A Throwback to the Internet Boom

12/21/2009 11:00 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, director of ETF analysis for Morningstar, and analyst John Gabriel find an ETF that invests in the survivors of the Internet bubble.

Internet HOLDRs (NYSE: HHH) offers extremely concentrated exposure to a few Internet-related stocks. Considering the secular shift toward online shopping, it might be worth keeping an eye on this fund as we sift through results from retailers’ holiday season.

This ETF was launched during the heyday of the tech bubble. [Its] initial holdings fund included such illustrious names as CMGI, Inktomi, Lycos, and Go2Net. As such companies went bankrupt, got acquired, or simply fizzled out, the number of positions in HHH has shrunk from the initial 20 to just 12.

HOLDRs are static portfolios that do not reconstitute or rebalance—[that’s] why Google (Nasdaq: GOOG), which went public after the fund [started] is missing from the portfolio.

Today’s portfolio essentially revolves around just three bubble-survivors: Amazon.com (Nasdaq: AMZN), eBay (Nasdaq: EBAY), and Yahoo (Nasdaq: YHOO). Those with favorable long-term outlooks for these businesses might look to this fund [instead of buying the individual stocks]. Investors should treat HHH strictly as a specialty satellite holding.

Online retailer Amazon makes up roughly 40% of total assets. After jumping [nearly 150% so far this year], Amazon’s current valuation ratios have many market participants scratching their heads. To justify its lofty multiples, investors must believe that Amazon can continue expanding (successfully) into new product categories and extend its international reach significantly.

EBay (20% of total assets) has seen its core auction business struggle amid a severe cutback in discretionary consumer spending, as consumers increasingly prefer the convenience of the fixed-price format. Competing sites such as Amazon and hyperlocal free sites like Craigslist have also weakened the appeal of listing on eBay.

EBay does have a crown jewel in PayPal, which accounts for about a third of total sales. PayPal continues to benefit from a strong network effect, particularly on the eBay platform. PayPal is currently accepted by about half of the top 50 online retailers and processes about 20% of online retail transactions in the US.

Yahoo, which makes up about 15% of assets, remains one of the most heavily trafficked sites in the world. Unfortunately, strong site traffic doesn’t necessarily translate into strong financial performance. Yahoo’s ability to monetize site traffic has been [hurt] by its falling search-market share, audience fragmentation, and diminished pricing power.

Our equity analysts estimate that Yahoo’s cash position ($4 billion) and ownership stakes in Yahoo Japan (35%) and Alibaba (40% of Alibaba Group) make up 60% of Yahoo’s total equity value.

The fund charges [eight cents] per share in annual custody fees (which are waived if the underlying securities fail to generate enough in dividends or cash distributions to cover them). This structure makes the ETF very cheap.

HHH offers very limited diversification benefits. Interested investors may wish to simply pick individual stocks and avoid paying management fees. Otherwise, those looking to a broad technology ETF could also consider Technology Select Sector SPDR (NYSEArca: XLK) and Vanguard Information Technology ETF (NYSEArca: VGT). 

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