Investors soon may get piece of favorite Internet firms

Investment guru Peter Lynch once advised ordinary folks to"invest in what you know."

For many small investors, some of the companies they are mostfamiliar with are the e-commerce and social media sites they useevery day.

Now some of these private Internet companies, such as Facebook,are expected to go public this year or next and will likely attracta rush of fans to their stocks.

But even if you feel like you know these companies well, there isa risk in investing in them. Competitors are constantly sproutingup, and it's difficult to predict which ones have staying power.Some Internet companies have raked in millions in revenue but haveyet to turn a profit.

And there's so much hype about these companies now that you cancount on paying a high price once they do start selling shares tothe public. That would be fine if the stock keeps going up into thestratosphere. But if the price falls back to earth, it can take awhile to recover your initial investment.

Early investors in Pandora Media Inc., an online music servicethat went public this month, are underwater. The stock shot up to$26 per share during the first day of trading. Buyers' remorse setin the next day, and the stock has been trading below its initialoffering price of $16 ever since.

California-based Pandora has been around for about a decade buthas never posted a profit. The fact that Pandora attracted investorsanyway has added to the debate on whether we're experiencingsomething similar to the dot-com bubble.

"It feels like we are partying like it's 1999 again," said JamesAngel, an associate finance professor at Georgetown University whowas on the New York Stock Exchange floor when LinkedIn, a socialnetwork for professionals, went public last month.

But Chuck Carlson, chief executive of Horizon Investment Servicesin Indiana, said the climate now isn't as frenzied as it was before,when investors would throw money at any company whose name ended in"com."

"It's unfair to paint the whole group as a giant Internetbubble," Carlson said. "Like any sector, there will be winners andlosers."

Small investors' best bet at gaining a piece of these companies -- without huge risk -- will be through mutual funds. Funds ownshares in dozens or hundreds of companies, so if one fails, thedamage to the investor is less severe.

Some mutual fund companies have sunk money into private shares ofsocial media and e-commerce companies, making those shares part oftheir fund portfolios.

Fidelity Investment's popular Contrafund, for example, holds atiny stake in Facebook. Baltimore's T. Rowe Price has funds withsmall positions in Twitter, Facebook, social gaming company ZyngaInc., and daily deals website Groupon.

As more social media and Internet companies go public, there willbe more mutual funds and exchange-traded funds that focus on thesestocks.

Still, some investors will want individual stocks. If you're oneof them, do your homework before investing. And make sure you areinvesting money you can afford to lose, and not your retirementsavings.

Here are some things experts say you should consider beforeinvesting:

Profitability: Of course, you want a company to have a history ofearnings. Still, it's not unusual for a young Internet company withfast-growing sales to operate in the red for a time. In such cases,you need to determine whether the company has a realistic plan tobecome profitable.

"Does this story make sense or is it a bunch of hot air?" askedDavid Straus, senior portfolio manager with Washington-basedJohnston Lemon Asset Management.

Amazon, for example, operated at a loss in its early years, as itput the money from sales back into the business, such as buildingdistribution centers, said Richard Cripps, chief investment officerwith EquityCompass Strategies in Baltimore. The upfront costs weresteep, but investors knew they would eventually subside, he said.

But it's a red flag, Cripps warns, if a company's revenue isbeing eaten up by marketing -- a continuing business expense thatwon't go away.

Competition: Are there competitors offering similar services oris the company's business model easy for others to copy? Groupon,which recently announced it is going public, is often cited as anexample of a business with many imitators -- even on a local level.

"It's a tough, tough game to stay ahead," said Peter Ricchiuti,assistant dean of Tulane University's business school. "Every dormroom is a potential competitor for you."

Some social networking sites have grown so dominant -- Twitter isan example -- that it would be difficult for any copycat to catchup. Then again, there was a time when Yahoo and MySpace were the topdogs, only to be edged out by others.

Know the risks: There are all sorts of business risks you likelyaren't aware of, and the investment bankers touting the stock won'ttell you, Straus said.

To find out the negatives, he said, read the prospectus. It's adense document and hard to plow through, but necessary reading.

"Read the risk section. It goes through every conceivable risk,"including information about the competition, Straus said.

Who's bailing? Check the prospectus to find out how the companyplans to use the proceeds from the initial stock offering to thepublic, Cripps said. You want to see that the company will use themoney for "general corporate purposes," meaning the cash will beplowed back into the business to help it grow, Cripps said.

It's a bad sign when all the insiders and venture capitalistswant to cash out by selling off their entire holdings as soon as thestock goes public, Cripps said. What do they know about the stock'sprospects that you don't?

"Ideally, as an investor, I want all the money to go to thefuture," Cripps said. He said he would be leery of an initialoffering in which more than 25 percent of the proceeds is slated togo to insiders.

The No. 2 position: The company is usually headed by thevisionary who came up with the idea for the business in the firstplace. But Cripps said he looks at the person next in line, thechief financial officer, who provides all the numbers that investorsmust rely on.

The person at the financial helm should have a history with thecompany and not be someone brought in temporarily from anotherbusiness to get the deal done, Cripps said.