As in previous historical periods, many investors lost large amounts of money either by trying and failing to pick the winners or by holding on to their former high-flying stocks once the peak in valuations had passed. It took roughly ten years for share prices in the telecoms, media and technology sectors even to start recovering from the dramatic declines that followed the bursting of the bubble in 2000. Now that the competitive landscape has settled down, investors have moved on to speculating where the next technlogical revolution will occur, and who the winners and losers will be in fields such as solar power, electric cars and biotechnology. The Internet and associated developments in mobile telephony and social media have meanwhile become an integral part of almost everyone’s life.
Looking back, the stock market’s initial reaction to the arrival of the Internet as a commercial reality was just what you would expect from studying earlier historical episodes. Investors sought to buy the potential winners and sell the losers. The problem was that this reaction was grossly over-simplified and exaggerated. On the ‘winners’ side, it meant that the valuation of any company that could even remotely be described as being part of the so-called ‘new economy’ was bid up regardless of merit. Almost any company in the TMT segments of the stock market went to sky-high valuations in what seemed like the blink of an eye. Favourable treatment was also extended to any company that could claim to have embraced the new digital world in some way. Even some sensible professional firms in law and accountancy were taken in by the hype, offering to have their fees for work undertaken for Internet start-ups paid in shares rather than cash. Most of the companies anointed as ‘winners’ fairly quickly turned out not to be winners at all.
The same initially indiscriminate treatment was meted out to the ‘losers’. Those that suffered included any company with products that could not easily have the ‘new economy’ label attached to them. It did not matter if their businesses were unlikely to be negatively impacted by the Internet. It was simply that, given that they could not be deemed to be part of the new Industrial Revolution, their share prices were marked down anyway – a case of guilt by association. While firms with plausible claims to be part of the new economy were bid up to the skies, the rest of the quoted universe of companies largely failed to participate at all. These bargain prices, ironically, provided those who owned and stuck with them much higher returns over the succeeding period than the companies whose new technology was creating so much excitement.
The research in this book strongly suggested that the winners would take many years to emerge and that only a minority of investors would be able to identify which ones they would be at such an early stage in the cycle. This has largely been borne out by experience, not least because some of the long-term winners, such as Facebook, did not even exist at the time of the peak in market valuations, but only emerged in a later stage of the cycle. Conversely, history strongly suggested that it would be possible to identify some of the losers at a relatively early stage. In reality it turned out that the markets misspecified both the winner and loser categories. The task was not made easy by the fact that, unlike most previous technology changes, there was no obvious single industry that faced being supplanted. It was not like railroads replacing canals, or the telephone replacing the telegraph.
The most obvious immediate threat was that electronic delivery of products would in time replace physical delivery wherever possible, a change that applied across a whole range of industries, not just one sector. In respect of tangible products, the threat that entirely new competitors operating with cheaper cost bases would supplant incumbents has proved to be limited. Few at the time predicted quite how dominant Amazon would become in reshaping the nature and logistics of the retail-distribution business. But while by example it has measurably transformed some aspects of retailing for everyone in the industry, it has not completely destroyed the high street, as many had expected. The best retailers have successfully adopted the new technology for their own purposes, using it to cut their storage and distribution costs and increasing their online sales. Retailers that failed to keep pace have disappeared, either through failure or in mergers with other threatened companies. Few of the online start-ups that raised money purely on the strength of promising lower costs, but enjoyed little or no retailing experience, have survived.
A notable early example of the speculative excess was the trendy online retailer Boo.com, which raised and burned through $135m of capital before going bust only 18 months later. Boo.com offered no pricing advantage for customers and had an over-specified but under-engineered website that proved unable to fulfil the orders it did receive. Its failure should not have been a surprise. Nevertheless, in the fevered environment of the time it attracted support from such luminaries as Bernard Arnault (the head of LVMH, the luxury brand business), Goldman Sachs and J. P. Morgan. In essence the companies that have dealt most successfully with the threat of the Internet have simply added a thriving digital business to their existing physical retail space. The business-to-business model for tangible products meanwhile retains many of the same characteristics as before, but with new features such as online search and ordering, digital stock control and electronic payment systems – all made possible by the new technology – becoming standard across the industry. Consumers generally have benefited from the positive impact of much greater price discovery, making differentiation by price much harder for producers.
The critical test for many Internet companies came, just as the model predicted, when they needed refinancing to survive. For some, this refinancing never took place and the companies folded. For others, the price of securing further finance was the loss of independence. Just as in the early 1900s (when AT&T and General Motors among others found out to their cost), evidence of a slowdown in growth or, worse, a recession, is typically enough to trigger a wave of rescue bids, as those with strong balance sheets gobble up those now desperately seeking finance to survive. This is the opportunity for well-run companies to buy their way back into the technology they have hitherto been unable to adopt by their own efforts.
Cash flow shortages, or a desire to monetise the capital created by new embryonic companies, also helps visionary companies which are further on in their development to add additional arms to their existing business. Recent history has produced many examples, such as Google’s purchase of YouTube and Facebook’s purchase of WhatsApp and Instagram. However, for every successful purchase, there are also many examples of acquisitions, distressed or otherwise, that fail to produce the desired success. Hewlett-Packard purchased Autonomy but ended up in litigation, Microsoft purchased Nokia and effectively closed the operation. News Corp’s purchase of MySpace ended up as one of the most costly failures of the new century, as the AOL Time Warner merger before it had been.
The term ‘Internet age’ might have been a useful catch-all for the TMT bubble and its aftermath but it clearly hides more than it reveals. The physical development of the Internet and its initial commercialisation was one thing but its impact on business and societal structure extends way beyond this. It might be a stretch to compare the impact to the Industrial Revolution but that should not lead one to underestimate its importance.
The broader impact and the future
While the technology of the Internet has genuinely transformed the way that many business activities are undertaken, just as the railways did in the 19th century, it has taken many years for these effects to mature and become apparent. The closest historical comparison is probably the radio industry in the years before broadcasting evolved. Everybody knew that the future was going to be different, but nobody at the outset could be sure exactly how, or where the effects would be most keenly felt. For investors, it has taken several years and many false dawns for the enduring winners from the Internet’s arrival to emerge. Some of the biggest winners today are companies, such as Facebook, which did not even exist back in 2000. Others for which investors held out extravagant hopes, such as AOL and MySpace, have
in time faltered or disappeared from view.
The Internet has spawned scores of individual millionaires, but we are still adding up whether investors in aggregate will prove to have made money from the technology, given how much capital was committed to its development. The past experience of the railways, motor car and aircraft industries is salutory in this respect. Many of the potential gains from these new technologies were competed away through a surfeit of investment, to the benefit of consumers but at the expense of investors. Technological success and corporate failure have been frequent bedfellows during the formative years of companies embracing new technology. Alongside its millionaires the Internet has also helped, as a by-product, to create huge numbers of low skilled, low-paid jobs, widening the disparity of wealth between the owners of companies and those employed lower down the corporate ladder. In this regard there may be more similarities with the Industrial Revolution than many care to admit. The political ramifications of this powerful change in social order remain to play out.
Although we may be in the final stage of the cycle, where ultimate success and failure become apparent for the early entrants, it does not mean that there are no more innovations to come. The ability of consumers to access music, films and news directly at home, for example – initially via personal computers and more recently through smartphones – has turned the media industry inside out. For incumbents in the media industry it has been a case of adapt or die. New entrants have been able to come and build successful franchises of their own more or less from scratch, as the examples of Netflix, Sky and Spotify illustrate. Cinemas have been through a complete revolution of the cycle, with physical film-watching at first seeming to go into terminal decline, only for the trend to be reversed once cinema chains realised the need to make the experience of going out to watch a film more varied and enjoyable.
The industry likely to be most profoundly affected by the emergence of new communications technology is financial services, one of the biggest in the global economy. Banking today is a very different business from what it was even 20 years ago. The disappearance of hundreds of high street bank branches is just one vivid symbol of this change. With the ready accessibility of online and mobile banking, new technology means that hardly anyone needs to visit a physical bank branch any more. This has produced distinct changes in the way that consumers behave, as well as, less beneficially, a thriving new industry of online fraud. In the first edition of the book, I speculated that the Internet would enable a swathe of brand new companies with radically different cost structures to come in and undermine the incumbents, just as Michael Dell was able to do in the personal computer industry before being overtaken by the move to mobility. The problems of out-of-date and inadequate computer systems, the so-called ‘legacy problems’ that exist in many financial services companies, hinder the ability to respond to the new world. One can see how various segments of the finance sector could be attacked by new entrants threatening the fat margins traditionally enjoyed by banks and insurance companies.
While some new entrants have indeed emerged, to date the degree of change in banking and insurance has been slower than I expected. An increasing regulatory burden, hugely reinforced after the global financial crisis of 2007–08, combined perhaps with customer resistance to change, has restricted the ability of new entrants to take market share from the big banks and insurance companies, which still dominate their sectors. The technology has, however, fundamentally changed the way that these two industries operate. Price transparency has increased, helped by the emergence of price-comparision websites for mortgages, pensions, insurance and other financial products. The Internet has enabled the process of financial intermediation to accelerate. Credit decisions have been largely outsourced to third-party providers. The manufacturer of financial products, whether it be mutual funds or insurance policies, increasingly needs to distribute through a network of third parties rather than having its own direct distribution capability. Many large financial companies have, as expected, struggled to cope with updating and maintaining information about a client base whose information is largely resident on computer systems which have been rendered redundant by Internet technology.
As for the development of new competitors, do not expect to see a wave of new digital banks replacing the incumbents any time soon. More likely is that we will see a gradual process of individual services being picked off by more nimble and attuned competitors. Any service that can be more easily conducted through mobile technology will be attacked. Clearly the higher the margin these services currently achieve, the more attractive they will be for competitors. As an example, it is almost impossible to imagine that the spreads charged for tourist foreign-exchange transactions will exist in ten years’ time. Paying a 10% margin for what is effectively a risk-free transaction is only sustained because of the lack of alternatives. A number of start-up firms are beginning to provide this service at exchange rates much closer to the spot rate historically only available to large institutional customers. There are numerous examples of new specialist entrants, from peer-to-peer lenders to ‘robo’ asset managers. Size and scale are not the barriers to entry they used to be. The point is that business models are being undermined and this will accelerate as the data reservoirs continue to swell and provide ever more accurate insights for targetting clients. Furthermore, the financial crisis holed the reputation of many large financial institutions below the waterline, which has had the effect of reducing that particular barrier to entry. The emergence of cryptocurrencies enabled by the technology of distributed ledgers should be viewed in this context. There are all the characteristics of historic precious metal bubbles in the price performance of bitcoin (for goldbugs read bitbugs), but its ability to garner such favourable comment and support is not unrelated to the reputational damage incurred by the financial industry in the aftermath of the financial crisis.
The point of technology is to create new things and make old things better and cheaper. By definition, making old things better and cheaper must have an impact on existing producers. In addition to its effect on physical products, technology is a huge enabler of buyer choice. For example, the Internet has become an extraordinary and transformative mechanism for price discovery. Consumers who might previously have had imperfect information and been forced to accept price regimes because of proximity or limited availability suddenly have a much wider field to work with. Price-comparison sites are the most obvious manifestation but it is much more pervasive than this. Not only do consumers gain access to more competitive pricing, but the search process itself reveals consumer preferences. Revealed preferences are potentially critical to the pricing decisions of producers, hence the massive expansion in ‘data’ as a valuable commodity.
This data is also being applied to the whole sourcing, manufacturing and logistics/distrubution chain to try and both remove cost and expand reach. The counterpart to the impact on digitisation and its effect on the need for physical storage has been the revolution unfolding in distribution of physical products. Amazon has been at the forefront of developing cutting-edge distribution capability, which has drastically cut the time from customer order to product delivery. This has been enabled by the ability to process and understand customer order patterns, the advances in robotics/recognition and the development of gps and mapping systems. As a consequence we now have a range of products that can be delivered within a very short time which would have been unthinkable even 20 years ago. For the consumer this is a huge improvement even if there is no discernable impact on published economic statistics. The technology improvements have also had an impact on the labour market just as they did during the Industrial Revolution.
An integral part of the Industrial Revolution and the subsequent development of mass production was the specialisation of tasks. So-called ‘piecework’, where workers were paid according to their output, had a history long preceding the Industrial Revolution. For example, the garment trade in the UK had developed what was known as t
he ‘sweating system’, where a ‘sweater’ oversaw production. The abject working conditions eventually stimulated legislation to protect workers in what become known as sweatshops. The advent of automation took piecework to new levels with the introduction of more accurate productivity measurement methods such as the ‘Scientific Management’ of Frederick Winslow Taylor. The resulting timed piece-rate system created a work environment where failure to meet output targets ended in penalties or dismissal. Just as the ‘sweating’ system was open to potential abuse, so too was the metered piecework methodology and eventually minimum-wage legislation was brought into place in most developed economies to protect the rights of employees.
Why is this relevant now? The answer is that the ‘gig’ economy is creating vast numbers of jobs effectively based on piecework principles. Not only employee output can be measured, but because of gps so can physical movement. Layered on top of this is the ability of companies to effectively subcontract these task to individuals by treating them as self-employed. All of this has been made easier by the Internet and its associated technological advances. On the assumption that human nature has not changed, it is likely that the power this conveys will tempt some employers to treat their employees or ‘subcontractors’ in a manner which will eventually prove to be unacceptable. More generally, it is likely that the gap in wage-bargaining power between the skilled and unskilled will continue to widen, bringing with it associated social and political issues. The historic backdrop is that when there are such changes in the societal structure, they bring with them unrest and political consequences that cannot be ignored.
Engines That Move Markets (2nd Ed) Page 63