Timeless lessons about technology investing
The ten episodes of profound technological change that make up the basis of this research highlight a number of common themes. Each episode naturally has its own distinct features and no two episodes are precisely alike. But they all underline how difficult it is ex ante for investors to make rational or confident decisions about where and when to invest in an emerging new technology. So many variables are uncertain or unpredictable. Periods of speculative excess clearly create opportunities for short-term gains. These gains are the honey that lures so many investors into the high-risk trap of trying to pick the winners from a new technology craze. This is a game, however, that only the nimble can hope to win.
For long-term investors, the issues are less clear-cut. In many historical cases, while it might have been possible to invest in the winners at lower prices earlier in the cycle, the probability of success would still have been quite low. Consider if, for example, one had foreseen the future success of the railways. At what point would it have become obvious that excess capital had been diverted to the sector? Or that much of it had been squandered on poorly built or inappropriate lines, to say nothing of the amount siphoned away by fraud?
To invest in the telephone one had to presume to greater foresight than Western Union, the dominant communications company of the day. On electric light one would have had (a) to go against mainstream opinion and not invest in arc lighting; (b) to go against public opinion and invest in incandescent lighting; but (c) only do so once the rationalisation of the various companies had taken place. At the time the question of which technology was going to win remained in the balance for some time.
11.5 – In the end it is all the same
Source: Montage – sources in art itself.
The history of the automobile provided an even more nuanced choice. If by chance you had been able to identify the genius of Henry Ford at an early stage, it would have been important to wait until he had been bankrupt twice before investing in his third venture, the Ford Motor Company. Or, in the case of General Motors, you would have needed to twice avoid the acquisitive excesses of Durant. In the same way the investor would have had to know that the two existing technologies, electricity and steam, would fail to maintain their progress and be overtaken by the internal combustion engine.
For the personal computing age one would have had to wait for Apple to appear, but remembered to exit before Microsoft attacked the space; to understand the dynamics of IBM and the coming of Compaq, but be ready for the arrival of Dell! This would have meant ignoring hundreds of other competing companies that grabbed the headlines and market share during the early years. In the case of Apple, the investor would later have needed to decide when and how to buy back into the company’s shares in anticipation of the extraordinary success of the iPhone.
With all of this in mind, the following are some of the general guidelines that I take from the analysis of past historical examples:
1. Many big breakthroughs in new technology are derided when they first appear
Far from being seen as potential transformers of economic or social life, many of the biggest breakthroughs in technology over the past 200 years have been initially greeted with hostility or condescension, even by experts who should have known better. The reason for this is that new technology by its nature threatens the existing order of things and in doing so creates a conservative reaction from incumbents.
The following contemporary quotations are just a few of many similar examples that could have been quoted:
The railways
“What could be more palpably absurd than the prospect of locomotives travelling twice as fast as stagecoaches?”
– The Quarterly Review, March 1825
“Rail travel at high speed is not possible because the passengers, unable to breathe, would die of asphyxia”
– Dr Dionysius Lardner, professor of natural philosophy and astronomy at University College, London
The telephone
“Well-informed people know it is impossible to transmit the voice over wires and were that it were possible to do so, the thing would be of no practical value.”
– Editorial in the Boston Post, 1865
“What use” he asked pleasantly, “could this company make of an electrical toy?”
– William Orton of Western Union turning down the offer of Bell’s patents for $100,000
The automobile
“The ordinary ‘horseless carriage’ is at present a luxury for the wealthy; and although its price will probably fall in the future, it will never, of course, come into as common use as the bicycle”
– The Literary Digest, 14 October 1899
Radio and television
“You could put in this room, De Forest, all the radiotelephone apparatus that the country will ever need.”
– W. W. Dean, president of Dean Telephone Company, to Lee de Forest on prospects for the audion, 1907
“For God’s sake go down to reception and get rid of a lunatic who’s down there. He says he’s got a machine for seeing by wireless! Watch him – he may have a razor with him.”
– Editor of the Daily Express in response to a visit by John Logie Baird, 1925
The Internet
“By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s.”
– Paul Krugman, Nobel Prize-winning economist, Red Herring, Issue 55, 1998
2. As a result, many pioneers of new technologies have to struggle in order to win initial acceptance for their inventions or breakthroughs
There are many examples of this phenomenon. Thomas Edison spent years battling to convince a sceptical world of the merits of his incandescent lamp. Guglielmo Marconi had to do the same with his early work on wireless technology. In these and other cases, without favourable economic conditions, the pioneers of new technology have often needed to display huge amounts of fortitude and stubbornness in order to prevail. Anyone who has read James Dyson’s autobiography will recognise how this phenomenon has not entirely changed, despite the ready availability of venture capital and other funding sources. It is only in exceptional conditions that shortage of capital and scepticism suddenly cease to be an issue for technology pioneers. These periods are the exception rather than the norm.
3. The inventors and pioneers of new technology are not always the best guide to what is going to happen
Despite their persistence and stubbornness, many inventors and pioneers of new technologies fail to grasp the true significance of what they have found; and even when they do grasp it, are not always able to cash in on it, usually because of financial pressures. History records many examples of those who have been forced to sell the rights to their inventions at what subsequently proves to have been giveaway prices. Heroic failures are two a penny in the story of new technology. When radio first appeared, it was widely assumed that its main use would be for interpersonal communication, competing with the telephone, whereas in fact its real growth was to come through the development of broadcasting. Many Internet companies made a similar mistake, believing that the principal market was in B2C applications of physical products.
4. New technology and overpromotion have always gone hand in hand
Scepticism and shortage of funds demand industry pioneers sound confident at all times if they are to have any chance of finding the risk capital that they require. Overegging the potential of new breakthroughs is part and parcel of the territory of developing new technology. When an overpromoted concept reaches the stock market, this can easily translate into a bubble if market and liquidity conditions are receptive. This is what happened with Internet stocks, just as it happened earlier with railway companies (the 1840s), radio shares (the 1920s) and electronics companies (the 1960s). Investors who are promised the earth from a new technology invariably need to adopt a healthy scepticism, and to beware of arguments that ‘this time it’s different’ – what
Sir John Templeton called the four most dangerous words in investment. When analysts dispense with traditional valuation criteria in order to justify prices that cannot be justified any other way, it is a ground for caution.
5. Winning the technology battle is no guarantee of commercial success. Nor does the best technology always win
In many cases, once a new technology has been demonstrated to work, it is followed by fierce competition from scores of rival producers to bring it into commercial production and viability. This inevitably lessens the possibility that investors can pick the eventual winners; and lessens also the scale of the returns that they stand to make even if they do successfully pick out the best technology. The winners of these competitive struggles are not always those who have the best technology, but those who can most clearly see the way that an industry or market is likely to develop. It is not clear whether Amazon necessarily had the best technology, but it is hard to argue that it did not have the vision. The path was clearly and unambiguously articulated by Jeff Bezos, and all contemporary accounts of Amazon point to his messianic zeal in driving the company to its position as the low-cost distributor with the highest reliability.
A company that has the capability to implement the right market strategy can overcome the disadvantage of having technology which is not necessarily superior. Microsoft is perhaps the best-known modern example, but there are others. Microsoft has consistently been managed against a vision of the future that has proven largely accurate, but it has also been swift to react when its original thinking was proved wrong. However, Microsoft was unable to navigate the shift to mobile platforms successfully, suffering the ignominy of losing the dominant share of the mobile market to Google’s Android operating system.
6. Insiders usually make the best returns from new technologies
Many new technologies in the past have made plenty of money for insiders, but outside investors have fared less well. In part this may just be an issue of timing and the investment cycle. Sometimes it has been the result of false and misleading accounting, sometimes the result of a lack of equity in the treatment of different classes of investor, and sometimes simply the outcome of outright fraud of one kind or another. This phenomenon recurs time and again in past periods, though fraud and misleading accounting were inevitably more common in the early years, before legislation and effective regulators emerged to provide greater protection to investors. It is no accident that the railway mania of the 1840s was followed by improvements in company law.
During any period when investors are willing to suspend rational valuation measures in order to chase short-term speculative gains, there will always be manipulation. Investors willing to suspend reality have always been simply too attractive a proposition for unscrupulous operators. The early railway companies, for example, all competed for investors’ capital by promising and paying high rates of dividend. As these dividends could not be covered by internally generated cash flow, the companies could only pay them by taking on large amounts of debt or by paying them out of capital. When this game was exposed, share prices in railway companies collapsed, never to recover.
A different aspect of the same phenomenon is that of the Ford Motor Company. This was unquestionably the most successful of the early automobile companies. Thanks to the Model T, Ford was able to achieve and sustain compound returns to its investors of more than 50% per annum for nearly 20 years. Unfortunately, the company was so successful financially that it was entirely self-financing throughout this period. Only the initial investors who participated in its first fundraising in the early 1900s enjoyed the benefit of these returns (but note that this company was the third that Henry Ford started, the other two having failed). Companies without need for external capital by definition have no need to bring in new equity investors. These companies are, though, relatively rare.
This iteration of the Internet has been characterised by the length of time companies have remained in private hands through funding rounds. This has been facilitated by the success on listing of their predecessors such as Google and Facebook, but it has allowed them to avoid the financial spotlight and scrutiny which comes with public listing. It will be very interesting to see whether investors who enter at the later stages of their private ownership will reap ‘private equity’-type rewards on exit.
7. Bubbles in financial markets require more than just a new technology
As has been mentioned, other necessary factors for a bubble include some or all of the following: easy monetary conditions (typically low interest rates), a previous period of relative prosperity and calm, the emergence of an extensive and uncritical trade press, and a general climate of optimism and overconfidence. Bubbles boosted by favourable economic conditions occurred in the 1840s, the 1900s, the 1920s, the 1960s and the 1990s. The timing of the bubble has more to do with external conditions than the current state of development of the technology that is ostensibly the subject of the bubble. Ironically, one of the clearest lessons to emerge from history is that in almost every case the quality press warned about the dangers of the market bubble emerging at the time. These warnings were usually ignored.
In recent years the world has been characterised by an interest-rate regime where governments have deliberately and openly lowered the cost of money in an attempt to boost asset prices. It would be perverse to expect that this has not assisted the flow of capital to funding private companies.
8. The only surefire way to make money from new technologies over any extended period of time is through monopoly protection
Even with the most successful inventions, commercial success may be short-lived. Unless the companies involved have patent protection for their products, or are shielded from competition by powerful barriers to entry of another kind (such as a sustainably superior cost curve), the degree of effective competition is probably the single most critical factor in determining how profitable investment in new technologies is going to be. Above-average returns are often simply competed away. In some cases, companies may be expropriated by government (a fate that effectively befell Marconi in the United States after World War I) or fall subject to a takeover. In other cases, it can simply be a case of a new technology being superseded by a newer and superior successor (as happened with the canals and railways, and the telegram and the telephone). Whatever the reason, as a technology company without monopoly protection, excess returns can only be retained by continually reinventing oneself, with all the risks that this involves. These questions are evident even for companies that dominate today’s market capitalisation tables: can Apple continue to produce innovative new products with global mass market appeal? How long will Google be able to resist regulatory pushback against its apparent natural monopoly?
9. All new technologies veer from capital starvation to capital surplus and back again
In virtually every industry that has experienced rapid or far-reaching technological change, periods of boom and abundant capital have invariably been followed by phases of retrenchment, industry consolidation and recapitalisation. These are usually much better times for investors to buy into a new technology than at the time when it is most in demand, as prices are invariably much lower and it is possible to invest on more favourable terms. By the same token, periods of capital surplus are the ones when the worst excesses tend to occur. The high prices that can be commanded for risky businesses, and the presence of widespread media attention, are magnets that eventually lead to an oversupply of the commodity for which investors are clamouring. Eventually the pendulum will swing in the opposite direction and access to capital will again become more difficult.
10. Understanding technology is a vital component of generating superior returns – but investing in early-stage technology companies is a losers’ game
It is worth emphasising that most new technology companies are fated to be losers. It is a high-risk game, in which many are called but few are chosen. New company formation in the technology area is characterised by a high mort
ality rate and fluctuating market leadership. Successful companies do eventually emerge, but they are rarely the ones that appeared successful in the first flush. Often they are companies that failed in earlier incarnations and have been recapitalised to try again. Recessions act as very powerful filters in this process. Investors need to own the companies that successfully deploy new technology and avoid those that do not. This takes time to unfold.
Engines That Move Markets (2nd Ed) Page 64