6 Rules for Investing in Internet Stocks and 8 Promising Picks

Ever since Al Gore (or whoever) invented the Internet, entrepreneurs and investors have been trying to find ways to profit from it. Few investment activities are more fun than picking Internet stocks -- fun, risky and, sometimes, fulfilling. In 2002, I invested in the stock of Netflix (symbol NFLX) shortly after the film-rental company's stock went public at $15. I loved its Big Idea: videos, ordered online, that you could keep as long as you wanted and return by mail, to be replaced by new titles. The business was deliciously simple; at the time, anyone could do the arithmetic and determine that if Netflix acquired three million subscribers, it would make decent money.

Quick Triple

In fact, the next year Netflix started to show a profit, and the stock shot up to $60. Well satisfied with a three-bagger (as Peter Lynch, the legendary former manager of Fidelity Magellan Fund, calls a tripling in share price), I sold all my stock. Shortly afterward, Netflix split two for one, and for the next five years I repeatedly patted myself on the back as worries about competitors and pricing pressure kept the shares from breaking out.

Then, in 2009, Netflix made some major breakthroughs. Customers began to forgo the mail for the joys of being able to download movies from Netflix via the Internet. Netflix even struck deals with Microsoft, Nintendo and Sony that brought videos directly to game consoles. Shares of Netflix, which now has more than 13 million subscribers, closed at $118 (the equivalent of $236 before the split) on August 6.

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An obvious lesson here (which I often preach but sometimes ignore): Don't trade, hold. Still, I have taken a certain paternal satisfaction in Netflix's success. Is it still a buy? I think so, although I worry about a business that requires large capital expenditures each year to maintain its infrastructure. Yet despite the sluggish economy -- or maybe because of it, with Americans cozying up at home rather than going to the movies -- Netflix has increased its profits dramatically for each of the past four years, and it will do the same again in 2010 and almost certainly in 2011. Analysts, on average, project annual earnings increases of 27% over the next three to five years, making Netflix's price-earnings ratio of 42 (based on estimated 2010 profits) defensible, if not rock-bottom.

Also, like many Internet firms, Netflix has a strong balance sheet. Last year the company took on $200 million in long-term debt (at 8.5% interest), its only loan on the books, to finance a stock buyback -- a display of confidence. And it holds $279 million in cash. Such conservatism is necessary because no one knows how the brave new world of on-demand video will shake out. Just as Blockbuster's store-based model ran aground, so could the Net-flix subscriber model. Already, you can order videos straight from the screen, on impulse, from your cable provider. Perhaps Netflix is not the exciting business it was in 2002, but with a market capitalization of $6.2 billion and an A rating from Value Line for financial strength, it's become a solid citizen.

Based on my experience with Netflix (and other, less pleasant ones) here are my rules for picking Internet stocks:

Invest in companies that strike you as having a brilliant business proposition. Worry less about the stock price. The Big Idea is the main thing, by far.

Look for innovators. Pay attention to companies, such as Netflix, that use advanced technology to operate their businesses, not merely to reach their customers.

Monitor the competition. It isn't hard to crack the Internet world. Netflix did not have to build thousands of stores to compete with Blockbuster, and Netflix's electronic competitors won't have to fashion a network of warehouses to speed DVDs by mail. So make sure the company you invest in has some kind of moat to keep out the invaders.

Check the balance sheet. Make sure that the company has enough cash to weather the inevitable storms.

Don't lose faith. Priceline.com (PCLN), the travel site, was nearly given up for dead in 2003 when, after three years of big deficits, the stock fell so low it had to undergo a one-for-six reverse split to escape penny-stock purgatory. Since those depths, the stock has appreciated 30-fold.

Diversify. A good rule of thumb is that three of your Internet picks will fail (that is, go to zero or close to it), but one may succeed spectacularly. One ten-bagger will do wonders for your overall results.

8 Ideas to Play by the Rules

Such a personal approach to stock picking eliminates mutual funds. Which is just as well. Look at Jacob Internet (JAMFX), founded in December 1999, on the brink of the high-tech collapse. The fund has a mere $37 million in assets, a ten-year annualized loss of 6.7%, and a whopping expense ratio of 3.64%. Its portfolio is led by Apple (AAPL), a company I love but one that is hard to consider an Internet firm, and Google (GOOG), which is favorably priced at 18 times estimated 2010 earnings. (Stocks in boldface, including Netflix, are ones I recommend.)

A more enticing choice is Internet HOLDRs (HHH), a kind of exchange-traded fund that has a more limited definition of Internet and a tiny portfolio led by Amazon.com (AMZN), the premier online retailer. Analysts estimate that Amazon's revenues will reach $33.2 billion this year, up threefold since 2006. But if you buy Internet HOLDRs, you had better like Amazon, which in early August accounted for 41% of the fund's assets. Next came eBay (EBAY), at 18% of assets, and Yahoo (YHOO), at 13%.

As for other Internet stocks, here's the most attractive Big Idea of the moment: A business called Blue Nile (NILE) markets diamonds on the Web. An imaginative site lets customers search for specific diamond rings and other jewelry using such measures as clarity, color and size, with prices from a few hundred to several hundred thousand dollars and overnight delivery by FedEx. The stock, at 46 times estimated 2010 earnings, is as pricey as the diamonds. But analysts expect profits to grow 20% annually over the next few years, and Blue Nile has less than $1 million in debt, a decent amount of cash and low capital-spending needs.

Looking at the earnings of companies such as Amazon, Apple, Google and Netflix, you would never know we had gone through a terrible recession and were in the midst of such a sluggish recovery. The potential bargains are the Internet stocks that are clearly suffering in this economic environment but should perk up if it improves. A good example is LoopNet (LOOP), which runs an online marketplace for commercial real estate. With $118 million in cash and no debt, the company has been profitable since its 2006 IPO, has a market cap of $470 million, and could soar as the real estate market rebounds.

A similar case is The Knot (KNOT), a site that targets couples as they become engaged, taking them through the wedding, setting up a home and parenthood. A major feature is a gift-registry platform. The Knot went public in 1999, survived the crucible of the high-tech crash and thrived, but it has been hurt by the economic slowdown. Still, it has no debt and holds cash equivalent to half its $260-million market cap.

There's also Geeknet (GKNT), which operates several Web sites (SourceForge.net, Freshmeat.net and others) that appeal to Internet hobbyists and professional programmers, with advertisements to suit. Founded in 1993, Geeknet has $28 million in cash and no debt, and it sports a market cap of just $81 million. The firm lost money in 2008 and 2009 and is expected to lose money again in 2010, but analysts project a 31% rise in revenues this year and an 18% gain next year. (Be aware that the stock is volatile and trades at little more than $1.)

Finally, consider Earthlink (ELNK), an Internet service provider whose core business is slowing but whose cash flow is strong. With a market capitalization of $960 million, EarthLink has $740 million in cash and $236 million in debt, and its stock yields a luscious 7.2%. (We think EarthLink has the resources to make an extra distribution to shareholders; see What's Special About Special Dividends?) EarthLink's leaders have the resources to shift into new businesses, and an investor in the company is acting on faith that it will do so successfully. Not a bad bet under the circumstances.

James K. Glassman's new investing book, Safety Net, will be published by Crown early next year. He hosts Ideas in Action, a weekly series on public television stations. He holds shares of Apple.