The battle pitting institutional portfolio managers against individual investors and day traders for big investment gains in Internet stocks is changing the way some money managers do business.
These new investors -- many using E*TRADE, Ameritrade and other Internet-based trading systems -- in aggregate represent a formidable market force. They help push Interned stocks to new, sometimes ridiculous, heights, portfolio managers say.
As a result, institutional and mutual fund growth stock managers must cope with stock valuation techniques they never learned in college or on Wall Street.
Still, the professionals can come out winners, especially in oversubscribed Internet-related initial public offerings.
IPO shares are apportioned at their original offering prices to brokerage firms' best customers, frequently institutional investors, said Brad Lawson, a senior research analyst at Frank Russell Co., Tacoma, Wash. When individual investors bid the IPO shares up, institutional investors can reap the benefits by selling at the higher price, and a money manager can boost overall performance.
One recent IPO was MarketWatch.com Inc., an online financial news publication that had an original offering price of $17 a share in January. The stock price hit a high of $129 Jan. 15, before falling back to about $62 March 4.
Internet mania is helping some portfolio managers look good against their performance benchmarks. Many of the Internet stocks with skyrocketing performance that the pros are buying aren't yet in the Russell 2500 or similar indexes with which many small-cap money managers are compared.
Median-performing small-cap managers are outperforming the small-cap growth index by more than 900 basis points. For the year ended Dec. 31, the median small growth manager in the Trust Universe Comparison Service returned 6.77%; the Wilshire Small Growth index returned -2.47%.
For the year ended Feb. 28, the median small-cap growth mutual fund outperformed the Wilshire index by more than 1,000 basis points -- -9.21% for the small-cap growth mutual funds vs. -19.67% for the Wilshire index, according to Morningstar Inc., Chicago.
Shaking with volatility
Volatility caused by Internet stock mania -- along with the Russian bond default, the Long-Term Capital Management hedge fund fiasco and problems in Brazil -- are shaking the stock market. Mr. Lawson wouldn't cite specific Russell numbers, but he did say that in 1998 the stock market volatility level was the highest it had been since the market crash year of 1987.
Market volatility, he said, is good for savvy investors. A manager can't make a lot of money if a stock price varies by only a dollar or two.
Prices for some Internet stocks are zigging and zagging. The stock price for eBay Inc., the Internet-based flea market, had a composite trading range of 827/64 to 1311/8 between September and March 4, when it hit the high number for the period.
A new challenge
But institutional investors also face a challenge from day traders and the new individual investors, said Drew Cupps, portfolio manager for the Enterprise Fund, an aggressive all-cap growth fund run by Strong Capital Management Inc., Menomonee Falls, Wis.
"Institutional investors are used to being the most wired in and the quickest on the trigger -- at least the aggressive ones," Mr. Cupps said.
Typically, he said, money managers have "the jump" on individual investors because they have better access to information -- they've been to trade shows or briefed by a Wall Street analyst.
But now money managers face a new phenomenon. The "average Joe" small investor understands the Internet. "This is a little bit different. This is unique," Mr. Cupps said.
Individual investors are thus poised to make money because they know what's hot. Consequently, money managers don't have the information edge they've become accustomed to.
Through the Internet, individual investors and day traders can see earnings reports "just about as quickly as you would on Bloomberg," said Russell Kinnel, a senior analyst and equity fund editor with Morningstar.
"It has been an uncomfortable time (for institutional investors), at least over the last three or four months particularly," Mr. Cupps said about the mania for Internet stocks.
One problem for mutual fund portfolio managers is that they will buy thousands of shares of an Internet-based stock about which they are optimistic. But inexperienced new investors having a "tough psychology day" will for no real reason knock down a company's share price. The result is that a mutual fund owning stock in that company is marked to market at the end of the day, making the portfolio manager look like less of a genius on those days, Mr. Cupps said.
Another problem, he said, is that with a big portfolio it is sometimes difficult to get enough shares in an IPO to make a difference in the portfolio's overall performance. Sometimes a manager can get 10,000 shares, he said, but he is usually lucky to get more than a few thousand.
'Goofy math'
Money managers have to invest in more established Internet stocks, which can individually or separately represent a major part of their benchmark. But managers often wonder about the basis on which the individual investors are making their decisions about investing in new Internet stocks that are trading at stratospheric price levels.
Sometimes "goofy math" has been used to bid up the prices on Internet stocks, Mr. Kinnel said. Many portfolio managers don't want to adopt such math and prefer more conventional valuation methods like earnings growth.
But the managers are in a predicament.
"Every growth manager has to have an opinion on what is going on" regarding the Internet, Mr. Kinnel said.
Just last year, American Online Inc. represented a significant percentage of the S&P 400 index, between 7% and 9%. The index is frequently used as a benchmark for midcap stocks.
As a huge driver of investment performance returns, Mr. Kinnel said, "getting that one stock right or wrong is vital to how you looked against your (performance) bogey." Managers who don't think fast get left behind.
Changes on the Internet are "happening with such lightning speed it is causing (some managers) to pay more attention to that valuation metric that they might have dismissed earlier," said Mark Baribeau, a portfolio manager with Loomis, Sayles & Co. LP, Boston.
Many Internet stocks have no earnings so some managers adopt what they until recently thought of as weird valuation methods, such as how many eyeballs have seen a particular Internet portal.
Maintaining discipline
For less experienced portfolio managers, it is "tough to go against the grain" and show restraint when the general public is bidding up a number of Internet stocks, Mr. Kinnel said.
"Each manager has to decide whether or not to stay with their discipline," said R. Patrick Rowles, executive vice president with Kempner Capital Management Inc., Galveston, Texas. While his firm is staying with its long-term value discipline, the issue of whether to vary from an investment discipline "is at the core of the debate of the industry right now," Mr. Rowles said.
New risks might be a permanent feature of the market.
One new risk component is short-term price volatility, Mr. Baribeau said. "This is a new element. I think it is indisputable that it is there."
Both individual and institutional investors might get burned in what some see as an investment bubble for Internet stocks.
"We look at this as a bubble . . . that has nothing to do with valuations," Mr. Rowles said.
Uncertainty
In theory, the entire stock market could be hurt if the bubble in Internet stocks burst, he said. Some individual investors faced with margin calls could be forced to stop investing in non-Internet stocks or sell off some of their portfolios.
But when Internet stocks fall, money managers could clean up. Despite some short-term pain, "there will be tremendous profits to be had," Mr. Lawson said.
"Professional managers should be a little less vulnerable to fear and greed," Mr. Cupps said.
Some of the individual investors and day traders already had gotten burned, he said.
