By Rob Walker

Perhaps you saw the chart in a recent New Yorker showing the phenomenal 5-year price appreciation of AOL in the 90s and the equally phenomenal 5-year price appreciation of RCA in the 20s. It also showed the next 5 years of RCA, which looks a lot like Niagara Falls. The next 5 for AOL are yet to come, but a worrisome wobble is already very visible on the chart.

Of course, nothing ever bothers the "new paradigm" folks. This time things really are different. They talk incessantly about the swiftness of this technology age. They say that the internet is the biggest thing to have ever been invented and it is now the nerve center of the globe. It will be the single biggest growth area in the U.S. economy for years to come and will change our lives in ways still unimaginable. They argue that AOL and RCA are in completely different eras with completely different products. Also, we are reminded that radio took 38 years to reach 50 million U.S. users – internet reached 50 million in less than 5 years. In short, you better buy on this dip. You’ll never see these prices again.

Perhaps it is different this time. Anything is possible. But remember what was said about radio. Robert Sobel wrote in his 1986 The History of RCA, "No other new product in the nation’s history – not railroads, automobiles, motion pictures, or personal computers – has ever experienced the kind of demand there was for radio receivers and broadcasting in 1922-23, a phenomenon that established RCA as the most glamorous and fastest growing corporation of the decade." Sound familiar?

Yes, AOL has done an extraordinary job. Supposedly, 39% of Americans’ time on line is spent using services the company controls – ten times the share of its nearest competitor, Microsoft. AOL expects to hi $5 billion in sales this year, more than the next 20 internet companies combined. Its market value is still bigger than any other media company in the world. It has 17 million subscribers and wants to double that over the next 5 years. To increase advertising revenues, the company is developing new services to lure users to stay on line for at least three hours a day (current average is 55 minutes). We are all going to become squinty-eyed, unshaven, smelly, blabbering idiots … but, boy, will we ever know a lot! But let’s not forget how all this started. When the teenagers on AOL were asked why they signed with AOL, 70% replied because their friends were there. We Americans do like to chat.

Clearly, AOL isn’t the only reason for a huge increase in the wealth effect. Other stories are equally dramatic. For example, Dell turns over its inventory 60 times a year (the stuff gets old fast). Since they take your money before they buy anything, the company has become very adept at rapid growth with negative working capital. Priceline.com discovered price is not embedded in the product. The list goes on.

So, are the internet stocks toast? Will AOL continue to dutifully follow the precipitous drop of RCA? Or is this the last decent opportunity to own ‘em? The scary part is that they’re still too expensive. This brings up the old joke of some 25 years ago … whenever you were tempted to buy a utility stock, there was a telephone number you could call that would talk you out of it.

The real problem has been succinctly put by Christo Cotsakos, the CEO of E*TRADE. "You have to watch your traditional competitors," he said, "but the one thing you fear the most is the two kids in a garage." As Jim Kimsey of AOL suggests, there used to be maybe 2,000 of these kids. Now there are probably 200,000 all dedicated to eating your lunch with something better, simpler, and cheaper. If you haven’t already done so, read Clayton Christensen’s book, The Innovators Dilemma, with its subtitle, When New Technologies Cause Great Firms to Fail. As Clayton explains, you tend to ignore disruptive technologies most particularly when your company is making record profits and is considered to be the best managed company in the universe. Of course, then it’s too late.

Needless to say, there are many examples. The networks ignored cable too long. Now CNBC makes $200 million a year, give or take, and NBC probably makes nothing. Sears, at its peak, paid no attention to discounters who worked for smaller margins but had four times the turnover. Wal-Mart and K-Mart were "disruptive technologies." The big steel companies gladly kept giving up their lower profit margin products such as rods to the mini-mills. At the same time the mini-mills were upgrading the scrap steel they used and thus could compete on a higher and higher level before the big guys fully realized what was happening. Remember when Digital Equipment was the top dog of the computer world? The best products, the best management, the most profitable. They just couldn’t be bothered with what they saw in their rear view mirror and had their socks blown off. Control Data was an extremely good company before it, too, slipped into the unknown.

Business schools have a real problem. How do you teach future managers that when things are going great guns, forget everything you learned in business school and look for those two kids in a garage. Your marketing people will scream and tell you that your customers don’t want that stuff and to stick with your proven high profit margin products. Your shareholders will continue to demand increasing stock value. Naturally, if you bring these two kids into the company, their production will be so small they’ll be smothered. They have to be separate so any small success becomes relatively important to their operation. And, of course, you have to pick the right two kids. Apparently some large companies, such as Microsoft, seem to be using the Bubba approach – grab as many players as possible and dispense with each until you find the guy with the ball.

So here we are at one of those many inflection points in our investment management lives. No doubt this technology thing has plenty of legs left and clearly these stocks are considerably less expensive than they were. Still, there are now way too many of them and the shakeout is yet to come. The more familiar companies are not exactly Graham and Dodd qualifiers, and no one knows how many of these will survive. It looks more and more like the best place to be is in the more mundane companies on the low P/E side of the fence. A relatively strong dividend (remember those?) should once again return to be part of security analysis. This cash up front should also provide some level of preservation in case there are some further market adjustments. Perhaps no one really knows where the so-called mean should be, but there can’t be much argument that the reversion to it has begun in earnest.

John F. Hotchkis