Humans are inherently optimistic. It is
this precise optimism that is a major driver in the creation of market bubbles.
Optimism gets carried away to epic proportions. Furthermore, it is in
technology, the gateway to human progress, where human optimism is at its most
dangerous. Two previous bubbles are a warning as to the perils of investing in
technology stocks.
The British Railway bubble developed in
the United Kingdom in the 1840s as a result of great enthusiasm for the
disruptive innovation which was railroads and a zealous view on the
innovation’s profitability. With the British industrial revolution in full
gear, railroads were developed as a means of efficiently transporting large
quantities of goods across the country. The first steam locomotive was invented
in 1804 and by 1810 there was nearly 300 miles of railroad track in the United
Kingdom. An economic slowdown in the late 1830s and early 1840s, high interest
rates and anti-railroad protests temporarily slowed the development of
railroads as industrialists and investors gravitated toward investing in
high-yielding government bonds instead of speculative railroad projects.
Soon after,
the Bank of England cut interest rates to stimulate the economy and, by the
mid-1840s, the UK’s economy was booming again, driven by manufacturing
industries. Railroads captured investors’ imaginations due to the rising share
prices of railroad companies and the increasing demand for transporting cargo
and passengers by train. Additionally, Britain’s investor class swelled as the
industrial revolution propelled an increase in the middle-classes. New business
ventures, such as railroads, could now raise capital from this new investor
class instead of solely relying upon capital from banks, aristocrats and
industrialists. Amidst this investment climate, railroad companies aggressively
promoted their shares as virtually risk-free as well as offering promotional
deals on their shares which allowed investors to purchase shares with only a
10% deposit while the company held the right to call in the remaining 90% at
any time. Investors were seized with excitement over railroad companies’
enormous potential.
In tandem, the
British government had a laissez-faire attitude towards regulating railroad
development, stipulating no limits on the number of railroad companies and
allowing practically anyone to form a railroad company and submit a Bill to
Parliament for approval of new railroad lines. In fact, there was heavy
conflict of interest with many Members of Parliament heavily invested in
railroad companies. Shares in railroad companies continued soaring and
investors continued to feed this technology bubble. Many of the
nouveau-investor middle-class invested all their savings in them. With
ludicrously large amounts of capital available to railroad companies, increasingly
audacious and impractical railroad development plans were initiated.
1845 and 1846
were the peak of Railway Mania with myriad proposed railway lines being almost
impossible to build and nearly every town wanting its own railroad. Just in
1846 2727 Acts of Parliament were passed incorporating new railroad companies,
who all proposed a total of 9,500 miles of new track. Moreover an index of
railroad company shares doubled from 1844 to 1846. Yet in 1846 this same index
peaked and began dropping rapidly. The cause was the Bank of England’s
tightening of monetary policy by raising interest rates in late 1845, which
tends to burst market bubbles as capital is no longer as cheap as before and
investors shift to the relatively more attractive bonds with higher yields.
Furthermore, investors began realizing that most railroads were not profitable
or even financially viable. From 1846 to 1850, railroad company shares plunged
50%, a plunge exacerbated by railroad companies exercising their option to call
in the remaining 90% of the money they had lent to investors in their
promotional scheme.
The bursting
of the railway bubble sunk many railroad companies and brought to light
revelations of fraud (think of Bernard Madoff, interest rate-fixing scandal, Rajat
Gupta, after the 2008 financial crisis). In fact, 33% of railroads authorized
by parliament were never even built. Thus railway mania demonstrates how human
optimism is caught up in technological advances, yet one positive of the bubble
was the development of the UK’s railroad system to become one of the most
advanced in the world. From 1844 to 1846, 6,220 miles were built, an important
contribution to the UK’s current total of 11,000 miles. Therefore, the railway
bubble is comparable to the telecommunications bubble of the late 1990s, as
they both left behind valuable infrastructure even after bursting.
A comparable bubble is the Dot-com
bubble of the 1990s following the advent of the internet. This bubble saw
shares of internet-related companies soar in developed markets as investors
engaged in “prefix investing” – investing merely because there was an “e-“ or “.com”
in the company name. The archetypical dot-com company’s business model depends
on leveraging network effects whilst operating at a sustained net loss (by
offering free service or product) in order to build market share. As soon as
their brand awareness multiplied they would charge profitable rates for their
services. Google and Amazon did not see profit for their first years as they
were focusing on expanding brand awareness and their customer base. The
globally low interest rates of the time period also helped to increase the mean
start-up capital raised. In fact, during the dot-com bubble, many internet-related
companies making an IPO raised substantial amounts of money without ever having
made a profit, or even any revenue. C-suite executives and employees became
instant millionaires when their companies conducted IPOs and companies invested
heavily to take advantage of the fervour surrounding this new technology. For
example, Nortel Networks over-invested in producing internet network equipment,
resulting in their downfall through declaring bankruptcy in 2009. Yet by 2000,
the USA’s 370 publicly-traded internet companies had grown to be collectively
valued at US$1.3 trillion or 8% of the USA’s entire stock market.
Many
of these companies were listed on the technology-oriented NASDAQ stock
exchange. Its composite index peaked at 5,048 by March 2000, double its value a
year before. Again, as interest rates rose rapidly (e.g. US Federal Reserve
raised them 6 times from 1999-2000), the economy began to flag. This had a
knock-on effect for the NASDAQ composite index, a barometer for the health of
technology companies. 2001 saw the dot-com bubble deflate rapidly, with many
dot-com companies burning through their venture capital without ever having
made a profit. The plunge in share values of dot-com companies was exacerbated
by the string of frauds (sound familiar) and inadequate financial planning:
·
The January 2000 merger of
America Online (pioneer of dial-up internet) with Time Warner (world’s largest
media company) turned out to be a failure three years later as they were not
able to successfully integrate.
·
WorldCom was found engaging in
illegal accounting practices to exaggerate its profits on an annual basis and
they eventually filed for the third-largest corporate bankruptcy in American
history.
·
Mattel bought The Learning
Company for US$3.5 billion in 1999 only to sell it for US$27.3 million in 2000.
·
Similarly, Yahoo purchased
GeoCities for US$3.57 billion in 1999 but they closed it in 2009.
·
Boo.com spent US$188 million in 6
months attempting to create a global online fashion store only to go bankrupt
in May 2000.
·
Over in Europe, Swiss Think Tools
AG had a valuation of CHF2.5 billion in March 2000 despite having no prospects of
a substantial product, and subsequently collapsed.
·
Also, InfoSpace’s share price had
reached US$1,305 per share by March 2000, which tumbled to US$22 per share by
April 2001.
·
Lycos, purchased by Spanish
telecoms giant Telefonica for US$12.5 billion in 2000, was sold in 2004 to
South Korean Daum Communications Corporation for US$95 million, less than 2% of
its initial purchase price.
·
Meanwhile the US Securities and
Exchange Commission (merely) fined investment banks, Citigroup and Merrill
Lynch, for misleading investors.
The bursting of the dot-com bubble
between 2000 and 2002 engendered the loss of US$5 trillion in market value, a
bursting exacerbated by the 9/11 terrorist attack on New York’s World Trade
Center.
A
few large dot-com companies, such as Amazon, eBay and Google, survived the
bursting of the bubble and grew themselves into world-class operators. Despite
this, their share prices suffered with Amazon stock going from US$107 to US$7
per share. However in 2010, Amazon’s share price has exceeded US$200 per share.
The dot-com bubble was propelled by market over-confidence that companies would
turn future profits, widespread speculation in the “new technology” internet
companies, and the promotion by venture capitalists to investors that they
could overlook traditional metrics (such as P/E ratios).
 |
| Tech Bubble 2.0? |
Are we now in another technology bubble
engendered by human optimism? Some postulate we are in the throes of Tech
Bubble 2.0 focused on social networks. Facebook and Goldman Sachs have the same
market capitalization of US$75 billion, with Facebook trading at a revenue
multiple of 37.5x. Meanwhile Groupon and BestBuy share the same valuation at
US$13 billion, with Groupon trading at 26x revenue. Zynga and Whole Foods are
both valued at US$10 billion, with Zynga trading at 40x revenue and LinkedIn
and jewellery stalwart Tiffany & Co share a US$9.5 billion market
capitalization. Skype is valued at US$85 billion, the same as Southwest
Airlines with its 570 aircraft operating
3,400 flights daily. However unlike its dot-com era counterparts, these
technology companies do have revenue, just not as much as similarly valued
companies. Groupon makes US$16 per user, Skype US$5.10 per user, Facebook US$4,
Zynga US$3.40, and LinkedIn US$2.40. Additionally, tech companies today have a
relatively large number of potential customers – 2.2 billion internet users (equal
to the number of people without toilets globally). This compares favourably to
the number of internet users during the dot-com boom – 300 million (roughly
equivalent to the number of iPhone users currently). Therefore, the jury is
still out on whether we are in another Tech Bubble focused on social networks.
 |
| The Education Bubble? |
There could be other bubbles out there.
China is one – the Chinese stock market has soared despite a weak global
economy with Chinese stocks trading at 13 times earnings and just in one month
this year, Chinese investors opened 485,000 stock brokerage accounts. Another
potential contestant is an emerging market bubble with investors pouring in
US$11 billion into emerging market mutual funds – 34 times the total amount
invested in US funds – whilst the MSCI Barra index of emerging stock markets
has outperformed the Dow Jones Industrials by 20% since 2007. In addition, the
education bubble may be bursting as people realize getting a degree may not
always be worth the escalating cost – in the USA the amount borrowed by
students to go to university grew by 25% to US$75 billion whilst in the UK
there has been a drop in the number of students applying to university.
Furthermore, future bubbles may manifest themselves in the form of a clean
energy or energy efficiency bubble or on a financial note, a life insurance
securitisation bubble as investment banks plan to securitise life insurance
policies that the retired can sell for cash while they are still alive (sounds
like subprime mortgages all over again).
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| A Bubble in Asian Tiger Economies? |
Bubbles can represent a danger, yet
there is also something distinctly redolent of the human condition in them.
Everything important has been built on the ivory towers of irrational
exuberance. Without this manic optimism, investors wouldn’t open their
chequebooks and finance these technological innovations. Therefore, bubbles can
be perilous, yet they are a specific human condition without which human
progress would be incremental.
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