Those who have read and listened to my advice over many years know that I'm not a market-timer and don't predict which industry group is going to do best over the next year. But, I have warned sometimes about speculative bubbles, flawed strategies and gurus with poor predictive records. I have also pointed out some good values (e.g. value stocks in the late 1990s and real estate now in many parts of the country).

In the second edition of my best-selling book, Investing for Dummies (Wiley) published in 1999, I added a new entry to the section of the book dealing with times of speculative excess and bubbles. The new section was entitled "The Internet and technology bubble." I warned readers to avoid overpriced technology and Internet stocks, which was the opposite of what Jim Cramer was advising at the time. (For perspective on what happened to technology stock prices before, during and after this period, see the chart below for the technology-heavy NASDAQ index and how it soared in the late 1990s and then came crashing back down.)




The first section of that section I wrote in 1999 is reproduced below as it appeared in the second edition of this book, published in 1999, which turned out to be just one year before the tech bubble actually burst.


Unless you isolate yourself from what we call civilization, you've surely heard about the explosive growth in the Internet. In the mid-1990s, a number of Internet-based companies launched initial public offerings of stock. Most of the early Internet company stock offerings failed to really catch fire. By the late 1990s, however, some of these stocks began meteoric rises.

The bigger-name Internet stocks included companies such as Internet service provider America Online, bookseller and online retailer Amazon.com, Internet auctioneer eBay, and Internet portal Yahoo!. As with the leading new consumer product manufacturers of the 1920s, many of the leading Internet company stocks zoomed to the moon. Please note that the absolute stock price per share of the leading Internet companies in the late 1990s was meaningless. The P/E ratio is what mattered. Valuing the Internet stocks based upon earnings posed a challenge because many of these Internet companies were losing money or just beginning to make money. Some Wall Street analysts, therefore, valued Internet stocks based upon revenue and not profits.

Valuing a stock based upon revenue and not profits can be highly dangerous. Revenues don't necessarily translate into high profits or any profits at all.

In the case of Amazon.com, its stock price soared in early 1999 to $221 per share, which gave the company's stock a total market valuation in excess of $35 billion, or more than 12 times that of competing bookseller Barnes & Noble. B&N had prior year sales of nearly $3 billion compared with Amazon.com's approximate $400 million sales as it was losing money!

Now, Amazon.com and other current leading Internet companies may go on to become some of the great companies and stocks of future decades. However, consider this perspective from veteran money manager David Dreman. "The Internet stocks are getting hundredfold more attention from investors than, say, a Ford Motor in chat rooms online and elsewhere. People are fascinated with the Internet - many individual investors have accounts on margin. Back in the early 1900s, there were hundreds of auto manufacturers, and it was hard to know who the long-term survivors would be. The current leaders won't probably be long-term winners."

Internet stocks aren't the only stocks being swept to excessive prices relative to their earnings at the dawn of the new millennium. Various traditional retailers announced the opening of Internet sites to sell their goods, and within days, their stock prices doubled or tripled. Also, leading name-brand technology companies, such as Dell Computer, Cisco Systems, Lucent, and PeopleSoft, traded at P/E ratios in excess of 100. Investment brokerage firm Charles Schwab, which expanded to offer Internet services, saw its stock price balloon to push its P/E ratio over 100. As during the 1960s and 1920s, name-brand growth companies soared to high P/E valuations. For example, coffee purveyor Starbucks at times had a P/E near 100.

What I find troubling about investors piling into the leading, name-brand stocks, especially in Internet and technology-related fields, is that many of these investors don't even know what a price/earnings ratio is and why it's important. Before you invest in any individual stock, no matter how great a company you think it is, you need to understand the company's line of business, strategies, competitors, financial statements, and price/earnings ratio versus the competition, among many other issues. Selecting and monitoring good companies take lots of research, time, and discipline.

Also, remember that if a company taps into a product line or way of doing business that proves highly successful, that company's success invites lots of competition. So you need to understand the barriers to entry that a leading company has erected and how difficult or easy it is for competitors to join the fray. Also, be wary of analysts' predictions about earnings and stock prices. As more and more investment banking analysts initiated coverage of Internet companies and issued buy ratings on said stocks, investors bought more shares. Analysts, who are too optimistic (as shown in numerous independent studies), have a conflict of interest because the investment banks that they work for seek to cultivate the business (new stock and bond issues) of the companies that they purport to rate and analyze. The analysts who say, "buy, buy, buy all the current market leaders" are the same analysts who generate much new business for their investment banks and get the lucrative job offers and multimillion-dollar annual salaries.

Simply buying today's rising and analyst-recommended stocks often leads to future disappointment. If the company's growth slows or the profits don't materialize as expected, the underlying stock price can nose dive. This happened to investors who piled into the stock of computer disk drive maker Iomega back in early 1996. After a spectacular rise to more than $27 per share, the company fell on tough times. Iomega stock subsequently plunged to less than $3 per share. This stock probably won't recover to its early 1996 price levels for many more years.

Presstek, a company that uses computer technology for direct imaging systems, rose from less than $10 per share in mid-1994 to nearly $100 per share just two years later - another example of supposed can't-lose technology that crashed and burned. As was the case with Iomega, herds of novice investors jumped on the Presstek bandwagon simply because they believed that the stock price would keep rising. By 1999, less than three years after hitting nearly $100 per share, it plunged more than 90 percent to about $5 per share.

ATC Communications, which was similar to Iomega and glowingly recommended by the Motley Fool's, plunged by more than 80 percent in a matter of months before the Fools recommended selling.

 

Copyright Eric Tyson, 2008 - 2010 all rights reserved.

Eric Tyson is the only best-selling personal finance author who has an extensive background as an hourly-based financial advisor and who does not accept speaking fees, endorsement deals or fees of any type from companies in the financial services industry or product or service providers recommended in his articles, books and his publications.