The antitrust parallels with Standard Oil and the Bell Companies are not irrelevant when appraising where the dominant companies in the new online world now stand. Social media and search are two business models the size and scale of which suggest that they are potential natural monopolies. Since history records that monopolies often end up abusing the power conferred on them by their market position, at some point they become the target of regulatory action. It is difficult to believe that Amazon, Google and Facebook, the new global titans of our age, will be the exceptions that prove the rule. Nevertheless, the history of the Internet as a new industrial force also reminds us that the development of a new technology rarely follows a pre-ordained script.
The initial killer application on the Internet was electronic mail. While email remains important, the reach of the Internet has expanded well beyond this. Various business segments have been defined: there is the so-called business-to-consumer (B2C) market, the business-to-business (B2B) market and also – something that AOL saw very early – a powerful mechanism for the delivery of multimedia content. The commercialisation of the Internet has evolved in phases. Initially it revolved around completing the creation of a global interconnected network. It migrated to the early business models of advertising and B2C-based companies. These models are still evident in more recent business creation, rippling out through a range of different industries and product types. The impact on incumbent companies will be no less profound than those which have already been experienced by, for example, the newsprint industry or consumer electronics retailers.
…and a monster stock market bubble
In the late 1990s the stock market initially reacted to the Internet much as it had to other technological advances, particularly those that took place during periods of low interest rates. Curiosity led to enthusiasm and then on, through an escalating series of events, to a full-blown mania. A brand new communications and distribution channel with relatively free access, when combined with cheap money, proved to be a potent mixture that later morphed into the mother and father of stock market bubbles. As the stock market success of early participants increased, a bandwagon formed. Many of the early participants had products that were integral to the development of the Internet itself, whether these were physical items of hardware, such as routers, or enabling software, such as browsers and search engines. Because of the enabling nature of these companies’ products, they were able to experience rapid growth in turnover.
This growth in turn reinforced the growing enthusiasm in the stock market for the ‘new economy’, one that appeared to operate in a competitive environment and therefore had few inflationary implications. It was also largely knowledge-based and capable of cutting out large elements of cost in a way that it was thought companies in the ‘old’ physical economy simply could not. Since the new economy required little capital, but promised great returns, it was almost tailor-made for the emergence of financial sector exuberance. Moreover, it was new companies that were expected to create the wealth and new companies by definition are not already listed on the stock market. They required the services of the financial community to reach a wider investing audience. As noted many times before, when investor enthusiasm is on the rise, the financial system has never been slow in creating a new supply of whatever is in vogue.
Two business models in particular – one funded by advertising and the second involving direct retailing to consumers – attracted most of the early money. Neither was in practice quite as revolutionary as the stock promoters in the investment banks wanted investors to believe. The advertising-based business model, for example, relied on accessing advertising revenues through the provision of entertaining or valuable online content. Effectively these ventures were merely an online replication of traditional media propositions and ones that in the boom period offered what was mostly inferior content. In an interesting twist, capital was also raised to create websites and services which were then heavily advertised to attract visitors, in the hope that they would in turn attract advertising revenues in the future. Such a circular model – advertising so as to get more advertising – lacked sustainable long-term growth prospects. In the short term, however, as in all bubble environments where the focus is on share-price gains rather than on business fundamentals, the absence of tangible signs of profits could be put off or ignored in anticipation of future growth.
To be clear, it was not that an advertising-based model was incapable of producing sustainable revenues, it was just that in the evolutionary phase it lacked genuine competitive advantage over historic print-based incumbents. The long-term winners from the Internet revolution in advertising were to materialise only some time later, well after the stock market crash. By then more sophisticated market research models could be used to determine and exploit consumer interests and behaviour.
The other main initial business model that investors initially latched onto was the Internet’s potential to revolutionise the business of direct retailing, where the promise of a superior cost advantage was expected to allow an army of new suppliers to undercut existing retailers. The incumbents, struggling with the need to maintain and operate physical assets and with customers who also (in the US) had to pay local sales tax, appeared to be at a huge disadvantage. While Amazon, the most effective newcomer in the retail field, for sound business reasons selected books as its main initial product, the stock market willingly embraced a host of other companies in the B2C sector for which the model was less appropriate. Many of the sectors that Amazon’s founder Jeff Bezos initially avoided as not being viable, were able to find willing suppliers of capital in the febrile atmosphere of the period. The main precondition for new ventures to obtain funding appeared to be the speed with which a stock market listing could be achieved.
From a stock market perspective, therefore, while capital flowed from investors to newcomers in broadly the right direction, its targets were often poorly specified. It was clear that some kind of revolution was taking place, but exactly what the Internet would mean for individual companies and sectors proved difficult to determine. What was undeniable was that there was meaningful and sustained growth in Internet usage, whether measured by the number of users, the number of domain names or the number of new websites. The latter two measures in particular experienced exponential growth, not the more linear growth of user numbers, and this was an important factor in reinforcing the belief among investors that they were witnessing a genuinely revolutionary new phenomenon.
10.26 – Exponential growth in Internet users, domain names and sites
Source: Nua Internet Surveys, Internet Software Consortium: Internet Domain Survey, and Hobbes’ Internet Timeline by Robert H. Zakon. www.zakon.org/robert/Internet/timeline
10.27 – Linear growth in Internet users, domain names and sites
Source: internetlivestats.com, ftp.isc.org
Inflating the bubble
Investors played only a small part in the development and testing of the research and build out of the Internet. Nor were they asked to fund the development of the crucial infrastructure of the World Wide Web. This reflected the fact that almost the entire physical system was already in place, thanks to the earlier funding by government and the existence of an established telecommunications network. Funding the companies that queued up to take advantage of the Internet in its early stages was not therefore particularly capital-intensive. Cisco had at least rudimentary products in place before the founders had left their place of employment. Mosaic had much of its development work completed at university before Jim Clark raised the funds to pull out Andreessen and create Netscape. Yahoo was the product of postgraduate students using their time on campus to pursue their own interests before realising that there was commercial potential in their efforts. All these companies were vital early cogs in the development of the Internet as a commercial venture.
This does not in any way decry the achievements of these early pioneers – they all had to raise funds, work long hou
rs and make personal sacrifices to create a business – but they had at least a rudimentary product at the point at which they were raising capital, and the amounts of capital they sought to raise were relatively small. The main company that differed in this respect was Amazon. Jeff Bezos from the beginning saw the potential of the Internet and set out to build a company that had the ability to take advantage of it. His business was self-funded in the early stages. External capital was only sought when he had run out of personal funds. By the time external capital was required the Internet bubble had begun to be inflated by the success of Netscape and others and he was able to raise funds without great difficulty.
The same optimistic environment that assisted Amazon fed on the early success of the company and continued to propel the share prices of other listed Internet-related companies. This created growing appetite for new securities that could potentially follow the same path. Because initial capital funding costs were relatively low, new companies were formed at a prolific rate. Wall Street embraced this lucrative money-making opportunity with enthusiasm and there emerged a seemingly endless supply of IPOs to meet demand from investors.
These IPOs followed the time-tested route of building a book of potential institutional investors and placing only a limited amount of stock with the general public. The aim was to ensure aftermarket demand, such that the share prices would immediately rise and the demand for IPOs would be sustained and fuelled by the instant profits. A lucrative chain of events had been set in motion, where everyone gained so long as share prices rose. Venture capitalists and owners gained as their investments were monetised at IPO. Investment bankers and brokers gained in three distinct ways: directly from the fees associated with the IPO process, indirectly from the power to place stock to hungry clients, and indefinitely from an ongoing corporate banking relationship with the companies in question. Institutional investors gained if they were given stock in an IPO, since they obtained both stock and the knowledge of the level of over-subscription, allowing them to measure the scope for an instant profit.
Members of the public also stood to gain directly from the run of IPOs if they were fortunate enough to obtain stock – or as long as the share price continued to rise after listing. They might also have gained indirectly if they held mutual funds which took stock in IPOs or placings. A number of institutions were unable to resist the temptation to ‘goose’ the performance of their funds by over-weighting their portfolios with stocks obtained in an IPO, thereby furthering the track record and attracting more assets.
The presence of collective funds distinguishes the period from that of the very early technology booms, but only at the margin. In an easy-money environment, stock market gains readily attracted additional capital. The specialist press which had grown with the new medium performed its usual evangelist role, which spread to the mainstream press to some degree, although the latter remained relatively balanced in its assessment of the new developments. As in previous booms, the mainstream press both commented on the potential of the new technology and questioned the validity of the expanding valuations. As the excesses increased, satirical cartoons lampooned what was happening, just as they had in times past. Moreover, the valuations, many of which were as patently absurd as those of the Japanese asset bubble of the 1980s, prompted the publication of a number of books spelling out just how detached from reality they had become.
Valuation issues
None of this did anything to dampen the enthusiasm of investors. Technology share prices were rising so fast that investors were quite willing to suspend their disbelief. This applied not just to private investors but to professional ones, many of whom either believed the hype or were so concerned about how their performance would look relative to their peers that they joined in the frenzy. The net impact was a stock market in which a relatively narrow segment provided incredible returns while returns from the wider market indices were disappointing by comparison. The reality was that even the returns from the wider indices were substantially higher than historical averages. This was also justified by reference to the new economy, the argument running that the Internet would have such a profound impact on the global economy that assumptions about the levels of non-inflationary growth that could be sustained in the long run were ratcheted upwards, making it easier to rationalise higher returns accruing to investors. In other words, the world was in the throes of a new Industrial Revolution.
10.28 – Unswerving faith: the disciples remain convinced
Source: Montage – source in art itself. Cartoon courtesy of Steve Way, ‘dosh.com’ strip in Punch magazine.
10.29 – But the sceptics remain unconvinced
Source: Montage – sources in art itself. Cartoon courtesy of Steve Breen, Asbury Park Press.
The question for the investor was therefore: did the Internet really have the capacity to change the investment rules of past decades? Was it of a different order of magnitude to the other technological advances outlined in the earlier chapters of this book? We know the answer now, but it was not so apparent at the time. Analytically the answer to these questions was relatively straightforward. The Internet was sure to prove highly disruptive to existing business models and to enable all manner of future developments – but would it in practice be any more disruptive or transformational than previous advances? Consider the traditional light sources that involved harpooning whales and harvesting their blubber to fuel lamps as compared with electric light. Or take the health benefits and impact on mortality rates arising from the absence of manure on the streets that followed from the replacement of horse-drawn transportation – not to mention the wider revolutionising impact of the internal combustion engine on transport and logistics. In the space of 30 years human progress witnessed the emergence of the telephone, electric light and the automobile. This is the context within which the Internet needs to be considered.
Irrespective of background, eventually the value of all companies is anchored to their ability to deliver profits. The trajectory of sales growth is important, but the trajectory has to be sustainable and deliver bottom-line profitability at some point. As the late 1990s bubble developed, share prices ceased to be rooted in serious analysis. To any fundamental investor it was patently obvious that valuations in the TMT sector were massively and indiscriminately inflated. An individual company might survive and prosper, but in aggregate it was simply impossible for them all to be worth as much as they were priced to be. The Internet bubble is an example of collective absurdity to rank alongside such predecessors as the 1980s Japan bubble or the Nifty Fifty in the 1960s. As is normally the case, those who tried to counter the notion that it was a bubble did little to rebut the fundamental analysis, but instead implied that any criticism was down to either a lack of technological knowledge or a failure of imagination.
It was inevitable that in due course the excesses of previous bubbles would be repeated and the bubble would deflate, although it took longer than even the most hardened sceptics expected (to that extent they were indeed guilty of a lack of imagination). The following years duly produced a string of revelations about share-ramping scandals of a kind that had, of course, been associated with previous periods of excess. Conventional accounts of the period marvel at how so many Internet companies raised venture capital and were able to translate this into huge stock market gains before the bubble burst. The behaviour of those who helped to bring so many worthless companies to the public markets, and the dangers of the many conflicts of interest which they faced, also inevitably came under the spotlight. In one notorious case, the Merrill Lynch technology analyst Henry Blodget was penalised for expressing one view in public and a quite different one in private (for example, giving Excite the second-highest rating to investors but describing it as “such a piece of crap!” in private emails). This led to a $4m SEC fine and a permanent ban from the securities industry. This might have been one of the more egregious examples but it was not isolated. Such misdemeanors and displays of cynicism and
greed did not differ significantly from history. Every stock market bubble has had them. Moreover, it was less than ten years later before similar venality was being displayed by the financial sector – culminating in the global financial crisis of 2008. In the financial crisis the ‘magic dust’ was not sprinkled upon increasing expected growth rates but rather on the supposed abolition of risk through the use of new and complex financial instruments.
Web 1.0 (1997–2003): analysing the Internet boom
The success of the early Internet companies of the TMT bubble could be judged in two ways. One is the traditional method of estimating the profits they earned and the potential growth that lay ahead. The second is to measure the gains that the positive stock market reaction gifted to investors who jumped on the bandwagon early enough to cash in before the inevitable denouement. The two categories should in theory be related, but in reality only a small number of companies managed to obtain the profitability that their share prices at the peak seemed to be discounting. A much larger number ended up flattering to deceive. Investors were willing to accept valuations based on estimated future prospects which were becoming ever less tangible, and as a result the pace of company formation and flotation shot up at a prodigious rate. Supported by a low-interest-rate regime and a vibrant US stock market, for a while demand for new issues seemed insatiable. Throughout the latter part of the 1990s increasing numbers of ‘new economy’ companies were floated, not just on NASDAQ, the specialist American technology market, but also on equivalent markets in the Europe, Asia and Latin America. It was a global phenomenon. Typically substantial premiums to issue price were achieved on the first day of trading, delivering immediate profits to those who subscribed for shares. As the level of over-subscription was usually released as a running commentary ahead of the IPO completing, those profits were often effectively risk-free. These instant profits were a classic example of the ‘greater fool’ theory of investing and provided the fuel that kept the IPO engine running.
Engines That Move Markets (2nd Ed) Page 57