Internet Stock Sell-off: A Long-term Buying Opportunity?

Apr 13 2014, 11:57am CDT | by

Disclosure: I own FB put contracts

Stock market sell-offs are usually the best time for long-term investors to invest in industries and companies with solid economic fundamentals. What’s the case with the recent sell-off in Internet stocks (NASDAQ:PNQI)?

I would be careful and very selective, as the industry is subject to two important limitations:

First, most Internet companies rely heavily on advertising as the primary source of their revenues. And there are not “enough dollars to go around,” according to Barron’s Jack Hough.

“Google, Facebook, Twitter, and a slew of other high-flying dot-coms are headed for a pie problem,” writes Hough in a recent piece. “Viewed individually, each seems to have endless potential to turn popular; free services into more revenue by grabbing a larger slice of the online advertising pie. But as a whole, online ad spending is growing at fairly predictable pace, and won’t be large enough anytime soon to justify all of the high-flying valuations on dot-com shares.”

“Over the long term, total spending has more to do with total wealth than with how people view or hear ads—a relationship academics call principle of relative consistency. Simply put, people only buy so much stuff, and companies only devote of their budgets to convincing people to buy.”

Second, Internet companies rely heavily on “network effects” as the primary source of their competitive advantage–the benefits associated with a larger and larger number of people joining the network. The larger the number of people using a product or service, the more valuable the product or service is to every user.

Network effects arise on the demand side of the market and allow companies to quickly reach a critical mass of consumers—the early majority—and cross the “tipping point.”

The problem here, however, is that as networks grow in size, the distribution of benefits across members may be unequal — according to an article Hana Halaburda and Felix Oberholzer published in the April issue of the Harvard Business Review. Some members may benefit a great deal while others very little or not at all.

Worse, the network may be fractionalized, divided up into groups that will only benefit only if the network moves in a certain direction.

This means that a larger network may not necessarily bring higher benefits to each network group. And that may provide an opening to upstarts to grab a piece of the market from early movers who have been building a network in an emerging industry.

That was the case with eBay and Taobao in China, as discussed in a previous piece.

Hype should never be a substitute for due diligence.

 
 
 

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