How To Avoid The Next Dot-Com Bubble

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors who can still recall the dot-com bubble should be mindful of today's Internet stocks. Is history really repeating itself? In my view, the market is set up for a major correction that will send under-appreciated stocks flying just as surely as it will send hyped ones plummeting. Below, I frame this viewpoint through providing 3 examples.

Zynga (NASDAQ: ZNGA), Facebook (NASDAQ: FB) Still Overvalued

In my view, the best businesses to invest in are those with recognizable operations and not ones that merely make you smile or feel "fuzzy" in size. Unfortunately, a series of tech IPOs ranging from Groupon to Zynga to Facebook have all been able to command large multiples due to their branding as "social media" stocks. While they may seem innovative, their foundation is totally ephemeral.

In Facebook's case, everything depends on a website and a virtual farm. In Zynga's case (the virtual farm), everything depends on strong listing on Facebook. And in Groupon's case, it's a website again. While you can argue that the same was true for Google, ultimately Google was able to offer the market something that was (1) previously unrecognizable and (2) unlikely to be out-innovated. Already, plenty of alternatives have emerged for Zynga and Facebook. Google+ is integrated on Android, YouTube, and even Google search results among others. That's a tough uphill battle for Facebook to manage. Media consumers are unpredictable and just like they abandoned the seemingly unstoppable AOL Instant Messenger a few years ago, they are likely to do the same for Facebook.

Zynga may have a future in the smartphone business, but it faces intense competition from more established game makers. In my view, the company will become the MySpace of social media gaming and become eventually bought out by a more established producer. And after Google's weak third quarter earnings report, momentum is working against more speculative Internet investments.

Rumors have it that CEO Mark Pincus gave a pep talk about third quarter earnings meeting expectations (not unexpected given how hyped up the sector has been). He reportedly spoke about focusing on mobile - yet another way to attract investors hungry for the "next big thing." At the same time, his management has led to key executives departing the social media game producer.

Dell (NASDAQ: DELL): A Surprising "Buy"

In light of all the hype surrounding Facebook and Zynga, it is necessary to give a reality check. While many say that Dell is a value trap, the tech producer is actually very safe and a consistent free cash flow grower. At only 5.8x past earnings despite 10.6% annual earnings growth over the past 5 years, Dell is well positioned for upside. Analysts only expect 3.3% growth over the next 5 years, which is much too low and sets the stage for outperformance. Complemented with a 3.3% dividend yield and a $13.82 price target, reward far outweighs risk.

Moreover, the company is making the appropriate investments in the future. It recently decided to launch a product that targets the pre-packaged data center system market. Takeover activity has also diversified away from PCs, which many feel faces secular risks from rising tablet and mobile demand. Expansion into enterprise computing should further help expand margins through penetrating a less competitive market. It should also be noted that a former executive of buyout house KKR recently joined the firm, which signals greater interest in inorganic growth and corporate restructuring.

With many bears arguing that there's nothing but a bleak future ahead, it's helpful to remember that much of this has already been factored into the stock price. The firm's historical 5-year average PE multiple of 12.8x (already low) is well above the current PE multiple. Ultimately, I find the negativity highly unwarranted as free cash flow has grown from $3.1 billion for the TTM ending April 30, 2010 to $4.3 billion two years later - a staggering 25%+ yield against the market cap!

Interested in Additional Analysis?

Zynga's post-IPO performance has been dreadful, and investors are beginning to wonder if it's game-over for this newly public company. Being so closely related to the world's largest social network can be a blessing and a curse at the same time. You can learn everything you need to know about this company and whether they're a buy or a sell in The Motley Fool’s new premium research report. Don't even think about picking up shares before you read what the Fool’s top tech analyst has to say about Zynga. Click here to access your copy.  


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Dell and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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