News Article
BusinessWeek.com
March 13, 2006
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Climbing Jacob's Ladder

Manager Ryan Jacob talks about how the Jacob Internet Fund bounced back after the Internet bust -- and how he sees the sector now

Internet companies are making money again, says portfolio manager Ryan Jacob, one of the most visible faces of the late-1990s Web-stock boom. He racked up an otherworldly 225% annualized gain as manager of Kinetics Internet fund (WWWFX ) before launching the Jacob Internet Fund (JAMFX ) in 1999.

Then he got a taste of the bear market -- and the fund suffered a fate similar to other Internet-themed offerings.

After its rocky beginning, though, the $99.2 million Jacob Internet Fund is reaping returns for its investors. Through Feb. 28 it had an average five-year annualized return of 8%, compared with 2.4% for the Standard & Poor's 500-stock index. Its typical peer posted a 4.6% loss over the same period, according to S&P. (The fund has posted an annualized loss of 19.85% since inception in December, 1999.)

PAYING THE PRICE.  Broader diversification and more active trading helped the fund regain its winning ways, Jacob says. Jacob expanded the fund's portfolio from between 25 and 30 stocks to between 45 and 50, and became quicker to cut loose overvalued stocks. "I'm a big proponent of high turnover if you're investing in a volatile sector," he says.

Frequent trading carries higher transaction costs, but Jacob says they're outweighed by the portfolio's improved returns. In 2002, the tech-heavy Nasdaq composite index slumped 31.5%, while the Jacob Internet Fund fell less than half that percentage.

Still, the fund is pricy, carrying an expense ratio of 2.64%. And investors who've been there from the start are still hurting. Since inception, the fund has reported a loss of 19.9%.

Jacob recently spoke with BusinessWeek Online reporter Marc Hogan about his fund's performance, Internet consolidation, click fraud, and the impact of new wireless technologies. Edited excerpts from their conversation follow:

The end of the Internet boom was tough on your fund, but your returns have improved since then. How did you bounce back?
We decided we needed to make some changes in the way we situated the portfolio. One of the biggest changes was we decided to add an element of value into the portfolio that we hadn't had in the past. We tried to balance the portfolio more between value and growth rather than just strictly growth.

We also decided to increase the turnover of the fund. That's a little bit controversial because it's conventional wisdom that low turnover is a more prudent course for a manager.

The reality is, in a sector that moves so quickly, it really is an advantage to be more active in your trading. With my previous fund, and very early on with this fund, we would have portfolio turnover somewhere between 20% and 40%.

In the immediate period during the correction, the 2001-02 time frame, our turnover got as high as over 1,000% on an annual basis. Now that was unusual. But it was also a very difficult period. It really helped us be more disciplined in capturing profits and cutting losses.

What's the biggest difference between investing in Internet stocks now compared to the late-90s IPO days?
A vast majority of the Internet companies today are profitable, very much so, and that's a stark contrast to what we saw in the late 1990s. That doesn't mean that valuations don't become an issue from time to time, but inherently the businesses are solid.

Tell me about some of your top holdings.
We've been active in Chinese companies over the past four or five years. They've gone from being larger weightings in the portfolio to smaller. Right now they're a bit heavier.

Today we have about 17% or 18% of the portfolio allocated to various Chinese Internet companies. Long-term, they have bright prospects. Their margins across the board tend to be high, and they have very defensible businesses.

A lot of U.S. companies have attempted unsuccessfully to enter the China market. What has happened in the past year or two is they've had to partner. eBay (EBAY ) bought a company called EachNet to have an auction presence in China. Yahoo! (YHOO ) made a $1 billion investment in Alibaba, a privately held Chinese Internet company.

Sina (SINA ) and Sohu.com (SOHU ) are two of our top holdings right now. They're general-interest portals, analogous to a Yahoo model here in the U.S., and they are considered by far the top two major Internet brands in China.

Sina is the larger. Sohu's interesting in that it also has a burgeoning search business.

Sohu acquired the sponsorship to the Beijing Olympics in 2008. We think this is an underappreciated agreement. The exposure that the Olympics get in China just dwarfs even what we expect here in the U.S. China's looking at this almost like their coming-out party. Sohu has acquired all the Internet rights to the Beijing 2008 Olympics, and there's going to be a tremendous number of monetization opportunities for them associated with that.

Are there any other top holdings you consider noteworthy?
On the value side, we've seen a lot of interesting opportunities in the software space. One of our top holdings is webMethods (WEBM ).

Many of these software companies went through a period during the crash where a lot of their customers went out of a business. A vast majority of them shouldn't even have been public. But there were also a lot of companies that had strong products and were trading at depressed valuations.

WebMethods is one company that has moved away from a minor loss to breakeven, and now they're back to being profitable. They do enterprise-application integration. It's software that basically ties in existing software [programs] in the enterprise so they can all talk to each other.

There has been some consolidation in your sector, from News Corp. (NWS ) acquiring MySpace to Google (GOOG) recently picking up a small Web-based word processor, Writely. Do you expect that to continue, and how does that factor into your strategy?
If there's a lot of acquisition activity, fundamentally it means these sectors are doing well. We had two acquisitions in the past week. We had MatrixOne (MONE ), a small software company that was acquired by French company Dassault Systèmes, and iVillage (IVIL ), which was acquired by NBC Universal (see BW Online, 3/7/06, "NBC Universal Takes an iVillage").

In terms of Internet media, it's an area that's growing, not only participating in a strong advertising market but also taking market share away from traditional channels. You're seeing companies like Scripps (SSP ) buying Shopzilla. You had The New York Times (NYT ) buying About.com.

What's really ironic is these were situations where major Internet companies were also bidding for these properties, and they got outbid. That's telling you the Internet is a critical piece of the advertising pie today, and whether you're an Internet company or a traditional media company you have to have a presence. We expect the acquisition activity to continue.

How does the rising interest rate environment affect Internet companies?
The good news is we're seeing opportunities in the technology and Internet sector, even though the sector is doing well, and being able to pay reasonable valuations. The bad news is that there are some macro trends at work right now that are a little troubling.

Rising rates is one of them. It's good to be aware and cautious, but that's another reason why we're shying away from extreme valuation situations. When we're a little less sure about the macro environment, we tend to be a little more valuation-conscious.

How big an issue do you think click fraud will be for these companies? I noticed that Google wasn't one of your top holdings, and Google recently said it would pay up to $90 million to settle a click-fraud lawsuit.
I'll tell you this. We have increased our positions on Google and Yahoo over the past several weeks. I don't want to give specifics because I have to be careful with disclosure issues, but we're getting more interested at these prices for sure.

In terms of click fraud, it's an issue. From what we gather, it's not insignificant, but generally it's not material. When you look at the companies' businesses and revenues, it's such a minute portion that potentially could be affected that I think it's something to watch, but it's just not really a big factor right now.

For a company the size of Google, $90 million is immaterial. If there were something lurking deeper, then at some point that would have to be disclosed. The fact that they're setting up this settlement the way they are leads one to believe that there isn't some big shoe to drop here.

Are there any other trends you've been noticing in the companies that you follow?
We're starting to get more interested in communications, whether it's wireless or Voice over Internet Protocol. We're positive on new wireless technologies like WiMax. It's the next generation of Wi-Fi (see BW Online, 1/23/06, "The Brave New World of Wireless").

Where Wi-Fi has a range of maybe 300 or 400 feet, WiMax has a range in miles. It could be a game-changer. We've been encouraged that Intel (INTC ) is pushing the WiMax standard hard. Originally, they were expecting to come out with WiMax-enabled chips in 2007. They expect them now by the end of this year.

We own a couple of small companies that basically make WiMax products. One is Airspan Networks (AIRN ), and the other one's Alvarion (ALVR ). They are understood as being pioneers in the WiMax space, and their products are being used in a lot of tests.

There are other advanced wireless technologies out there, but we think WiMax has the best shot of becoming that next-generation standard. But you have to be careful because it's a little early. There are going to be a lot of bumps along the way.