A Wild Ride

Texas Internet stocks are on a roller coaster these days. They’re not for the faint of heart—and they may not be for the stout of heart, either

June 1999By Comments

Maybe we should call them “the ninety-niners”: the millions of people who, like the forty-niners of another era, are panning for riches, only this time by buying and selling Internet-related stocks. “There’s a mania going on,” says I. Craig Hester, the CEO of Hester Capital Management in Austin. “There’s a huge appetite in the investing public for companies associated with the Internet.”

That mania, a kind of gold-rush fever, has been one of the biggest business stories lately, raising the eyebrows of everyone from Doonesbury’s Garry Trudeau to Federal Reserve Board chairman Alan Greenspan, who has compared the spikes and dips of Internet stocks to a lottery. The Fed chief has also warned senior citizens to stay away from these stocks because of the risk, and he isn’t the only one counseling caution. “You need ice water in your veins,” says Art Bonnel, who manages the Bonnel Growth Fund for U.S. Global Investors in San Antonio.

It’s certainly true that some investors in a few of the hottest Internet stocks have doubled, tripled, or even quadrupled their money in an astonishingly short time—at least on paper—while others have taken a bath (or, if you prefer, a cold shower). Shares of two online companies, bookseller Amazon.com and auction house eBay, rocketed in value in the past year, giving them market valuations exceeding $20 billion. As recently as last October eBay was priced at just over $8 a share but within six months hit a high of $177, a 2,200 percent gain. But both companies have also seen one-day devaluations of as much as 30 percent. In a two-week period in January eBay climbed to more than $100 per share and then dropped to just over $50.

Several Internet-related companies in Texas have followed similar patterns, causing both elation and heartbreak for investors. Take Dallas’ Broadcast.com, which specializes in audio and video broadcasts over the Net. The company went public last July with an offer price of $18 a share. On the first day of trading the stock closed at $62.75. Then it dropped to about $16, shot up to $144, and sank to about $50 before climbing back up to $86 in March. Founder and president Mark Cuban, who has a 26 percent stake in the company, was at one time worth about $500 million on paper, but his stake’s value has varied as much as 900 percent in nine months.

Or take Perot Systems, an Internet and data-services company bankrolled by quirky Dallas billionaire H. Ross Perot. It went public on February 2, with an opening price of $16 a share. The stock closed on the first day at $43.50, a 272 percent gain. It then climbed to nearly $86 a share but fell back to $66 the next day and lost half its value the next week. Then there’s Internet America, another Dallas company that sells access to the Internet. The company—whose NASDAQ ticker symbol is GEEK—went public last December with an offer price of $13 a share, closing the first day at $14.88. The stock dipped to $11.50, then shot up at the end of 1998 to more than $60. It fell back to between $20 and $30 in February and then hit $31 in March.

Austin’s pcOrder.com, which helps businesses do electronic commerce, and Vignette Corporation, a Web software firm, both doubled their market value within a week of their initial public offering (IPO) last February: pcOrder swung from $38 to nearly $70, and Vignette went from $37 to $79. The following week both companies dropped about $20 a share. These wild swings in stock value are unprecedented, and so are several other aspects of this mania. For instance, the old rules of investing (looking at dividends and price-earnings ratios, examining such “fundamentals” of a company as earnings, management, and business strategy) seem to have gone out the window. Hardly any of the new Internet businesses—including Amazon.com and eBay—have made a dime in profit, which makes it difficult for investors to know how to separate the gold from the dross. It’s tough for the experts as well. “How do you value an electronic blip on a computer screen?” asks Bonnel. “It’s brainpower we’re trying to evaluate.”

The new strategy seems to have been set by the best-known new electronic commerce firms. What’s important right now to the e-commerce sector is not revenue but “branding,” or market recognition and leadership. By filling a particular market niche first, establishing a brand that consumers will know and search out on the Internet, and investing heavily in both technology and marketing, these companies expect their faith to be rewarded in the long run. America Online’s was: After losing money for a decade, it’s now the most widely known brand for Internet access—and it’s profitable. Another example is Amazon.com, which set the standard for selling books and is now expanding into CDs and other goods.

Here in Texas, in Austin, Andrew Busey, the 28-year-old founder of ichat (now known as Acuity), has started a new company called living.com, which hopes to dominate an as-yet-untested market on the Internet for home furniture. Busey told one of his investors that he expects to lose nearly $50 million in the next three years. Rather than showing him the door, according to the Wall Street Journal, the investor congratulated Busey for a strategy that imitates Amazon.com’s. He got several million dollars for his start-up, the majority of it from Benchmark Capital. That’s not surprising when you consider that the venture-capital firm’s less than $5 million investment in eBay back in 1997 is now worth more than $4 billion on paper.

Investment advisers are divided on the question of whether the Andrew Buseys of the world are too hot to handle. Brian Goffman, a principal in Austin Ventures, a venture-capital firm that has backed both living.com and Vignette, believes it would be inadvisable for new Internet companies to focus on profits in the short term when the competition for market share is so tough. “Not being profitable is not a liability when capital is so inexpensive to raise,” he says. “These are once-in-a-lifetime opportunities.” He concedes that a lot of these companies are unstable, but, he says, “that doesn’t mean you don’t invest. It means you just need to follow basic strategies of portfolio management and consider your ability to handle risk.” Others, however, are far less optimistic. “The valuation levels of these companies do not meet our criteria,” Hester says. “We’re not putting our clients’ money there. It’s expensive. Eventually there’ll be a shakeout, and there will be plenty of time to invest in the winners. People seem to have no fear these days. There’s nothing like seventeen years of a bull market to make you drop your guard.”

“If you have a chance to invest at an initial price in an IPO, you’re good,” says Bonnel. “But if you have to buy in secondary markets, it’s too dangerous. It’s very difficult to invest in Internet stocks.”

That’s especially true when the stock is volatile. Mark Stryker, the CEO of CyBerBroker, an online securities trading firm in Austin, maintains a list of seventeen to twenty companies—among them Broadcast.com and Internet America—whose share price is on enough of a roller coaster that they warrant a higher margin requirement. The Securities and Exchange Commission requires a margin of 25 percent to hold a stock, but in the riskiest of cases, CyBerBroker requires a 50 percent equity ownership, which makes buying and selling more expensive. Other brokerage firms are following suit. One thing the experts do agree on is that the nature of the Internet suggests that potential investors should pay careful attention to a company’s talent, such as management and technical expertise. But there’s a catch. “When you’re a private company,” Goffman says, “you have much more flexibility in valuing your company, and therefore more flexibility in pricing stock options. Once you go public, you lose this flexibility. Your stock options are priced for you.” This is a problem because stock options are a big part of compensation packages these days. If options are priced low in a company with a potentially high value, they are more attractive to talented people. But if a public company’s stock is overvalued in the market, it becomes harder to convince new hires that stock options are worthwhile. Vignette aggressively hired new people just before its IPO for precisely this reason, a source close to the company says. The apparent easy money available in the public securities market these days may tempt some companies to go public earlier than they might have five or ten years ago—possibly before they’re ready. “Many managers of these companies underestimate the value of venture capitalists,” says Doug Le Bon, the managing director of Pathway Capital Management, which is based in Irvine, California. “When they turn to the public securities market for financing, there’s a cost to their company. They often forgo the experience and management capabilities that can be offered by venture capitalists.” In addition some find the paperwork and management overhead of going public a serious distraction from their core business. After Iron Computer, an Austin company that developed a PC for harsh environments, went bankrupt in December, CEO John Opincar told the Austin Business Journal, “I spent two years focused on [our] IPO, so when it fell through, there wasn’t much room to go anywhere else.”

The big question for investors is whether the Internet frenzy is a speculative bubble that might burst at any time or whether it represents a fundamental realignment of commerce that will make many people rich. Some experts attribute the wild gyrations of stocks to the phenomenon of day trading, the activity of the estimated 5 million individual investors who are buying and selling stocks on the Internet itself. Others point out that the money volume of the activity in these stocks is too large to be attributed to individuals alone and that large institutions are equally to blame.

The most common piece of advice you hear is that all investors—not just those interested in Internet stocks—should forget about the prospect of short-term gains and hang on for the future. “Over the long term,” Stryker insists, “the stock price is going to reflect the basic health of the company.” “It’s very hard to make money day trading,” Bonnel says. “Probably ninety-five percent of people will lose money day trading. If you have high expectations, you’ll get low rewards.” “I can’t tell you where this ends,” Hester says, “but I doubt the market will appreciate fifteen percent per year, more like eight and a half percent to ten percent.” The Gold Rush of 1849 made a handful of people rich, but it stranded thousands of unlucky souls on worthless, rocky land. What will be the fate of the ninety-niners? Probably something similar: There will be a few big winners, and the rest of us will have to keep right on panning.

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