Friday, August 16, 2002
Some thoughts on the internet bubble.
I object to the name. The pioneers of the internet did not cause the bubble, and their stocks were not those most inflated by the bubble. Rather, the bubble was caused by easy credit and the greed and fraud that flowed from jealousy on the part of other market participants towards the deserved gains reaped by the internet pioneers.
How can I say these things? Don't we know that the whole reason we are in our current pickle is that companies like Amazon.com were able to raise equity capital to finance gossamer dreams? Don't we know that the internet was one big scam and fraud?
Well, no. I took a look at the stock performance since IPO of some of the leading internet companies. And what I found is: if you bought these companies early, you would still have a pile of money - and a considerably bigger pile than you would have if you had invested in mainstream technology companies or in the market as a whole.
I focused on companies that, at and before their IPOs, generated considerable interest because of their innovative - even crazy - business models. These are the companies that invented the internet, not the companies that followed in their train. There is no question that at the time, and even before, their IPOs that these companies were viewed as the most interesting new businesses of their generation, the companies who were defined the new business models made possible by the internet.
I picked 4 companies, one from each year beginning in 1995 and ending in 1998, when the credit-fuelled stock bubble really began.
Here are the companies:
NETSCAPE: IPO in August of 1995. This company's IPO inaugurated the genre of the internet IPO. It was the first example of what would become an avalanche of companies launched with tiny revenues and tinier or negative earnings, companies that gave their products away, companies that went from concept to IPO to multi-billion-dollar market capitalization in a matter of a few years. Netscape is the company that put the internet on the map of the public imagination.
How would you have done buying the stock at its IPO? Netscape is actually the toughest of the list, because it was acquired by AOL in March of 1999. At its purchase price, it was worth seven times its split-adjusted IPO price. Since then, of course, AOL's share price surged and collapsed. It's now down over 80% since March of 1999. Even after that drop, however, an investor would have made about a 25% return on Netscape - a lousy return, certainly, compared with either the market in general or with tech stocks in particular, but probably not as bad as you would have thought.
The other names look substantially better.
YAHOO: IPO in April of 1996. Yahoo was a revolutionary company that upended everyone's expectations for how the internet was going to work. It didn't provide internet access, and it wasn't a piece of software. It was a truly new business model, a company that would make money by organizing the internet for people. It was widely recognized as a revolutionary business at the time, and has remained a leader in its business niche since its IPO.
How would you have done buying the stock at the beginning? Yahoo has declined 95% from its peak price in January of 2000. Nonetheless, had you invested in Yahoo at the IPO price, your investment would now be worth 11 times its original value. That's an extremely good return for any investment. By contrast, a basket of mainstream technology companies today would be a worth a bit less than 3 times its April 1996 value, and the S&P 500 is worth about 1.5 times its value in April, 1996.
AMAZON.COM: IPO in May of 1997. Amazon had been making headlines for some time before 1997. It had its worshippers and its vehement deniers; people either believed it would become the Wal-Mart of the internet or this it was going to lose vast sums following an insane business model, only to be crushed by Barnes & Noble or Wal-Mart itself. Again, this was a company that from the beginning was identified with the internet; you didn't need to have any inside knowledge to have heard of it or to know from the beginning that it was a leader, for better or worse.
How would you have done buying the stock at the beginning? Amazon.com has had its share of troubles. From its peak price, the shares have declined almost 90% - they were down more earlier this year, but have recovered somewhat. Moreover, Amazon.com is burdened with a heavy debt load acquired in the boom years, and has faced far higher negative cash flow than your average internet company. Nonetheless, if you had invested in Amazon.com at the IPO price, your investment would today be worth nearly 10 times its original value. That compares with 1.7 times for the basket of mainstream technology companies and 1.1 times for the S&P 500.
EBAY: IPO in September of 1998. I remember making fun of this one, so naturally it has been the best-performing internet company in the history of the boom. eBay is that rare company that has made money from day one, and it is one of the few internet ventures that can truly say it invented an entirely new business. It has continued to grow by leaps and bounds, making money all the while. Had you invested in eBay at its IPO price, your investment would have appreciated to nearly 20 times its original value. That's against a 30% gain on the basket of technology stocks and a 13% loss on the S&P 500 since eBay's IPO date.
It may be objected that it was difficult to buy these companies at their IPO price, and that's true. But every one of them, after a startling jump on day one, declined over the next few weeks. While investors could not buy at the IPO price, they could often get close. If you bought all these stocks 2 weeks after their IPOs, your returns would still have well outstripped the market as a whole or the mainstream technology sector.
It may be objected that I'm cherry-picking, choosing only those companies that made it, ignoring the PSINets and Excites and Priceline.coms. But truly, it was not that hard to identify the best companies emerging on the internet, any more than it is hard to identify the best companies in the technology sector. What was hard was knowing whether they were a good buy, relative to other internet concerns or relative to non-internet investments. I'm using a very simple screen to pick these four stocks: these are the companies that most people would have heard of at the time, the companies that you would not have had to follow the market or the industry at all to have heard of, the companies whose products and services you were most likely to have used. Moreover, I'm comparing these four companies to a basket of technology stocks that were similarly famous at the time: Applied Materials, Cisco Systems, IBM, Intel, Microsoft, Oracle, Sun Microsystems, and Texas Instruments. If anything, you were more likely to have heard of Amazon.com than any of the mainstream tech companies, with the exceptions of IBM and Microsoft.
It may be objected that I'm cherry-picking my dates, choosing only names from far enough back in time that my results will inevitably show big gains for the portfolio. But first, I'm comparing returns to returns on the S&P and my tech-stock basket over the same period; second, I've picked four companies from four different years precisely to smooth out the effect of any one date; third, the lowest return among my four stocks is also the earliest IPO; and fourth, and most important, the dates are part of my argument.
That argument is: the bubble started in 1998 with the Russian debt crisis, accelerated due to the Year 2000 panic, and was caused by the combination of cheap credit and fraud. Cheap credit was twice pumped into the economy by the Fed in great big gouts, in late 1998 and late 1999, in the first case because of concerns about the stability of the financial system in the wake of Russia's default and in the second case because of fears about the Year 2000 bug. That excess liquidity found its way into the stock market and caused a massive inflation of financial assets. This effect was exacerbated by the fraud perpetrated by companies like Enron and Worldcom that we are now learning about. Not only did these companies raise their own stock prices through fraud, but they distorted economic decisionmaking across the economy as their competitors made uneconomic decisions in order to try to keep up with these companies' apparent success. That's why I haven't picked any companies to compare from 1999 or onward: by then we were in bubble-land. But the bubble wasn't caused by the internet except insofar as men like Ken Lay and Bernie Ebbers committed the frauds they did out of greed and jealousy towards those who were legitimately making a great deal of money revolutionizing business on the internet.
Of course most internet companies were flops. As well they should have been. Many internet companies went belly-up all through the boom years from 1995 to 1998. Had it not been for the bubble, more would have been killed off sooner and fewer would have gotten over-funded in those days of free capital and riskless wealth. My point is not that the kind of "investing" we saw in 1999 and early 2000 was sensible, but that the kind of investing we saw in 1995 through 1998 was - including and especially investment in the internet.
The reason we have to remember all this is that all kinds of proposals are being tossed around now for how to "fix" our markets, and its likely that many of these improvements will actually make them worse. The markets were working well through 1998, a long way into the boom years. We don't want to "fix" things so we can't get back there for decades; we do want to fix things so that bubbles like 1999-2000 are less likely. The way to fix markets is to make sure that risk is being priced appropriately. To achieve that, monetary policy must be responsible and corporate accounting must be honest and fair. With that achieved, we should let 'er rip.