The philosopher Søren Kierkegaard once memorably observed that “life is lived forward, but understood backwards”. In practice, it is usually only with hindsight that we can see how and why most of the technical and corporate success stories we know about today were destined to become long-term winners. By the same token the confidence with which investors typically embrace new technologies at times of rapid change may be understandable, but anyone who studies the historical record is more likely to come away with an appreciation of how little certainty, predictability or inevitability there is about technological advance translating into financial rewards, either for the key protagonists in the change process, or for the investors who seek to profit from their discoveries and inventions.
It is not much of an exaggeration to say that the corporate history of technological change is as much a history of heroic failure as it is of triumph and success. While in retrospect the winners are usually clear, there is a huge amount of survivorship bias in the data. At the time, what investors are faced with is rarely anything like as sure a thing as subsequently appears. There is a thin line between success and failure. Knowing this does not make the task of the investor any easier, as genuine technological shifts – ones that transform social and economic behaviour – cannot be ignored. Whole industries or ways of doing business can be made redundant when such shifts occur and companies which will not, or cannot, adapt are simply washed away.
This is really just another way of saying that businesses that seek to develop and exploit new technologies are, in the absence of patent protection or other monopoly features, inevitably high-risk, high-reward ventures. The risk involved in backing new or uncertain technologies is one reason why the returns from venture capital have historically been so high. The distinguishing feature of most stock market bubbles, on the other hand, is that for a brief period investors in public markets are prepared to pay ridiculous prices for businesses that ought by rights to command the much higher ratings and risk premia that are justifiably accorded to venture capital projects. They are periods when conventional and broadly rational relationships between risk and return are not just ignored, but turned completely on their heads.
Technological advances that hold out the promise of huge gains in wealth as rewards for riding a wave of profound change are particularly prone to creating such bubbles. At the peak of the Internet bubble, investors were paying prices for dot-com stocks and other Internet-related businesses with minimal track records and no earnings that implicitly assumed they were less risky than established companies with strong franchises that had been trading profitably for many years. This was not only clearly unsustainable, but a phenomenon that can only be explained by a rare combination of coincident conditions.
As with previous market bubbles, these conditions included:
the emergence of a new and potentially transformative technology about which extravagant claims could be made with apparent justification
a climate of relatively easy money and credit conditions
general investor and consumer optimism
a wave of new publications promoting the merits of the new technology
an efficient supply machine, capable of creating a host of new companies to meet investor demand
suspension of normal valuation and other assessment criteria.
We can also observe that such periods are typically christened quite early on with a simple defining name or phrase that lends itself to exciting the popular imagination. The ‘Nifty Fifty’, which was used to characterise a relatively small number of fast-growing stocks in the late 1960s, is a classic example. ‘TMT’ stocks (short for telecoms, media and technology) became the watchword of the Internet craze. BRICs (the initial letters of four emerging markets) and FAANGs (an acronym for the big five Internet age stocks: Facebook, Amazon, Apple, Netflix and Google) are more recent examples. The emergence of such monikers is typically a sign that sentiment has replaced fundamental analysis in market valuations, and is usually the precursor of eventual widespread disappointment for those who embrace them.
As with earlier technologies, it has taken several years for the true impact of the Internet to make itself felt. Few people intially recognised that the first killer application would be email. No investor in 2000 had any idea quite how successful Amazon would turn out to be, nor that two companies which exploit the new world that the Internet helped create (Facebook and Google) would grow from nowhere to become two of the five largest companies in the world – while other companies with multi-billion-dollar market valuations at the height of the bubble would turn out to be more or less valueless. While the ‘connected world’ has become a reality, as the early pioneers hoped, it has not followed a blueprint that a majority of participants who were caught up in the bubble would necessarily have recognised.
The technology cycle
It would be an oversimplification to force an exact repeating pattern on all the technological advances examined in this book. There is, however, a clear cycle of ‘events’ associated with most of the technological advances examined. This can be formalised, for the sake of convenience, as a five-stage model (see figure 11.1).
11.1 – The repeating cycle and the dynamics of technology
The early stages, up to the point where profitability is reached, are typically a battle between the rate of cash burn and retention of investor confidence. The rate at which the needed capital is supplied depends crucially upon the confidence that can be placed upon the technology’s projected commercial viability. This is determined not just by perceptions of the specific technology, but also by the general economic and financial environment in which these perceptions are formed. The latter are what largely determine the timing of stock market bubbles associated with technological change.
Stage one: concept and feasibility
The early stages of development are characterised by a large number of distinct small groups working on similar research projects at similar stages of development. Typically, they are aware of their rivals’ activities and keenly motivated to win the race against them. The telephone (Bell, Grey, Edison, Dolbear, Reiss et al) and the radio (Marconi, Fessenden and De Forest) are good examples. In each case, the inventor who won the race to demonstrate feasibility, and with it the right to be recorded in the history books as the ‘inventor’, did so by a very narrow margin.
The funding of research on pioneering technology comes from a variety of sources, including large corporations, research foundations, governments, and small groups of individual backers with personal ties to the researcher. In most cases the chain of events goes from an idea to intial funding to a business. The impetus initially comes from the power of persuasion and the vision of an individual scientist.
The initial target is to demonstrate the technology’s feasibility. In many cases, the inventors are viewed by the scientific establishment with some disdain. The inventor has to combat the negative influence of this conventional wisdom in order to maintain continued access to capital. This is rarely possible by reference to theory alone, which is why a demonstration of feasibility is vital to generate and maintain the confidence of investors.
The general economic environment has always been critical. If the economy is growing, interest rates are low, and the financial markets buoyant, stories about exciting new technologies are more likely to fall on fertile ground. Of all of these factors, the availability and cost of money is by far the most important element. If these conditions are not in place, the scientist or innovator is usually left to his own resources and contacts. What is striking from the historical examples we have cited is that the feasibility demonstration itself provides no guide as to which companies will ultimately prove successful. The Duryea brothers, for example, might have had the earliest gasoline-powered automobile in the United States, but this was not sufficient to sustain the company as competition intensified and the industry matured.
In practice, technical feasibility has to be accompanied by some
degree of patent protection before commercial success can be assured. However, even at this early stage, it is usually clear who the losers are going to be. The companies whose technology is being superseded discover that their share prices are in long-term secular decline unless they are able to adapt. Few industries have managed this successfully, and even within industries there have been only a limited number of examples of incumbent companies successfully embracing a new technology.
The early history of the Internet is unusual in that almost all the early research and development work was financed by government, initially the US Department of Defense. Where previous pioneers such as Babbage, Marconi and De Forest had to court the military for funding, the drive to link computers into networks came at the behest of government, rather than the other way around. Companies that developed this infrastructure therefore had their R&D paid for them. Basic research was conducted within the academic community, and again largely funded by government grants. While it was many years before commercial applications came to the fore, when they did, the fact that an infrastructure was already in place meant that they could move straight to the second stage, without the need for public demonstrations of feasibility.
Stage two: from feasibility to prototype
The stage that follows the announcement of an apparent leap forward in technology mainly revolves around attempts to reinforce the perception of success. The demonstration of scientific feasibility has rarely been sufficient on its own. A robust prototype is usually required. The press is typically enthusiastic and extrapolates the technology to provide a vision of all its potential future benefits, while academia remains sceptical.
Taking the new technology from a theoretical demonstration to a technically proven and robust model requires capital. Again, the extent to which capital is forthcoming depends more upon the economic conditions of the time than on the inherent merits of the new technology. If the economy is growing and interest rates are low, sentiment among capital providers will be more favourable. If the converse is the case, then for the inventor it is very much a case of beg, steal or borrow.
Buoyant financial markets typically seize on technological advances. Those pursuing a new technology find that capital can be raised relatively easily. The knowledge that cheap capital is available soon attracts others. It does not take long for a boom to develop. At this point, investment in technology typically becomes more a function of expected stock market returns than about the merits of the technology itself. The excesses of this period are usually recognised by both the quality and satirical press, but their warnings tend to fall on deaf ears as share prices continue to rise.
This is the stage when many new companies appear, attracted by apparently low-cost capital. Failure rates increase and profitability remains distinguished by its absence. The new entrants, funded by ‘cheap’ capital, exacerbate the already difficult competitive conditions for the old technology companies and industry profitability slumps. Markets typically remain relatively sanguine about the pace of progress, preferring to focus on the brave new world about to arrive. This stage also sees the emergence of a strong ‘support’ group. The interest generated by the technology itself and the accompanying reaction creates a rapid growth market in periodicals devoted to the new technology and its applications (see figure 11.2). This need is met by a surge in the availability of reading matter, almost all of which, not surprisingly, tends to be evangelistic for the new technology.
11.2 – Disciples come and disciples go
Source: D. G. Gayer, W. W. Rostow and A. J. Schwartz, The Growth and Fluctuation of the British Economy 1790–1850, (2 vols.), Oxford: Oxford University Press, 1953. K. C. Smith and G. F. Horne, An Index Number of Securities, 1867–1914, London and Cambridge Economic Service Special Memorandum No. 37. Banker’s Magazine. Railway Times. Thomson Financial Securities Data, Datastream. British Newspaper Library, Electronic Catalogue. The Newspaper Press Directory 1846 (UK).
Stage three: funding and commercial viability
How long the excitement lasts during the phases of feasibility demonstration and prototype development has historically been a simple function of the supply and demand for capital. That is, an excess of capital or a shortage of ‘opportunities’ sustains and encourages investors to feel that they are in some way ahead of the game. In stock market terms, prices are also driven by supply and demand; the balance between the inflow of capital from investors and the absorption of this capital through new company formation and expansion. As long as the former outweighs the latter, the environment remains positive.
The move from feasibility to prototype involves increasing amounts of capital, often with little or no revenue being generated, and this typically places a strain on the balance of capital flows. As a consequence, during this stage of the process, investor scepticism increases, and requires a steady stream of positive propaganda about prospects to counter it. The scepticism is not an issue so long as the stock market backdrop remains positive. Those who fund the process become increasingly anxious when conditions begin to change. At this point the fundamentals of the company and its commercial viability increase in importance. The cash burn rate is viewed with increasing alarm. Confidence vies with cash for supremacy.
In such circumstances time is the enemy; when confidence begins to wane, the raising of cash becomes well nigh impossible. For a company to be successful requires both time and capital. Both these commodities are extremely sensitive to changes in interest rates and the economy, and should these turn against the company then almost inevitably the game is up for many participants.
Stage four: rationalisation and refinancing
By this stage, the large number of companies that set out to profit from the same new technology are facing rationalisation. All of them face the same goal, which is to translate the technology into a practical and sustainable commercial business. This consumes funds. There is a constant need to maintain confidence; hence an inflow of capital remains of paramount importance. Some ventures will fail because viability cannot be reached. Others will ultimately succeed in a technological sense but fail as an investment. The need to maintain confidence requires heavy marketing efforts to ensure that the propaganda counters the inevitable rise in scepticism fuelled by repeated ‘near’ successes (failures), the public utterings of the ‘old’ technology advocates, and an increasingly impatient general populace.
Many companies which will ultimately prove to be successful require capital infusions before this stage is reached. This results in rationalisation of the original investor group, which can take many forms, ranging from large-scale dilution to the removal of the original investors. The only companies that can avoid this stage are those which enjoy some form of legal protection from competition, through ownership of intellectual property rights. This is the stage where the survivors require to be refinanced and the long-term winners become more obvious.
Paradoxically, the stock market is often slow to react to this phase, principally because it tends to be initiated by poor financial and economic conditions. Few companies survive to reach this stage. Even companies that do survive to this stage face a big problem, which is not so much about their continued survival, but about how they can sustain the earnings growth rates which their market valuations are discounting. The option of using highly rated paper to fund new acquisitions tends to be closed off by falling share prices. Those companies who by planning or good fortune have strong balance sheets or access to capital have a huge competitive advantage, which is compounded when excitement and easy money turn to scepticism and risk aversion. It is not a coincidence that two of the most successful companies in Amazon and Google were able to navigate just such a period.
Stage five: ultimate success and failure
The history of technological change supports the view that long-term commercial success is more difficult to achieve than technological triumph. Those who understand the new technology can readily identify those within the old guard that are d
oomed to failure. Relatively early in the cycle their lack of competitiveness can be clearly seen. Existing companies must either adapt to embrace the new technology, diversify, or fade away. In pretty much all cases their share prices underperform the broad stock market indices as the new technology captures market share, growth and margins. For the investor, missing out on the poor relative returns associated with investing in these companies is easier than identifying which of the new technology companies are going to become clear long-term winners.
The long-term winners typically only emerge after a period of capital shortage has caused distress in the industry, pruning the number of participants dramatically. Only once this has happened, refunding has been secured and the unlucky companies have fallen into bankruptcy, does the ‘success rate’ pick up. There tends initially to be a fairly small number of successful companies and only after a period do new entrants appear and start to eat into the margins and profitability of the refinanced survivors. This is the stage where the market structure at last becomes relatively clear and stable.
What works and what does not
The path of technological development is influenced by a large number of factors, but a relatively small subset stand out. Success or failure depends upon not only the ultimate intrinsic viability of the technology itself, but the speed and cost of its development, its deployment, its access to funding and its protection from competitors. Historically the repeated requirement for cash injections means that the company always finds itself in a race to reach a point where a convincing case can be made before capital runs out.
Engines That Move Markets (2nd Ed) Page 61