Horse Race

Do Internet ETFs justify their recent run-up?

Horse Race

Internet ETFs somewhat deserve their recent run-up, but we would be cautious. There are plenty of signs of a fundamental shift in the economy due to the Internet. There are many companies coming up with novel, interesting solutions to everyday problems using the Net, and these solutions are just starting to produce revenues. These revenues, if continued, should create good earnings. But to create more profits, the companies have to build up scale.

There is real value being created for people and businesses using the Internet -- no going back to the days before the Internet. Even more rapid changes are ahead, as the Internet will find more uses and become more important in all phases of commerce. The Internet will grow from the entertainment it offers and by using e-commerce in old ways. It allows the average person to do things differently and more efficiently. The Internet has barely begun to scratch the surface of potential uses. Advances could be dramatic, with unforeseen consumer conveniences flooding the market.

Buying and selling goods and services are now possible to everyone globally. Prices are competitive on a worldwide basis, and there are little or no transaction costs. This is new. A perfect market such as this appeared only as an economist's dream or a textbook example of how a market should work. This perfect market is due in part to the Internet. Other facets of the Internet are not diminished. People can still go into a chat room to discuss any number of things: politics, movies, stocks. This is a fun, informative, and perhaps even profitable. E-mail has become a necessary mode of communication; finding out weather forecasts in the areas in which a person is about to travel is important information to have; mapping out a trip at the click of a mouse is a marvel of convenience. But the driving force of the Internet evolution is commerce, and in the maturing Internet world, the way people and businesses interact for profit is growing and showing up on income statements.

A new type of economy

The markets are favoring technology stocks, which are selling at high valuations. After a three-year market correction, which we believe finished not that long ago, the market seems to be picking up where it left off: chasing technology stocks that have little or no earnings. Many think that the risks are too high to buy tech stocks. Traditional valuation yardsticks such as price earnings ratios (P/E) have very high multiples. But traditional yardsticks are not the only way to value stocks, especially those in the tech sector. Price/earnings growth rate (PEG) ratio and sales/price (S/P) might be much better yardsticks to use when valuing tech and Internet stocks.

As far as the general economy is concerned, Michael Murphy, Editor of "Technology Investing" newsletter, says that "we have been in what I call a "transcession" - a transition to a new economy that feels like a recession in the old economy - for several years." Murphy says that advances from economic slowdowns are always led by the newer, more modern economic sectors. In this case, technology. Murphy points to the study done by Ned Davis Research that calculated that in the last six bull markets from 1980 through 2000 technology was the top performer in five of them, and the second best in the sixth. In the upward market since the September 11, 2001 bottom and the October 22, 2002 bottom, the technology sector once again outperformed.

Perhaps the greatest sign that investors overreacted by selling down Internet stocks over the last three years is a report by Pegasus Research International showing that over 41 percent of the remaining 209 publicly traded Internet companies were profitable in the fourth quarter; this compares with 17 percent a year earlier. Many companies were not survivors, but the ones left have a shot at doing very well.

Broadband is growing toward fulfilling its promise, and Internet advertising, which had burned so many people by not expanding as it was expected, is coming back. Advertising has had a two-year cooling-off period, and this time investors have lowered expectations to more realistic levels. Consumer usage, frequency of usage, and time spent on line continue to grow and evolve. Also, E-commerce spending is climbing steeply. Thus, Internet usage now is more realistic and need-based rather than novelty and entertainment-based. The fluff of the past is gone and what remains is hard-core Internet usage.

At the end of 1999, the percentage of people using broadband as a connection to the Internet was about six percent. At the end of 2000 that number had swelled to about ten percent. At the end of 2001 the number was 17 percent. Then the numbers escalated sharply: from 2001 to 2002 the number using broadband was 26 percent; in the first five months of 2003 users werup another eight points, to about 34 percent. So today more than a third of Internet users are on broadband rather than a dial-up slower connection. Not only have upgrades occurred, but the pace of shift has accelerated, especially recently. This shift should increase the number of Internet users, since using broadband makes the Internet experience much more pleasant. Whether one is shopping, looking up the weather, mapping out a trip or checking out the latest news, a quicker, fuller response makes people want to return and use the Internet more. Broadband should be considered part of an Internet play.

Internet ETF's for consideration

The Morgan Stanley Internet Index Fund ETF (AMEX: MII) is comprised of about 23 stocks. The top ten holdings, which follow, represent about 47 percent of its holdings.


Company Symbol EPS (trailing 12 mos.) EPS (trailing 12 mos.)
Freemarkets, Inc. FMKT -0.30 0.00
AOL Time Warner AOL -9.92 0.44
DoubleClick DCLK -0.82 0.12
VeriSign VRSN -21.02 0.58
EMC Corp. EMC 0.00 0.15
Intuit INTU 1.08 1.36
Oracle ORCL 0.43 0.47
Juniper Networks JNPR -0.19 0.08
Charles Schwab SCH 0.05 0.29
Monster Worldwide MNST -132.00 0.37



Source: Yahoo!

Another ETF dedicated to this group is the Internet HOLDRS (AMEX: HHH). The following table lists its top eight holdings, which comprise about 97 percent of the ETF:


Company Symbol EPS (trailing 12 mos.) EPS (projected)
Ebay EBAY 1.00 1.46
Yahoo! YHOO 0.24 0.35
Time Warner AOL AOL -9.92 0.44 AMZN -0.37 0.48
Network Assoc. NET 0.45 0.59
E-Trade Group ET 0.31 0.49
Ameritrade Holdings AMTD -0.11 0.25
Realnetworks RNWK -0.27 -0.05



Source: Yahoo!

As for broadband, there is the ETF Broadband HOLDR's (AMEX:BDH). Following are the top seven holdings, which comprise about 82 percent of BDH.


Company Symbol EPS (trailing 12 mos.) EPS (projected)
Qualcom QCOM 0.63 1.40
Motorola MOT -0.82 0.20
Nortel Networks NT -0.70 0.04
Corning Incorporated GLW -1.92 0.03
Lucent Technologies LU -3.44 -0.32
JDS Uniphase JDSU -1.37 -0.18
Scientific-Atlanta SFA 0.24 0.70



Source: Yahoo!

The Internet Age is just starting. Yes, we had a meltdown, but the fundamentals are still in place. The Internet is not going away; it is still in the early innings. The Net in its new, more mature and probably more profitable stage continues to evolve. As more companies prosper, the industry adjusts to new realities, and more survivors show that the Net companies can be profitable as well as helpful, investors will be quick to rediscover Internet stocks as timely investments.