?

York: Yes, long-term, content is a great play. We owned and may again own Time Warner. It’s early for that now, but the play is that they are an incredible storehouse of information and entertainment, which will be very valuable when the Web enables the widespread use of all that content. In the adolescent group, we own a Canadian company called Alliance Communications, which is a cable TV producer with high-tech animated characters, almost Disney characters of sorts. Their programs broadcast in Europe now, but we think they have a lot of potential for the Internet.

Times: Qualcomm is a wireless communications company you own that has been hurt by South Korea.

York: We aren’t terribly anxious about Qualcomm. It’s selling all around the world, in Russia and Africa, in countries that don’t have infrastructure and aren’t going to lay cable. We might add to our position.

Times: Would you say that this fund and investing in the Internet in general is appropriate only for the more risk-oriented portion of one’s portfolio?

York: Well, the Internet should be part of your retirement plan, because it’s the future. It’s volatile, but it’s not going to go away. In terms of risk, we think it is the companies that don’t have any Internet strategy that have the most risk! If your industry is in the midst of a transformation and you don’t take it seriously, what is going to happen to your market share? What’s going to happen to your earnings?

Coming Wednesday: The Internet is helping small businesses become bigger players in international commerce. Small Business

Times staff writer Edward Silver can be reached at emsilver@msn.com

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WWW Internet Fund

Strategy: Seeks long-term appreciation by investing in companies that are building and developing the Internet.

VITAL STATISTICS

Year-to-date total return, as of Feb. 12: +11.49%

Avg. return, Lipper Analytical’s science and technology fund group: +10.47

1997 return: +0.43

Avg. 1997 return, Lipper Analytical’s science and technology fund group: +9.66

Five biggest holdings as of Feb. 12:

1. Cisco Systems