This piece first appeared in Reader's Digest in September 2000
 The text here may not be identical to the published text

Welcome. Welcome to the biggest, newest, highest tech roller coaster ride in the world. On this monster, like poker, you keep the score in money. As it goes up you make it. As it plunges towards the earth, your hard-earned disappears like the morning dew. Welcome to the Dot Com Ride of Terror.

Before you are allowed on board you must promise that you have got a safe little nest egg tucked away in an individual savings account – preferably invested in a tracker fund as recommended a couple of months ago. You may even have a bit more put (fairly) safely by with a well known managed fund. And you have some cash of course, ISA’d again. You must also promise that you will not bring more on the ride than you can afford to lose over the side. And I really mean that – it may all disappear. And of course you have to like roller-coasters – excitement, fun, risk. If not, please leave now in an orderly fashion. Still here? Good. Pull down your safety harness, wait for the click, and remember the mantra ‘shares can go down as well as plummet’.

As it’s your first ride, you will not be alone. Up front will be Arithmetic, she is always the most helpful companion. Next to her sits Business (sometimes they hold hands) and in the back is History. Indispensable of course, but his view is restricted and he is not always a perfect guide to what’s ahead. At your side, always, sits Commonsense.

While it is still quiet, Arithmetic and History chat and remind us that six months ago the price of shares in the new hi-tech companies was shooting up. Buying them seemed a certain way of making money. In the 14 weeks up to March 6th the index of shares in our biggest 100 technology, media, and telecoms companies – the FTSE Techmark 100 – doubled in value. So when a week later lastminute.com, an internet retailer of anything from hotel rooms to flowers, was launched on the stock market everyone expected to make a killing. One listener e-mailed my radio programme and said ‘How do I apply for shares. I don’t want to miss out on the free money.’ In the event 189,000 private investors were allocated just 35 shares each at £3.80. When trading began on 14 March the price did rise, peaking at 555p. But by the end of the day had fallen back and by the time the public could sell the shares they had paid £3.80 each for, the best they could get was £3.20. Soon they fell to half the initial price, where they still languish. As the end of June approached, the Techmark 100 also almost halved in value, back to where it was in November. Free money? I don’t think so.

Perhaps our companion Commonsense has at last been getting through. New companies starting from nothing, carrying the magic word ‘internet’ or ending with the phrase ‘dot com’ (a reference to the internet address of companies which normally ends with a full stop followed by ‘com’ or ‘co.uk’) became worth tens of millions of pounds within a few months as sober and experienced City dealers marked up the price of their shares in a buying frenzy. They talked of the ‘new economy’ and said these firms were the investment opportunity of the new century. But no-one quite knew how to judge them. Because they don’t make profits. In fact most of them don’t make anything at all. A chief executive of one of these start-ups told me – when I asked how he would make money from the people visiting his website "I will offer them a range of value-added services." I didn’t have a clue what he meant. And the terrifying thing is, I don’t think he did either.

At this point, Business turns round to remind us that most internet sites are nothing more than a mail order catalogue coupled with an electronic billboard. OK, potentially they reach the whole world. But all the income still has to come either from selling people stuff directly or from companies paying to advertise – and then selling people stuff. Either way, unless someone buys something no long-term income is generated. Arithmetic explains the problem. Suppose a company has two million registered users and one in ten of those actually buys something, spending on average £100 each. Income is £20 million a year and profits on the sales alone – the margin – is say £5 million a year. But the company is actually spending £20 million a year on advertising, running the website, administration, building warehouses, delivering goods, and paying its staff. In order to break even it has to quadruple its sales. In the UK with around 10 million people connected to the internet – mainly at work – is it practical to imagine 8 million registered users and 2 million purchases at £100 each? Of course not. And that is just to break even year on year never mind paying off the debt and then giving shareholders a return. The model cannot work.

That was something the ex-directors of boo.com forgot. Boo was an internet retailer selling fashion clothing. In eighteen months it got through £80 million advertising its brand and developing an impressive website – you could even try clothes on models and spin them round. But it did not make many sales. And its investors decided that any prospects of profits was too far away. When the directors asked them for another £20 million, they pulled the plug. Fortunately, no amateur investor lost money – but a dozen wealthy professional ones did. They should have known better. It was the first major casualty and it will not be the last. Accountants PricewaterhouseCoopers has estimated that most internet start-ups will need more injections of capital within fifteen months – long before profits begin. It is all down to arithmetic again. How quickly are they using up their capital – the so-called burn-rate? Will it run out before profits start the long haul back? Is the debt drain just too deep ever to be blocked by the fat of profits? However big the crane, if it arrives too late it cannot pull you out of a black hole.

Profits are at the heart of any investment. They are the return on your money, the income from your capital. The share price simply reflects the estimated future value of the profits the company will make. But we have seen, still see, on the stock market, companies with no profits now and indeed no clear prospect of profits, with shares selling at tens of pounds each and the company valued at hundreds of millions of pounds. And what do many of them have? Nothing but a smart website and a lot of visitors to it. Commonsense points out that lots of people visit Trafalgar Square in London. But it does not make any money. Except for the people surrounded by pigeons who take 50p and give you peanuts.

So what collective madness has overtaken city investors? First, they are afraid to miss the next big thing. So they pile in and ignore the simple rules about what makes a good investment. Second, they do not actually understand the internet or what it does. And when some companies start to fail, everybody pulls out as indiscriminately as they piled in. We are still not seeing that essential separation by the market into companies that look as if they will make it and companies that look as if they won’t. Of course, some will surprise us – some things are essentially unpredictable. But there are still rules and they should be followed.

History says gather as much information about the company as you can – annual reports (if the company is old enough to have one), the prospectus when it floated, its own corporate website (if it does not have one with information about the company rather than stuff it is trying to sell you, then worry about that). Use the dozens of websites that give stock market and background information. Beware, though, the discussion groups and tip sheets. They may know less than you or have an ulterior motive. There is no such thing as a free hunch.

Then, says Business, look at how hard it is for another company to come in and compete. Remember that many established companies in travel or banking do not currently threaten the start up companies that are taking away some of their business. John Wall, the chief executive officer of the US high tech stock market NASDAQ, told me recently

"The old companies are embracing the new technology and becoming part of the new economy. Those companies have big deep pockets in terms of capital that they are able to put towards these new concepts and Businesses so don’t rule them out. Many of the old companies are going to come back strong and hard in this new economy."

Do not be dazzled by companies that are offering to sell you books or holidays or insurance or mortgages or savings accounts or flowers over the internet. Many established companies sell those products very successfully through traditional routes. If they choose to bring their deep pockets to the market they could steal the sales very easily. Selling to other businesses has more potential than the overcrowded and hard-pressed retail market.

Arithmetic warns you to look at where those profits are coming from, and match them up against costs. Some new technology companies are not internet sites – they make real products like modems, or fibre optics, or processors, or time on the phone. Or they have intellectual property – patents and copyright – that can be rented out again and again. Some even make profits. Companies with a product and a market are more likely to succeed.

Commonsense chips in. Look at the track record of the directors. What have they run before? What experience do they have in retailing or advertising? Where have they been before? If the answer is ‘nowhere’ that tells you a lot. And listen to what they say. Are they telling you a good story about the business? Or is it a fairy tale?

With Arithmetic and Business hand in hand in front, History behind and Commonsense always by your side, the ride seems a lot less frightening. Of course, even the most exciting and well-planned roller coaster costs you money. But at least the ride leaves your feet slightly closer to the ground than when you started.

September 2000

e-mail Paul Lewis on paul@paullewis.co.uk