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Buying the leading internet stocks during sharemarket corrections over the past five years has been a rewarding strategy. The sell-offs gave a fleeting opportunity to buy REA Group, Seek, Carsales.com and Webjet when they were not priced for perfection.

The same will be true of the next group of emerging web-based stocks:  OzForexGroup, Freelancer and accounting software provider Xero. Like their internet predecessors, this group of “disruptors” is best bought during significant bouts of sharemarket weakness.

Xero and Freelancer are hard to buy at current prices. Freelancer, yet to earn significant profit, is capitalised at $602 million. The loss-making Xero is capitalised at a staggering $3.7 billion. At one stage, it had soared almost fivefold from its 52-week low, before pulling back.

I am no fan of chasing loss-making stocks that have incredible growth expectations factored into their valuations, and avoid being caught up in their hype. One broker labelled Xero the “Apple” of accounting software, and Freelancer had huge publicity around its listing last year.

Don’t get me wrong: Xero, Freelancer and OzForex have great long-term potential. Xero is superbly positioned to capitalise on cloud-based computing as accounting software transforms into service rather than a product, changing the relationship between accountants and small enterprises.

The well-run Freelancer has quickly become a dominant player in the micro-jobs markets. The trend of more people having a portfolio of micro-jobs, sourced worldwide, rather than one full-time job, seems unstoppable. A global army of self-employed freelancers is a lucrative market.

OzForex is at the vanguard of a huge emerging trend: insurgent financial service providers having web-based business models that make life difficult for incumbent players. Who knows what will happen when Google, for example, moves more aggressively into online banking services?

Understanding these trends is the easy part: knowing how to value the “disruptors”, and buying them when they trade below intrinsic value, is the bigger challenge. Owning loss-making companies that have multi-billion-dollar valuations is hard for even the most bullish investor.

An absence of earnings, at least for now, in Xero further compounds the valuation challenge. I cannot buy Xero at current prices, even after its share price falling in a hurrying from the 52-week high of $42.96 to $29.60. Its recent operating update showed strong revenue growth, but projected a similar loss in the second half of FY14 to the first half. Profit takers moved in.

Freelancer looks more interesting on valuation grounds. After raising $15 million at 50 cents a share in November, 2013, it briefly touched $2.60, before retreating to $1.25. Freelancer is expanding rapidly: it recently acquired virtual market place Fantero.com and Polish freelancing site.

Freelancer has slumped from around $1.70 in early March to $1.33. It ran too hard, and the market might be digesting the rush of acquisitions. This well-run company has a shot at justifying its heady valuation, although I’d be looking to buy below $1.20. The selling momentum could continue given Freelancer has broken share-price support around $1.40, albeit on limited trading history.

After raising $439 million and listing on ASX in December, OzForex’s $2-issued shares have rallied to $3.06.

OzForex provides online international payment and foreign exchange services for consumers and businesses. Its low-cost, easy-to-use online service will inevitably become a bigger headache for banks and other traditional financial service providers that enjoy fat margins on such transactions.

OzForex has an estimated 5 per cent market share in Australia. It should be able to grow organically in this market and overseas for years to come.

OzForex has a great business model. Like other internet-based disruptors, it has a low-cost service and the ability to scale quickly without huge capital investment. By white-labelling its service to other financial institutions, and expanding its direct presence, OzForex is rapidly growing customer numbers, in turn improving its scale and product offerings.

There are, however, significant risks. OzForex does not have a clear “economic moat” or sustainable competitive advantage. It needs to build a much larger customer network that, by virtue of its size, becomes a significant barrier to entry for online and traditional rivals.

And it is up against some mighty competitors in the big banks. They will respond aggressively if OzForex becomes more of a threat to their foreign exchange and international payment services. Moreover, a forecast Price Earnings (PE) ratio of 40 for the company, according to consensus analyst forecasts, leaves little room for earnings-growth disappointments.

In a recent research note, Morningstar values OzForex at $4.10 a share and has an accumulate recommendation. The current price is $3.10. It clearly suits long-term investors comfortable with higher risk and potentially higher volatility.

Unlike Xero and Freelancer, OzForex is trading below fair value and is profitable. It is the pick of the three internet-based disruptors at current prices. Freelancer is also worth watching if recent share-price falls continue, and is worthy of being added to portfolio watchlists in anticipation of improving value. Like other stocks in this article, Freelancer suits experienced investors who are comfortable with higher risk stocks.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at April 10, 2014.

 

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