The Future for Investors

by Jeremy J Siegel

  It is no surprise that these stocks collapsed when the bubble burst. Sycamore Networks, which traded as high as $199.50 shortly after it was issued, subsequently fell to $2.20; Akamai, which hit $345.50 a share, fell to a low of 56 cents, while Corvis, which a few weeks after it was issued reached $114.75, giving the firm an even larger market value of $38 billion, subsequently fell as low as 47 cents a share, a decline of 99. 6 percent.

  As Benjamin Graham has written, “Some of these new issues may prove excellent buys—a few years later, when nobody wants them and they can be had at a small fraction of their true worth.”13

  Extraordinary Popular Delusions and the Madness of Crowds

  During speculative manias, the degree of investor gullibility is astounding. Two strikingly similar IPOs, separated by almost three centuries, caught my eye. One occurred during the South Sea bubble that struck England in the early eighteenth century, and the second occurred during the latest Internet bubble that overran the markets in 1999 and 2000. One would think that the level of financial sophistication has risen dramatically over the past three hundred years. I will let the reader judge which set of investors showed the most financial savvy—or lack of it.

  THE SOUTH SEA BUBBLE

  The South Sea bubble that struck Britain in the eighteenth century has taken its place in history as one of the most extraordinary examples of collective mania. No better description of this craze is provided than by Charles Mackay, who penned an investment classic, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, in 1841.14

  Mackay depicts how men and women who are normally quite prudent with their affairs and investments can be deluded into throwing substantial sums into the market, bolstered not only by glowing reports of the profitability of the enterprise behind these shares but also (and primarily) by seeing others, quite like themselves, profiting handsomely from similar investments.

  The South Sea Company, started in 1711 by the earl of Oxford, was given monopoly rights by the British Parliament to trade in South America. The west coast of South America was known to be rich in gold and silver mines, and investors envisioned South Sea Company ships, loaded with gold and silver, sailing back to England and enriching shareholders of this new venture.

  British mining technology was considered the best in the world, so it was plausible this company could purchase large veins of precious metals for nominal sums from those who had no way to access its riches. These fantasies fueled the increases in the demand for the shares of the South Sea Company.

  As the public was drawn into this bull market in South Sea shares, other joint stock companies were formed to take advantage of the public’s newfound excitement with stocks. These other new ventures were particularly attractive to those who didn’t get in on the ground floor of the South Sea shares. This behavior was not dissimilar to what occurred when Netscape went public in 1995 and primed investors’ interest in Internet and technology companies.

  Mackay noted that all manner of projects were proposed, and most were quickly funded and sold for a profit in the open market. This behavior, too, was identical to the act of “flipping” or “spinning” IPOs during the Internet bubble when shares acquired at the issue price were quickly sold to the public for a profit.

  It is of interest that the term bubble, which is now almost universally used to denote a period of intense speculative activity, actually originated during the South Sea fiasco. Although this word strongly implied an ephemeral and insubstantial existence, the designation did little to deter speculators.

  During the South Sea bubble, some of the schemes proposed were plausible, but most were devised to take advantage of the public’s willingness to buy shares in any newly formulated companies. One bubble company was formed for the construction of a perpetual-motion machine. But Mackay regarded the most absurd scheme of all an enterprise that went under the name “A Company for carrying on an undertaking of great advantage, but nobody to know what it is.” This company’s business, if it had any, would be kept secret, even from the investors in the company. As Mackay put it, “Were not the fact stated by scores of credible witnesses, it would be impossible to believe that any person could have been duped by such a project.”15 But the next morning, when the founder of this firm opened his office, crowds of people besieged his door. When he closed for the day, he had sold no less than 1,000 shares, and he collected cash deposits of £2,000 for the shares.16 After accumulating the cash, the perpetrator set off that same evening for the Continent and was never heard from again.17

  NETJ.COM, A PERFECT BUBBLE COMPANY

  Could this happen today? Short of outright fraud, one would think not. New shares must be registered, and a prospectus filed with the Securities and Exchange Commission must reveal all financial information and give a realistic assessment of the risks of the enterprise. Certainly nothing quite like the secretive bubble company Mackay referred to could be floated today.

  But fast-forward 280 years from Georgian England to the United States at the turn of the millennium. A new form of communication, the Internet, has burst upon the scene. Investors see this communication revolution as enabling virtually costless access to not just hundreds of millions of Americans but billions of potential consumers throughout the world.

  The shares of all Internet companies are flying high. But one stock stands out among the others. A company called NetJ.com is actively traded, and in early March 2000 its nearly 12 million shares are selling for about $2 per share, making its market capitalization $24 million.18

  And what did NetJ.com do? I quote from its filing with the Securities and Exchange Commission on December 30, 1999: “The company is not currently engaged in any material operations or had any revenues from operations since inception.” Note that this statement is much stronger than the warnings that appeared on many prospectuses during previous bubbles. Burton Malkiel noted that during the electronics boom of the early 1960s, investors routinely ignored the words printed on the cover of many a prospectus: “Warning: This company has no assets or earnings and will be unable to pay dividends in the foreseeable future. The shares are highly risky.”19

  But NetJ.com’s filing went much further. The company had never collected a dime of revenue, and its original business plan had long since been abandoned. The company’s balance sheet registered an accumulated loss of $132,671, and the firm had no prospects of any revenues, not to speak of earnings or dividends.

  Then what could give NetJ.com a market value of almost $25 million? Its value, so investors believed, lay in the fact that it was already a going concern and was listed for trading. It takes time for private companies to complete the process of floating shares to the public. And in the heady days of late 1999, time was money.

  To bypass the lengthy process of going public, a company could conduct a “reverse acquisition” and effectively merge with NetJ.com. In other words, NetJ.com was a shell in which other new companies could live. With Internet mania raging, dot-com companies rushed to sell shares quickly to a more-than-willing public, and a merger was much faster than the lengthy process of issuing an IPO.

  But could NetJ.com’s potential as a “reverse acquisition” candidate be worth $25 million? A quick reading of the company’s filing with the SEC suggests not. The company’s own paperwork states, “Other better capitalized firms are engaged in the search for acquisitions or business combinations which firms may be able to offer more and be more attractive acquisition candidates.” Furthermore, “There is no compelling reason why this Registrant should be preferred over other reverse-acquisition public corporation candidates. It has no significant pool of cash it can offer and no capital formation incentive for its selection. It has a limited shareholder base insufficient for acquisition target wishing to proceed for application to NASDAQ.” And the next sentence of its SEC filing should disturb any potential investor: “In comparison to other ‘public shell companies,’ this Registrant is unimpressive, in the judgment of management [emphasis add
ed], and totally lacking in unique features which would make it more attractive or competitive than other public shell companies.” The only source of value for NetJ.com will be “entirely dependent” upon its management in locating a “suitable acquisition or merger candidate.”

  But in the very next paragraph, the firm states, “Management will devote insignificant [emphasis added] time to the activities of the company.” Furthermore, management “is not desperate or overly eager to find a business partner.” And if all the above was not enough to discourage investors, NetJ.com was also under an SEC investigation for hyping its prospective mergers, none of which materialized.

  It seems incredible that any investor would pay good money for such a venture. But wait! A couple of months after this filing, on March 9, 2000, one day before the absolute peak of the Nasdaq stock market, NetJ.com claimed it had found a merger candidate. It was going to merge with Global Tote Limited, a firm based in the United Kingdom that developed interactive horse racing via satellite and the Internet. On this announcement, its shares surged upward, reaching a high of $7.44 on March 24. This valued the company at over $80 million.

  But this merger quickly fell through, as had previous ones. The announcement only temporarily discouraged investors, who sent the price of NetJ.com back to the $2 to $3 range, still valuing the company at tens of millions of dollars and anxiously waiting for the next “merger” to be announced.

  A few months later NetJ.com announced a merger with BJK Investments, but that also was abandoned, as was a proposed merger with Genosys Corporation a month after that. Eventually NetJ.com sank in price to a penny per share, engineered a 100-to-1 reverse split, and transformed itself into Zoolink, an Internet service provider with a market value in April 2004 of $98,000, a loss of 99.8 percent from its market peak.

  POSTMORTEM

  NetJ.com had revealed all its faults in gory detail, and the public didn’t care. As long as speculators thought they could unload NetJ.com’s shares at a higher price, they were more than eager to buy. All the information, transparency, and full disclosure in the world will not prevent people from throwing money at an investment that captures their imagination or convinces them there is someone out there that will buy the stock at an even higher price.

  Who was more foolish, the eighteenth-century speculators who lost £2,000 in 1720 buying a company that claimed it had a profitable “secret” that it would not yet reveal, or the twenty-first-century speculators who lost tens of millions of dollars buying a company that had no operations and no revenue and was under government investigation for hyping nonexistent mergers? You be the judge.

  A Recap

  “Those who cannot remember the past are condemned to repeat it.” This saying by George Santayana is quoted by those who believe disaster can be avoided by heeding the lessons of history. Yet when it comes to the financial markets, no matter how often the lessons are told and retold, the public seems forever condemned to repeat the past.

  If investors want to find someone to blame for the Internet bubble, they should look in the mirror and say mea culpa. The bubble was fueled by the investors themselves, motivated by talk of easy stock profits at company breaks and social gatherings and a speculative craze so intense that CNBC often replaced ESPN as the channel of choice at the local bar. Bubbles are perpetuated by the “greater fool’s theory,” a belief that no matter how ridiculous the price is today, there is always going to be someone who will pay more. But when that “someone” doesn’t show up, the last buyer is left holding the bag.

  Although a disaster for investors, there is a silver lining to these euphoric episodes. They have marked, and perhaps encouraged, many of the advancements that have occurred in the last three hundred years, from the canals and railways to the automobile, the radio, the airplane, the computer, and of course the Internet. The railroad boom in Victorian England became an investment bust, but England’s rail system enabled the country to advance economically and politically.

  Each of these innovations changed our lives profoundly. Their development was made possible by the huge quantities of capital that were thrown at them by overexcited investors.

  But history proves that it is best to let others fund these innovations. Originality in no way guarantees profits. In fashion, you may want to buy what everybody else is buying. In the market, such impulses are a road to ruin.

  CHAPTER SEVEN

  Capital Pigs:

  TECHNOLOGY AS PRODUCTIVITY CREATOR AND VALUE DESTROYER

  “The great lesson in microeconomics is to discriminate between when technology is going to help you and when it’s going to kill you. And most people do not get this straight in their heads.”

  —Charles Munger

  Conventional investment wisdom has it that getting in on the ground floor of new products and technologies is the way to wealth. Living in an age of rapid technological change, we seek out new companies with new inventions that will capture both the public’s imagination and consumers’ dollars. These are the companies that drive and create economic growth. Investors assume that by buying their stock, their fortunes will grow along with these great corporations.

  But these assumptions are wrong. Economic growth is not the same as profit growth. In fact, productivity growth can destroy profits and with it stock values.

  A striking example is embodied in three of today’s most popular technology gadgets, the TiVo video recorder, the iPod music player, and the Xbox game machine. All of these products sprung from remarkable advances in data storage technology. In 1976, it cost roughly $560,000 to store one billion bytes of data. Today, it costs less than $1.1

  While technological advances in the storage industry went well above expectations, the data storage firms struggled to make profits. In the run up to the new millennium, when all other technology companies’ profits were reaching record highs, the storage drive companies were still losing money. Seagate Technology, Maxtor Corporation, and Western Digital, leaders in this industry, have consistently disappointed investors.

  The travails of these firms capture one important theme of this book: technological change does not guarantee good returns or good profits. Storage technology is only one example. Nowhere was technology more destructive to investors than in the telecommunications industry.

  “You Have to Stop Inventing Things”

  As Internet mania mounted in the 1990s, there was near-universal agreement: the Internet was the wave of the future, and profits were guaranteed for those who could provide the pipeline for this communications revolution.

  Growth in demand for bandwidth—the pipeline that connects users to Web sites—seemed insatiable. “Internet traffic,” the Commerce Department said in a 1998 report, “doubles every 100 days.”2 If that were so, demand would increase twelvefold every year—resulting in an increase in demand of nearly 100 billion over the next decade.

  Many predicted there could never be enough capacity. In April 1998, Salomon Smith Barney analyst Jack Grubman prepared a research report saying, “Like the attic of a house gets filled, no matter how much bandwidth is available, it will get used.”3

  Technology guru George Gilder echoed these sentiments. In 2001 he wrote, “Today, there is no economy but the global economy, no Internet but the global Internet, and no network but the global network.” Gilder predicted that two telecom companies, Global Crossing and 360networks, “will battle for worldwide supremacy, but in a trillion-dollar market, there will be no loser.”4

  At first, bandwidth enthusiasts were dead on. Supply struggled to keep up with demand. Prior to 1995, telecom carriers were restricted to piping only one beam of data-carrying light through the fiber-optic lines, which was the equivalent of 25,000 one-page e-mails per second.5 But a new technology, called dense-wave division multiplexing, or DWDM, essentially split that light beam into many colors, thereby multiplying the available wavelengths and capacity by up to 320. In 2002, one could send 25 million e-mails over the same strand of fiber, a thousandfold
increase of capacity in just seven years. This increase far exceeded the pace cited in Gordon Moore’s famous law, which states the number of transistors that could be placed on an integrated circuit would double every two years.

  Compounding these technological breakthroughs was one of the largest building sprees in history. The Wall Street Journal estimates that 40 million miles of fiber were laid during the technology bubble, enough to make more than eighty round-trips to the moon.6

  Unfortunately for all of the telecoms, demand did not keep pace with this gargantuan increase in supply. From 1999 through 2001, demand only quadrupled, far less than had been predicted.7 It turned out that one of the most widely quoted statistics of the Internet age was false: Internet traffic was at best doubling every year, not every 100 days or less.8

  As the glut of capacity became apparent, the telecom firms had no choice but to discount their prices. In 2000 it cost over $1.6 million to lease a telecom line that could send 150 megabytes per second of data between Los Angeles and New York. Just two years later, the same line could be leased for $150,000, and in 2004 it could be leased for close to $100,000. There was no way that the industry that raised over three-quarters of a trillion dollars since 1996 to lay the cable and make the connections could begin to cover their mammoth building costs.

  In March 2000, at the height of telecom optimism, the aggregate market value of the telecommunications sector in the United States was about $1.8 trillion, representing 15 percent of all stock market value. By 2002, this sector had fallen 80 percent to about $400 billion. The Economist speculated that “the rise and fall of telecoms may indeed qualify as the largest bubble in history.”9

  Dr. David Payne of England’s Southampton University, who is regarded by many as the grandfather of the capacity-multiplying technology, said he could never forget how one leading industrialist admonished him at an industry conference a few years ago. “He said, ‘You guys have to stop inventing things!’ and he was deadly serious.”10