How did this differ from previous technology bubbles? The answer is that it did not. The chart showing how rising share prices and the potential for immediate gains attracted investors’ capital in the railway mania of the 1840s is more or less identical to that which characterised the Internet bubble. Monetary conditions at the time of the railway and Internet bubbles, even allowing for the different historical circumstances and economic conditions, are uncannily similar. In the case of the Internet the most striking characteristic was the shortness of time it took to move from concept to public listing. As listed equity investors no longer cared about proof of profitability, it meant that there was little discrimination in the placing of funds. When pie in the sky was the prevailing imperative, one stock was as good as another.
The ‘bubble’ arose because collectively the implied profits that needed to be created to sustain the aggregate valuation of the sample were simply implausible. You did not even need to be in the Internet business to command an Internet premium. Higher valuations accrued to any business which could plausibly claim to have links to the emerging technology, however tangential. Telecom companies that were not even directly involved in the Internet at that stage had valuations which could not survive any form of sober analysis. Even traditional print media companies, which were to become among the most prominent victims of the new technology, saw their valuations ascend simply because they could be lumped in, on superficial analysis, under the broad ‘TMT’ moniker.
Experience from earlier bubbles suggested that professional analytical standards would inevitably slip as valuations became ever more absurd. Typically what happens is that the higher share prices move, the higher up the income statement analysts look to base their valuations. In the case of the Internet bubble, valuations moved up from profitability to revenues, and then beyond revenues to concepts such as website ‘hits’ and promises of future revenue some years ahead. While it can be justified to look beyond dividends and earnings to cash flow and revenue as an indicator of value, and out in time beyond a four- or five-year horizon, it rarely makes sense to do both at the same time. For the Internet bubble the horizon appeared to be off the scale on both counts. While companies such as Cisco benefited in the traditional way in its early years by delivering impressive revenue and profits growth, that phase soon passed.
As investors watched the drama of the Internet unfold, they were increasingly prepared to accept the absence of profits so long as top-line revenue growth was evident. Eventually analysts resorted to using any type of metric they could find, however implausible. Measures such as the number of ‘eyeballs’ looking at a website, the number of visits made to a site and the ‘stickiness’ of those visits were now used to justify investment. Some analysts resorted to asserting that in the new economy ‘old’ techniques of valuation did not work and could therefore be discarded. Unfortunately it did not make their use as valuation measures any more justifiable than when share prices soared in previous technology bubbles.
Many companies also increased the proportion of employee remuneration paid in the form of equity. Investors in turn became increasingly complacent about the future dilution of their interest in the companies they owned and the risks involved in diverting precious cash flow to share buybacks rather than reinvestment in the business. Companies buying back their own shares were rewarded by a rising share price, apparently irrespective of the impact which the change in capital structure would have. In retrospect, it is clear that this new dynamic dangerously distorted the priority of CEOs. It also showed that investors had failed to learn one of the most important lessons of earlier technology bubbles. In the end, just as Fayant described when writing about the boom in radio shares nearly 100 years earlier, there is no escape from the scissor blades of cash flow. No amount of financial engineering can make up for the absence of profits and dividend-paying capacity, a classic red flag for investors.
10.30 – Dot-con
Source: Wall Street Journal, 17 April 2000.
10.31 – The link between interest rates and Internet share prices, 1997–2001
Source: Federal Reserve Board of Governors. Thomson Reuters Datastream.
Out of the wreckage
If the valuations attributed to many TMT companies in the bubble era were patently absurd, it did not mean that no new enterprises of real value were being created. As so often in the past, out of the wreckage of the stock market crash some survivors prospered. New companies that nobody had heard of before emerged to create businesses which in some cases, such as Google and Facebook, have become industry titans in their own right. To give a flavour of the transformative effect of what happened since the dot-com crash, at the end of 2016 the combined market capitalisation of three such companies alone – Google, Facebook and Amazon – exceeded that of 50% of the top 100 companies listed in the UK. It was also equivalent to roughly 20% of the Dow Jones Industrial Average index, which includes companies such as Apple, Microsoft and Cisco.
There is nothing ephemeral or illusory about the success that these companies have enjoyed. The impressive rewards earned by shareholders in the first two of these companies fairly reflect the underlying growth in sales and profits they have achieved. Amazon is a slightly different case. Despite its remarkable transition from bookseller to global retail platform, and its subsequent move into the creation of digital content and provision of cloud services, the jury is still out on the profit margin that will finally be delivered on the company’s incredible growth in revenues. Nobody can dispute, however, how impressive the company has been in executing the development of its business.
It is worth noting in passing another echo from previous technology bubbles, which is the prosaic nature of many of the businesses that the Internet revolution spawned. When the Royal Mail introduced the ‘Uniform Penny Post’ in 1840 it coincided with the growth of the railroads. This happy conjunction allowed the Welsh entrepreneur, Pryce Pryce-Jones, to launch the first modern mail-order business in 1861. In the US, Tiffany’s mail-order Blue Book was created in 1845, with the Montgomery Ward business following a similar path in 1872 and Sears in 1888. For the Penny Post/railways and mail order, read the Internet and Amazon. Similarly, inducements for consumers to reveal their preferences to advertisers and producers have a history which long predates the birth of Google and Facebook.
Advertising: the tectonic plates have already shifted
The narrative of how the Internet has developed follows – and builds on – earlier technology breakthroughs in other ways too. The global interconnected network it has created is a natural successor to the telegram, telephone, radio and television. The telegram transmitted short written notes from one individual to another. The telephone enabled one-to-one verbal communication. The radio transmitted audio content from a single person to many listeners. Television did the same for visual content. The Internet now enables interaction in all these media to move from the many to the many. The data implications of this are enormous. Now it is possible to build a record of consumer preferences based on actual activity, operating in real-time. Companies can immediately monitor consumer behaviour in response to variations in pricing and product.
The first iteration of this has been the updating of the traditional model of market research. The historic model of consumer surveys or interviewers on the streets offering vouchers/cakes to their victims as an incentive or reward has been replaced by ‘free’ access to highly sophisticated and powerful tools such as search, email and social networking. Enabled by the ubiquitous development of the Internet, consumers have become avid users – to the extent that many would be lost without the ability to ‘Google’ a question or ‘Facebook’ a friend. Notwithstanding the level of penetration of these tools, it is revealing that they share a common characteristic: consumers cannot be persuaded to pay for the services directly. In this sense the providers can be termed ‘by-product’ companies; companies whose revenue derives not from the service they provide but from the information whi
ch their usage creates.
While users may not be willing to pay for the services directly, they do pay significant amounts indirectly through the value of the information that their use provides. Advertisers have been very quick to realise the power of the Internet and revenues have shifted swiftly to the ‘new’ medium to the point that the rate of growth is already slowing. The initial losers were the ‘old’ medium stalwarts such traditional newsprint-based advertisers but TV has now also begun to lose share. Growth in online advertising revenues will continue but the field will become more competitive as other ‘by-product’ companies such as Twitter and Snapchat seek to access the same revenues.
10.32 – New for old: advertising swiftly moves online
Source: Magma Global Advertising.
Consumers are the biggest gainers so far…
For consumers the Internet is an ideal tool for price comparison. It is instant and widespread. As a consequence a multiplicity of price-comparison websites have emerged across a wide range of product types. These sites make it difficult for producers to discriminate on price between different consumer groups and they threaten the survival of inefficient retailers. The irony here is that branding becomes an enemy of price discrimination for the retailer. Where the product is clearly defined, so long as the consumer is convinced of its authenticity the key question becomes its price. Hence the greater the homogeneity of any product, the more likely it will become prone to price competition. This improved pricing information puts the consumer in a much stronger position.
For producers, on the other hand, increased insight into consumer behaviour helps both to identify potential new customers and to determine the effectiveness of price discrimination. An obvious example is premium pricing during periods of shortage, one which Uber has already sought to exploit with differential pricing during peak periods.
The effect of these competing forces appears thus far to have been to benefit consumers more than producers. The difference between what consumers wish to pay and what they actually pay, what economists call ‘consumer surplus’, is moving in their favour. Although this has the effect of lowering prices it is not necessarily deflationary. It is simply that inefficiencies in the distribution system are being eroded by the availability of better information. Combined with improvements in logistics/delivery, it is devastating for those companies whose existence depended upon these inefficiencies. The wholesale destruction of segments of the retail sector is testament to this.
Whereas the early years of the Internet revolution were largely about the shift from offline to online retailing, and associated changes in the source of advertising revenues, recent trends have increasingly been about the rise of digital distribution and more efficient asset utilisation. Distribution of digital content is an obvious and straightforward business proposition that depends mainly (a) upon improving data compression and (b) increasing bandwidth. The insatiable demand for accessibility has driven the roll out of fibre optic cable and the advent of standards such as DOCSIS (Data Over Cable Service Interface Specification) to add fixed-line capacity for both direct access and as a backup for mobile access. Mobile technology has itself moved on apace. The connectivity afforded by 2g is considered prehistoric and the 3g dream of the TMT bubble has swiftly moved on to 4g, with the roll out of 5g expected by 2020. Voice, data and video content are being augmented by ever more sophisticated locational-based services. The number of devices connected to the Internet is rising sharply and this will soon be joined by the widespread adoption of in-car connectivity. It is unlikely that the pace of development of either mobile or fixed-line will slow.
By whatever circuitous route, therefore, the vision of Vannevar Bush looks close to being realised. The so-called ‘memex’, where information was stored in a manner that better reflected human needs, is being achieved through the use of links, algorithms and artificial intelligence. The intuitive way that the Internet can now be interrogated has led to an explosion in its use, making it indispensable to modern life. That use has created a massive amount of new information, so-called ‘big data’, which can itself be interrogated to learn about human behaviour and improve decision-making. The economic value embedded in big data is huge. It has already revolutionised the retail sector and is increasingly adding to the richness and convenience of everyday life. Analytical techniques such as artificial intelligence have moved from the rarified sphere of academia to everyday use, allowing repeating data patterns to be identified with relative ease. The ‘professions’ will inevitably adopt this technology to simplify and enhance analysis in areas as diverse as the law, finance and medicine. Many jobs which were historically deemed as highly skilled will face the intrusion of numeric- and logic-based applications which can do the job cheaper and better.
Despite this, there remain areas where progress has been painstakingly slow. Since World War II financial services have taken an ever greater share of GDP and this trend accelerated after 1980. Advances in technology and communications, not to mention scale, have produced little evidence of cost reductions for end users. Indeed, on some estimates the “unit cost of financial intermediation appears as high today as it was around 1900”.¹⁰⁶ This is not to say that there have been no beneficiaries. “In 1980 the typical financial services employee earned about the same wages as his counterpart in other industries; by 2006, employees in financial services earned an average of 70% more.”¹⁰⁷ This has not gone unnoticed and some, such as Lord Turner, former head of the UK Financial Services Authority, have suggested that “it is possible to extract rents from the real economy rather than deliver economic value”.¹⁰⁸ Thus we have a position where technology is an increasing threat, traditional customers have lost trust, costs have escalated and regulators are suspicious of the merits of incumbents. It is hard to believe this is not the next major battleground between incumbents and challenger firms. To an extent this is already being anticipated by financial markets with new private start-ups achieving staggering implied valuations.
10.33 – Financial service value
Source: R. Greenwood and D. Scharfstein, ‘The Growth of Finance’, Journal of Economic Perspectives, vol. 27, Spring 2013.
Web 2.0 (2008+): a new bubble?
The early years of the Internet – what is often now called Web 1.0 – was brought to a close by the bursting of the great stock market bubble. This bubble was a commentary on the exuberant behaviour of investors as much as on the potency of the industrial and social changes which the explosion in Internet use and availability had created. That potency has not diminished and indeed raises the question of whether the economic and stock market impact of the technology is once again creating inflated expectations among investors.
Stock market bubbles tend to ‘burst’ rather than gradually deflate and the TMT bubble was no exception. The fallout from the bursting of the bubble in 2000 was certainly severe, with leading market indices falling by 50% or more between 2000 and 2003. From being awash with liquidity, the appetite for risk in financial markets dissolved almost overnight. Companies that had locked in capital reserves were suddenly in a position where this became a competitive advantage, rather than a hindrance.
Risk replaced reward as the driving dynamic. This was true of both the financial community and the financial press. For the financial community, the IPO market remained dormant for an extended period. Less capital was available and more proof of operating success and profitability was required before a stock market listing became feasible. The primary funding route for new businesses reverted to being private individuals and private equity. As competitors disappeared, private equity firms which had capital to invest suddenly entered a golden period of investment opportunities. In the media, the downturn produced a flood of inquests into how investors allowed themselves to be so foolish. Most Internet publications went to the wall. Hundreds of people who at one stage had been paper millionaires on the basis of shareholdings in fashionable Internet stocks discovered that they were nothing o
f the sort.¹⁰⁹ The Federal Reserve and other leading central banks slashed interest rates in an effort to stave off a damaging recession – a move that was to have unhappy consequences just a few years later.
Eventually the pessimism induced by the stock market crash faded and companies with successful business models began to show results. Early attempts to monetise search and social media through licensing payments foundered because users were mostly unwilling to pay meaningful amounts for the service. However, the richness of the personal data that use of the services provided proved in time to be a goldmine and accelerated the trend in advertising revenue from offline to online, producing fabulous revenue growth for Google and Facebook. The obvious flip side was the melting away of advertising revenues for traditional print media. In retail, meanwhile, few companies can now survive without an online distribution capability and the pricing discipline which that entails. Those that manage it well have found good support from newly enthused investors. Having a good online strategy is widely seen as a positive differentiator. Although it took a decade or so to do so, the technology sector of the stock market has once again delivered strong and positive growth for nearly five years.
Engines That Move Markets (2nd Ed) Page 58