(By Mani) The past two years have been good years for stock-pickers within the Internet space. There have been a number of transformative events, including several IPOs, spin-outs, and acquisitions across the space, and many of these new and emerging opportunities have made investing in the right stock in the Internet sector a challenging task. The biggest mistake investors can make, and have made over the past two years, is paying a high multiple for a business that doesn't necessarily deserve the premium. This has been the case with many of the recent IPOs in the space, which are in new business areas that offer significant potential growth, but are a little less predictable and understood by investors.
The classic example is the much-anticipated IPO of social networking giant Facebook Inc. (NASDAQ: FB), which is considered one of the biggest technology IPO failures. Facebook's IPO was marred by series of problems, including a technical snag at Nasdaq that led to tens of millions of dollars in trades being wrongly placed.
Then, reports emerged that the underwriters -- Morgan Stanley (NYSE: MS), JP Morgan (NYSE: JPM), and Goldman Sachs (NYSE: GS) – cut their earnings forecasts for the company in the middle of the IPO roadshow. In addition, allegations propped up that some Facebook executives revealed the company's earnings to industry insiders before it went public.
Ultimately, Facebook, Morgan Stanley, and Nasdaq are facing litigation over these matters. The stock lost over a quarter of its value in less than a month and went on to trade at less than half its IPO value in three months.
"Facebook's IPO was priced at 30x forward EBITDA, Groupon's at 25x, Demand Media at 25x, Velti at 15x and Millennial Media at 20x. All very high growth potential businesses, but generally (and yes, in hindsight) a poor investment choice at these valuation ranges," Deutsche Bank (NYSE: DB) analyst Ross Sandler wrote in a note to clients.
But, here is a catch. Some of these companies will likely prove to be very smart investments at current depressed valuation levels that are more in line with the peer universe, especially considering the growth opportunities in their respective end markets. But there is no need to greatly overpay for these names relative to similar companies in the same end markets.
"Looking at all the volatility, one very clear thesis emerges (at least in our view): one of the best ways to generate alpha in this group is generally at the lower end of the valuation spectrum vs. the higher multiple-end," Sandler wrote.
Some opportunities do exist at the momentum driven higher-end of the valuation range for the group, but investors need to be very careful in finding the right companies with the right near-term sentiment, and the right entry points for those opportunities to play out.
"Investing at the low end can sometimes lead to portfolio under-performance for extended time periods. Take AOL from 2010-2012 as an example. Ultimately, we have found that even in names that are perceived as value-traps, investors who waited for fundamentals to turn around or for a value-creating transaction have been rewarded handsomely," the analyst noted.
The multi-year turn-around of eBay Inc. (NASDAQ: EBAY) and Expedia Inc. (NASDAQ: EXPE) are good example of the above thesis.
Most of the under-performance in the high-multiple bucket is a result of under-performing new higher multiple IPOs in the space. In other words, don't overpay for hype.
"Buying a high multiple Internet name that has something unique about their business model and has a long track record of generating above-average returns can be a very smart investment strategy," Sandler said.
Amazon.com Inc. (NASDAQ: AMZN) is a good example of this phenomenon, the company has the best management team globally in e-commerce and has over a 15-year proven track record of generating well-above average returns in just about any economic environment. In the case of Amazon, the higher multiple justifies its strong fundamentals.
TripAdvisor Inc. (NASDAQ: TRIP) or HomeAway Inc. (NASDAQ: AWAY) are two other examples of companies that have a dominant and sustainable position in their respective markets, and are expanding their revenue into many new areas that should generate strong returns long term for investors.
"Hence ,while the current multiples are above the online advertising peer average, in some cases, this may be warranted," the analyst wrote.
However, the entry point is critical in these situations, as these names tend to carry a lot of momentum risk. Also, getting into a high-multiple name at the wrong time can be a low-return strategy for investors, even in the best companies in the space.
So, the ultimate question is what should investors do?
A mix of low-multiple Internet stories that have decent fundamentals, or have opportunities to improve their business further, are core holdings in any Internet portfolio.
"We advocate owning a few select high-multiple names that have opportunity for upside estimate revisions in front of them. This barbell strategy has been a winning strategy over the past decade in the space," Sandler said.
Based on the barbell strategy, Sandler recommends Google Inc. (NASDAQ: GOOG), Priceline.com (NASDAQ: PCLN) and Amazon on the large cap side. In the lower multiple bucket, he prefers Expedia, AOL Inc. (NYSE: AOL), IAC/InterActive Corp. (NASDAQ: IACI), Liquidity Services Inc. (NASDAQ: LQDT) and Web.com Group Inc. (NASDAQ: WWWW).
Meanwhile, Blue Nile (NASDAQ: NILE) and HomeAway are higher multiple growth names that screen more favorably on free cash flow yield.