(FORTUNE Magazine) – Wearing a baseball cap emblazoned with the word FOOL, stock market wag and watchdog Tom Gardner tosses a question to a roomful of tech entrepreneurs and MBAs at the University of Virginia's Darden School: "How many people here think Internet stocks are generally overvalued?" Two-thirds of the audience at Darden's "e-summit" raise their hands. Grinning as if he knows it all, Gardner says, "I'll share with you my belief. Ninety percent of Internet stocks are overvalued, and 10% are dramatically undervalued."

You might call Gardner a fool--he is, after all, co-founder of the popular Motley Fool investment Website--but there's nothing foolish about his advice. Wall Street's top-rated Internet analysts pretty much agree, saying that the vast majority of publicly traded Internet companies will eventually fail. And--sorry to dampen your holiday cheer--this Christmas will deliver the first e-shakeout. "This will be a make-or-break Christmas for the third, fourth, and fifth players in their categories," says Merrill Lynch Internet analyst Henry Blodget. "The companies need to make it now, or they'll go out of business."

What a difference a year makes! Investors greeted Christmas '98 with e-tail euphoria, lifting Internet stocks sharply in the fourth quarter. This holiday season the Internet sector is keeping pace (up 49% halfway through the quarter), according to Morgan Stanley, but there's growing anxiety about consumer e-commerce stocks. Two reasons: the flood of Internet IPOs--167 so far this year, vs. 27 in all of 1998--and a shift in investor attention to hot new areas like business-to-business e-commerce and Internet infrastructure. Plus, online retail sales are expected to double this holiday to $6 billion, according to Jupiter Communications. But startups are spending so wildly to grab eyeballs that marketing costs are spiraling for everyone--and some will bankrupt themselves. "There are too many companies competing," says the most influential Internet analyst, Mary Meeker of Morgan Stanley. "It's likely we're going to see some ugliness in the first quarter of next year."

How do you choose winners? History suggests long-term stars will be few. When Morgan Stanley's tech research group examined the 1,200-plus IPOs since 1980, they found that just 5% of the companies have created 86% of the wealth. A few guidelines:

--Mass matters. The biggest e-tailer, Amazon.com, lost 7% of its value one day in October when CEO Jeff Bezos said the company would triple its holiday spending on marketing. "I've been stressed out about Amazon," admits Meeker--but she has kept her buy rating on the stock. "The winners in the end," she reasons, "will be the companies that have the most customers. It's the lesson learned from AOL." Like AOL during its early years, Amazon is likely to lose about $1 billion as it builds its infrastructure and enormous customer base. But this Christmas is a turning point: Amazon should make money in its core book business for the first time. "Amazon hasn't proven that its business model truly works," Meeker says. What management needs to do after Christmas is show how it made the book business profitable and how it eventually will replicate that success selling other stuff. "The message has been 'Trust us,' " says Meeker. "It'll shift to 'Get out your calculators.' "

--Winners deliver. Internet investors will be leaning on their calculators more and more, so companies must convert eyeballs into revenue-producing customers. One champ in this regard is eToys. When I studied the company a year ago ("Inside the First E-Christmas," Feb. 1, 1999), eToys had 10,000 products, fewer than 100,000 customers, and few online competitors. Today it has 100,000 items, 600,000-plus customers, and lots of competition. The stock is extraordinarily high priced--at $59, it's selling for 60 times estimated 1999 revenues per share--but most analysts discount the risk. In surveys, eToys consistently ranks as the best online toy vendor. And while Amazon is a daunting rival, the $200 billion global kids' market is a big enough playground for both. What about Toys "R" Us? Wall Street just doesn't see it as a threat. Says Aram Rubinson, who follows Toys "R" Us for Paine Webber: "They'll do in the virtual world what they do in the offline world: disappoint customers."

--Maturity is good. Many investors want in on Internet companies at the startup, but that's the riskiest stage at which to invest. Today's best bets may be the "adults" of the industry. Pressed to name her favorite stock, Meeker says it is AOL. Dispelling worries about slowing subscriber growth, she notes that AOL's expanding lineup of brands--ICQ, CompuServe, Netscape--and rising ad and e-commerce revenues are helping to lift profit margins. After losing half its value this past summer, the stock, which just split, has bounded back. At a recent $85, it's a shade off its all-time high.

Another veteran of the Net was the hands-down favorite at the recent Darden School e-summit: Yahoo. CEO Tim Koogle is a University of Virginia grad (he told me at the Avis rental car line that he put himself through school by working as a tractor mechanic), and I wondered, Was Yahoo favored because the boss is a Wahoo? Apparently not. Blodget (a Yalie) says Yahoo is his No. 1 stock: It's an Internet company with profoundly un-Netlike financials--a 35% operating profit margin--plus an expanding shopping service and huge international opportunity. "Yahoo has the clearest path to long-term growth and dominance of any Internet company," he says. Adds Meeker, who says Yahoo is her second-favorite stock: "One of the stories that will emerge next year is how powerful Yahoo is outside the U.S."

As for the little guys? Unless they excel at the 3C's--commerce, content, and community--they'll lose customers to giants like Yahoo. Case in point: the globe.com, which urges members to "debate, flirt...build a homepage" on its site. It has missed revenue targets, and losses are increasing. Also, beware e-tailers that compete in cutthroat segments, such as software vendor Beyond.com. Says Credit Suisse First Boston's Lise Buyer, who downgraded the stock amid a management shakeup: "The business is very price-competitive, and Amazon is a threat." The same goes for Value America, sure to suffer as Staples and Office Depot ramp up online.

While this Christmas brings the battle of the dot-coms, next holiday season will probably usher in new competition: the pure-play e-tailers vs. the land-based retailers that finally get the Net. One stock to watch is Tandy, which just forged a partnership with Microsoft to turn its Radio Shack outlets into Internet-access stores. "Tandy is an Internet company being valued like a retailer," says Paine Webber's Rubinson. So start making your list now for next year's clicks-and-mortar Christmas.

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