THE
TECHNOLOGY
STOCK BUBBLE
Review and Outlook
David S. Carr
Contemporary Topics in Finance
MBA –8439
Prof. W. Delva
April 25, 2001
1
Introduction
The last several years will go down as one of the most volatile periods to invest in stocks.
Nowhere is that volatility more prevalent than in the technology-laden Nasdaq Stock
Market. This index has seen stock prices rise to stratospheric levels in the late 1990’s
and early 2000, driven mainly by the vast potential of the internet and technologies
developed to exploit its use. But, as many investors have learned, potential does not
equate to earnings, and sooner or later a lack of earnings equates to failure.
This
document will examine the Internet bubble and subsequent technology fallout that
occurred from the late 1990’s to today. It will attempt to explain the causes that led to an
abundance of e-commerce initial public offerings, ease in accessing capital, and inflated
stock prices. Predictions from e-commerce executives, fund managers, and Wall street
analysts during the bubble will also be provided. Furthermore, reasons why the bubble
“popped” will be explored.
Finally, a historical perspective draws parallels to other
“revolutionary” times in American History, which will offer support why the internet and
the technology sector, are by no means dead, and are poised to provide the long term
economic growth engine for the world.
2
How did it all Start?
Arguably, it all began with Netscape in 1995. The IPO was extremely successful as the
stock price rose from $28 to $71 on the first day, and ultimately cleared the way for
hundreds more net companies to do IPO’s far earlier than ever before. A firm with $3
million in losses was suddenly worth $2 billion. Jim Clark, Netscape’s co-founder had
been advised strongly against going public, but went ahead anyway because he had to
make payment on a mega-yacht he was having built. If he missed the payment, the
builder would give his slot to someone else, and he wouldn’t get his yacht for years.
From such motives, among others, grew one of history’s great stock manias and a new
model for venture funding.
E-Commerce Examples
E-Toys is a great example of a dot-com start-up with an innovative idea, great promise,
and huge Wall Street backing that ultimately felt the pinch when customer demand dried
up. On its first day of trading in May 1999, shares of E-Toys opened at $20, catapulted
to $120, before closing at $76. Immediately it boasted a market capitalization of $7.6
billion, bigger that bricks and mortar giant Toys R Us. Chris Vroom, Internet analyst for
Thomas Weisel partners initiated a strong buy on the stock, predicting that the company
is likely worth $10 billion, and will continue to dominate online toy sales.
3
In June 2000, with losses mounting, cash dwindling and the stock price near $6, the
company received another $100 million infusion from three private institutional
investors. The sale was from preferred convertible stock over three years. E-Toys CFO
indicates that the cash should carry the company until the fall of 2001, and that the
company expects to be profitable by early 2002 at the latest.
In January 2001, the once-darling of e-commerce companies slashed its staff by 70
percent, and indicated that it will continue to search for a buyer. It also shut down all
European operations. The news was no surprise as holiday sales came in at roughly half
of the company’s projections. E-Toys attributes its decline to a “generally harsh retail
climate and the continued disfavor of internet retailing.” At this time it’s stock traded
around 16 cents.
In February 2001, E-Toys was de-listed from the Nasdaq stock
exchange, officially closed its doors and announced its intent to file for bankruptcy.
Another great e-commerce example is online grocer, Webvan. At the time of its IPO in
November 1999, its promise was compelling, however its operational record was suspect.
Yet at one point during its first day of trading the shares reached $34 giving it a market
capitalization of $15 billion. Overall, the company raised more than $1 billion over its
short lifetime. It has a star-studded list of venture capital backers and hired George
Shaheen, former head of Anderson Consulting (now “Accenture”). For the year-ended
1999, the company reported $13 million in revenues and $144 million in losses (See
CHART 1 below). But unlike many other e-companies, Webvan can lay claim to a
substantive core that other e-retailers cannot. In groceries, it is offering something that
4
every single household purchases at great trouble (2.6 visits per week), and on a grand
national scale ($450 billion annually) than far dwarfs the book business that brought ecommerce into view.
CHART 1 – Webvan Income Statement Data
Webvan Income Statement
In Thousands
2000
In Thousands
1999
Net Sales
Gross Profit
Net Loss
$178,456
$47,217
$(453,289)
$13,305
$2,016
$(144,569)
It now appears, however that its business model is also severely flawed. The costs of
picking, packing and delivering most orders are likely the main cause of its sub-par
financial performance. Furthermore, the company is a scale business with significant
fixed costs that can only be covered with a certain amount of customers. Needless to say,
they haven’t come close. Their problem, along with many other e-commerce companies
also lies in the fact that they are expecting a dramatic change in consumer behavior.
Instead of shopping at supermarkets, customers must opt for a more expensive, planahead method of shopping for groceries. That hasn’t happened.
WebVan now has roughly $200 million in cash and at its current run rate will burn
through the cash in two quarters. Furthermore, its stock price now at 13 cents, and faces
5
imminent de-listing from the Nasdaq Stock Exchange. It’s dismal stock performance is
charted below (CHART 2).
CHART 2 – WEBVAN Stock Performance
The E-Toy and Webvan stories are commonplace nowadays as more than 130 dot-coms
closed their doors in 2000 and approximately one per day is shutting down this year.
Nowadays the fun is gone, as executives and employees are on a grim march towards
profitability, hoping to reach that elusive goal before running out of cash.
So what did the E-Commerce companies do wrong? Mostly everything, but looking
back, these issues can be pointed to that contributed to their ultimate demise.
6
They did stupid things.
Million dollar Super Bowls were run by many of these
companies that ultimately produced little to the bottom line. Many dot-commers wanted
branding, but “they don’t know what branding means,” says Rena Kilgannon, co founder
and principal of the Ad Incubator, an Atlanta marketing firm that works closely with
start-up tech companies. “Bright people run these companies but they’re clueless about
low cost ways to market, the kinds of strategies start-ups should be implementing.”
They underestimated the importance of real-world know-how. Significant vertical
know-how is needed to succeed in retailing and “e-tailing” is no different. Expertise is
needed at sourcing and pricing products, something many dot com companies never
developed. To outperform the established bricks and mortar players without this acumen
turned out to be devastating for most e-commerce companies.
They overestimated consumer demand. Consumers were much slower to adapt to new
technologies than most entrepreneurs had thought. Many of these companies incurred
exorbitant expenses simply trying to persuade customers to shop online. A bricks and
mortar start-up doesn’t have to spend one dime explaining to consumers how to shop at a
local mall. But online it’s different where most consumers still haven’t made purchases.
And these companies never made a strong enough case for consumers to switch from
bricks and mortar store to online buying.
They never factored in customer acquisition costs in their business models. They
also were not getting repeat business. Many companies eked out some sales by offering
free shipping or significant discounts, but it never amounted to any kind of customer
7
loyalty. Customers would simply move on to the next site offering the lowest price.
Furthermore, when many did make sales, they failed miserably when it came to order
fulfillment. Shipments were late, wrong or not made at all. That’ll hurt customer loyalty
for sure.
They lacked fiscal controls. Many of these companies had no fiscal discipline. Dotcoms spend wildly on everything from office space to freebies for workers such as free
massages and free yoga, and many more “non-traditional” expenditures.
They settled for unimpressive management. There was a real lack of talented top-level
management during the internet boom.
During the tough times, management
inexperience and inadequacies became glaringly obvious.
They didn’t execute. Perhaps due partly from poor management, many start-ups were
built on good ideas, but companies never executed those ideas. This seems to be true of
virtually every failed dot-com.
Given these weaknesses it’s no wonder that most of these companies fell by the wayside.
So who is to blame? The executives, investors, Venture Capital firms? The answer is “D” - all of the above. While it is certainly true that executives of many of these
companies drove their companies into the ground, Venture Capital investors should share
much of the blame. These supposedly shrewd investors took wild plunges with these
companies without doing their due diligence. There was a herd mentality and they
invested irrationally.
8
The rest of the Technology Sector (2000 and 2001)
As the e-commerce shake-out began to take hold in late 1999 and early 2000, many
professional investors and analysts were still extremely bullish on the Nasdaq and most
technology companies. “This time it’s different” was the mantra heard throughout Wall
Street
as
B2B
companies,
PC
makers,
semi-conductor
manufacturers,
telecommunications and wireless players, and biotech firms were cruising along, boasting
stratospheric stock prices and phenomenal actual and expected growth rates.
The
fundamentals were less important as ludicrous P/E ratios were somehow being supported
by equally optimistic anticipated growth rates. At their peak, the average P/E on the
Nasdsaq (excluding stocks with no earnings) approached 120, as compared to the S&P
historical average of 14. At that time, the Nasdaq P/E’s traded at approximately 2.2 times
the P/E on the S&P 500 (See CHART 3 below). Also at that time, technology stocks
represented over 35% of the S&P 500, the highest weighting ever for any industry group
(See CHART 4 below).
9
CHART 3 – MERRILL LYNCH TECH INDEX P/E RELATIVE
TO S&P 500
2.50
2.30
2.10
1.90
1.70
1.50
1.30
1.10
0.90
0.70
0.50
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
CHART 4 – TECHNOLOGY STOCKS AS A PERCENTAGE OF
S&P 500
40%
35%
30%
25%
20%
15%
10%
5%
0%
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
10
Beginning in March 2000, that all started to change. As many e-commerce companies
were no longer in the landscape, other technology companies that relied heavily on these
big spending dot-coms to purchase their equipment, started to feel the pinch.
PC
companies experienced slower demand as there was no real compelling new technology
to drive new PC purchases. The dot com fallout coupled with the PC slowdown also
caused inventory issues and slower growth for the chip makers and server producers.
The trickle down theory took effect as optical networking companies experienced slow
downs as their primary customers, the telecommunication companies, were experiencing
their own inventory glut. Virtually every technology sector experienced the slowdown in
2000. All of a sudden, even the mightiest of high-flying technology companies (Cisco,
Sun Microsystems, Microsoft, Dell, Oracle, and countless others) started experiencing the
slowdown. Investors started questioning the growth rates, P/E’s and yes, stock prices.
The Nasdaq continued its decline, losing 39% in fiscal 2000 (See CHART 5 below).
11
CHART 5 – NASDAQ COMPOSITE 5 YEAR TREND
To exacerbate the matter, the Federal Reserve continued in its fight against inflation and
raised interest rates several times in 2000 and even held its “tightening bias” through
November 2000. Not until December 2000 did the Federal Reserve “loosen” its bias and
then ultimately began reducing the Fed Funds rate on January 3, 2001 and continued to
reduce rates through its most recent meeting in March 2001. But it may have been too
little too late, as the hiked rates in 2000, and December earnings warnings dampened the
12
climate, squelched additional corporate borrowing and placed downward pressures on
stock prices.
The interest rate declines in 2001 gave investors hope that the now economic slowdown
would rebound in the second half of 2001. As a result, the Nasdaq was up more than 10%
in January alone. But as profit warnings came flowing in at an alarming rate, fears of a
hard landing were rampant, bleak earnings visibility, and technology spending estimates
dropping through the floor, the Nasdaq plunged to a 2 ½ year low of
1619,
approximately 68% off it’s all time high in March 2000. The Merrill Lynch Tech Index
P/E still stands at roughly 1.5 time the P/E on the S&P 500 (See CHART 3 above). As
of April 6, 2001, the Nasdaq stood at 1,719, and technology stocks now represent
approximately 18% of the S&P, down from 35% in March 2000 (See CHART 4 above).
Initial Public Offerings
Initial Public Offerings saw a similar pattern whereby they skyrocketed in the late 1990’s
(in quantity and value) as companies thinly floated their shares to achieve instant market
capitalization. In March 2000, 65 companies went public, mostly on the Nasdaq. The
average first day returns of those stocks was 78% and 18 of the 65 jumped more than
100% in one day. Today, 62 of those 65 stocks remain publicly traded (the other three
have been bought out.)
The 62 stocks stand, on average, at nearly 70% below their IPO
price.
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Consider the following chart (CHART 6) of the highest ever one day gains from IPO’s
and look and the sharp decline in stock price today.
CHART 6 – HIGEST EVER FIRST DAY GAINS FOR IPO’s
Company
VA Linux Systems
Theglobe.com
Foundry Networks
Webmethods, Inc.
Freemarkets, Inc.
MarketWatch.com
Akamai Technol.
CacheFlow Inc.
Crayfish Co.
Public Date
12/1999
11/1998
09/1999
02/2000
12/1999
01/1999
10/1999
11/1999
03/2000
Offer Price
$30
$9
$12.50
$35
$48
$17
$26
$24
$240
Day 1 Close
$ 239.25
$ 63.50
$ 78.13
$ 212.63
$ 280.00
$ 97.50
$ 145.19
$ 126.38
$1,126.00
4/5/01 Price
$ 1.94
$ 0.19
$ 7.19
$19.00
$ 8.69
$ 3.88
$ 7.50
$ 4.00
$ 6.50
Over the past year, IPO activity has dropped drastically. After the mid-April Nasdaq
correction, investors had to look cautiously for quality giving a green light only to
companies with actual profitability, strong business prospects and an established
customer base. Prior to this period, only an interesting idea was needed. Activity dried
up so much that in the first quarter of 2001, only 21 IPO’s came to the market, compared
with 135 in the first quarter of 2000. CHART 7, below highlights the declines in IPO’s
underwritten by some of the major Wall St. Investment Banking firms.
14
CHART 7 – Investment Banking Firms IPO’s Underwritten
Firm
Morgan Stanley Dean Witter
Goldman Sachs
Merrill Lynch
Lehman Brothers
Deutsche Bank Alex Brown
IPO’s Amt Raised
IPO’s
March 2001
Raised
4
$5.8 billion 22
3
$0.4 billion 19
4
$1.4 billion 9
2
$0.2 billion 7
1
$0.1 billion 10
-
Amt
March 2000
$ 8.0 billion
$12.8 billion
$ 3.3 billion
$ 2.1 billion
$ 6.4 billion
This decline has led to dramatic drop in underwriting revenues and has forced many top
Wall Street firms to announce significant layoffs. Long gone are the days of picking their
deals and raking in the cash. Now its back to fierce competition for a few deals, and hope
the window opens again.
Venture Capital Market
The venture capital (VC) developments tell a similar story. The burst of the internet
bubble, the high-tech bust, the IPO market gone dry, and the slowing economy have
resulted in a serous decline in VC deals, and a major dent in VC portfolios. A little more
than one year ago, VC firms could do no wrong. Anything they invested in, especially if
it had “dot-com” in its name would take flight as soon as it hit the market. These days,
instead of doing deals venture capitalists are licking their wounds and trying to shore up
the companies they already invested in.
15
Last year, VC firms financed an estimated $100 billion worth of start-up companies and
entrepreneurs.
This year, the bewildered stock market and shaky economy have
prompted industry experts to project only $25-$30 billion in financing deals in 2001. Just
as the case with IPO’s. VC firms are only backing firms that can produce a sound
business plan and can generate profits virtually immediately. Blueprint Ventures, a San
Francisco VC firm lists its worst pitches for start-up companies approaching VC firms:



“Contact me as soon as possible so that I can start this profitable venture in a few
weeks.”
“Financial performance doesn’t really matter for our company prospects.”
“The market we are targeting has yet to be defined.”
These quotes weren’t so laughable just one year ago.
Predictions during the inflating bubble:
Throughout this tumultuous period, investors, fund managers, Wall Street analysts,
company executives and anyone else who could get on the air or on the internet, posted
their opinions about the seemingly endless rise in internet and technology stocks
throughout the late 1990’s and into 2000. The predictions are extremely varied. Some are
way off, and some seem to have hit nail right on the head. Below is a sample of these
quotes and predictions.
The Skeptics
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
In December 1999, Burton Malkiel, Author of “A Random Walk Down Wall Street,”
indicated that the Internet was “clearly a speculative bubble – dangerously close to
the boom in biotechnology stocks of a decade ago, the Nifty Fifty boom of the early
1970’s, and the bubble in Japanese stocks that ended in 1990. I think it’s going to
come to a very bad end.”

On March 10, 2000, the day of the Nasdaq peak, Jeremy Siegel, a professor at the
Wharton school, and a long time bull on Wall Street, appeared on the TV show
Moneyline and indicated that the bluest blue chip tech stocks were dangerously
overvalued. He claimed that it had become “too much of a good thing.”

Anthony and Michael Perkins, Author of the widely popular 1999 book, “Internet
Bubble” said, “Sell Now.” They were referring to 133 publicly traded internet
companies with market capitalization of more than $100 million.

In February 2000, after many of the e-commerce “B2C” companies were
experiencing major declines in their stock prices, and Business to Business (B2B)
internet companies were the next hot thing, Youssef Squali, analyst at ING Barings
indicated, “It’s only a matter of time before investors lose interest in “B2B” stocks.”

Towards the end of 1999, JP Morgan investment strategist Douglas Cliggot, began
telling investors to trim their tech holdings. He indicated that “an aggressive tech
exposure is making an enormous leap of faith.” He also downgraded the then hot
telecom sector in April 2000 based on U.S factory orders of U.S. communications
17
equipment which showed slowing order growth.
Unlike many others, he was
focusing on fundamentals.
The Optimists

James Glassman and Kevin Hasset, authors of “Dow 36,000,” when discussing the
abnormally high P/E ratios in existence as of early 1999 says, “Could it be that the
model that Wall Street has been using to assess whether stocks are overvalued - a
model based largely on historic price to earnings ratios is deeply flawed?----We think
so.”

On March 10, 2000, the day of the Nasdaq peak, Ralph Acampora, Prudential chief
technical analyst forecast that the Nasdaq could hit 6000 in the next 12 to 18 months.

In July 1999, Mary Meeker, an analyst and managing director with Morgan Stanley
Dean Witter discussed the markets and the requirements for going public. “The old
rule of the 80’s was that a company needed three quarters of profitability and to show
a rising trend before trying a public offering. Now, companies should act rationally
reckless to use capital markets as a tool and proceed as if they have nothing – and yet
everything- to lose.” When asked if we were in an internet bubble, she responded,
“No. The next trend – businesses selling internet based services to other businesses
will dwarf the revenues of the past four years.
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
In March of 2000, now Merrill Lynch mutual fund manager James McCall stated,
“We don’t get too hung up on valuations. Even if it’s a gazillion times earnings,
that’s not my part of the decision.” Two funds he manages opened in March 2000 are
both down more than 65% since inception.

In April of 2000, Thomas Bock, SG Cowen analyst, who has never even taken an
economics course indicated, “We’re not focusing on earnings or even revenues.
We’re looking at the size of the market and a company’s defensible position in it.”
Examples of excesses:
Consider the following mind-boggling statistics of some of these once high-flying
internet/technology stocks.

There are 4,321 companies on the Nasdaq composite. More than 450 are down 90%
from their highs. These names include E-Toys, Webvan, Teligent, Scient, Drkoop,
AskJeeves, CMGI, NetZero, Internet Capital Group, Theglobe.com, NBCi,
iVilliage,Akamai, VA Linux, Inktomi, Chinadotcom, Realnetworks, RedHat,
Broadvision, and Peapod. And hundreds more.

Priceline.com’s market value last year exceeded the total valuation of Continental,
Delta, Northwest Airlines and United Airlines - $13.8 billion versus $12.3 billion.
Despite its dismal financial performance, ($1.1 billion in losses on $482 million in
revenues), investors perceived the online ticket auction firm to be worth more than
the big airlines flying his customers. Priceline’s current market capitalization is near
$500 million.

Sycamore Networks is in the optical networking field. In March 2000, Sycamore’s
outstanding stock was worth $40.1 billion, while nine of the Dow Jones Industrial
giants including Alcoa, Boeing, Caterpillar, and United Technologies. The smallest
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of these Dow firms had revenues of $14.1 billion. Sycamore’s revenues were near
$60 million. Sycamore’s market cap is now at $2.4 billion.

The companies that comprise Nasdaq have lost more than $4 trillion in market
capitalization. Consider the following analogies:






The GNP of France in 1999 was $1.4 trillion.
The GDP of the entire manufacturing sector in 1999 was $1.5 trillion.
The value of all U.S municipal securities is $1.5 trillion.
President Bush’s tax cut over the next 10 years in $1.6 trillion.
The combined value of all 401k plans is $1.5 trillion.
In one year, Cisco, Microsoft, Intel, Lucent and Oracle lost over $1 trillion in market
capitalization. That’s more than what the entire market was worth in 1980.
What caused the bubble?
The Nasdaq chart above (CHART 1) is a constant reminder to everyone that we did in
fact experience a bubble. As the markets continued their rise throughout 1998 and 1999,
individual investors, day traders, and even institutions were enamored with technology
stocks.
Although many e-commerce stocks began their decline in 1999, investors
continued to dump cash into high flying larger cap issues such as Cisco, Microsoft, Sun
Microsystems, Oracle, Dell, Intel and a host of other high cap, high technology names.
Several factors contributed to this technology frenzy. They are highlighted below:
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
A Fundamental Economic Revolution. The internet has opened up so many
opportunities by changing the way consumers shop and the way companies do
business. E-commerce and technology companies are attempting to exploit its
vast potential by being the first. But as the historical perspective discussed later
will indicate, first is usually not best.

Greed and Hope. These human traits together are strong enough to overcome
minor inconveniences such as common sense and logic. The herd mentality was
at work here as stories of glamour and riches intoxicated everyone down to the
smallest investor.

Day traders. While many studies indicate that more than 75% of them lose
money, the lure of easy money was so powerful that more kept joining in. For
such traders, fundamentals ceased to matter, and it was only the day’s hype that
counted.

The relatively small floating stock. This brings us back to basic economics of
supply and demand.
Technology company executives would float a small
percentage of the company to 1) inflate prices given the small supply of shares,
and 2) to retain a larger part of the company and ultimately reap the rewards their
own pockets are filled as share prices rise.

For the more professional players, there was the lure of the internet-based “new
economy” of perpetual low inflation, increasing productivity, and banishment of
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business cycles. In their minds this justified extraordinary stock prices and Price
to Earnings (P/E) ratios.

Role of Venture Capitalists. They added to the feeding frenzy, with investments
in technology companies increasing from $3-$5 billion per year in the mid-1990’s
to $25 billion in 1999 and near $100 billion in 2000. Having invested at high
stock prices, their hopes of making profits were tied to a continuation of the trend.
What caused the bubble to pop?
Unlike other market bubbles, there was no one event that led to the precipitous fall in
internet and technology stocks. Certainly there were some warning signs of a bubble,
such as increases in domestic debt, corporate debt, as well as personal and corporate
bankruptcies during the boom. But the real causes of the bubble popping is a complex
issue with many forces at hand. The following factors were significant factors in the
Nasdaq slide.
The Federal Reserve raising interest rates. The degree to which the Fed’s interest rate
hikes affected the technology stock bubble is a widely debated topic. Some (including
Mr. Greenspan) indicate that it was necessary to stem fears of rising inflation. However
others believe that inflation was non-existent, and was a major cause in the technology
sector’s decline in 2000. Eric Guftason, Managing Partner of a prominent fund portfolio
indicated in a February 2001 interview on CNBC that “…..the cause of the technology
22
stock decline rests solely at the feet of Alan Greenspan and the Federal Reserve Board.”
One thing we know, the rate hikes certainly didn’t help the fate of technology stocks.
Secondary Offerings.
Many companies are very dependent on IPO’s to generate
excitement and attract capital. After these companies burned through the cash generated
on the IPO, investors started asking those questions like, “What did you spend the money
on last time?” and “Why should we give you more money now?” This thought process
snowballed. This was emphasized in a March 2000 article in Barrons, which indicated
that many internet companies are running out of cash at an alarming rate.
Furthermore, a large number of those secondary offerings in late 1999 and early 2000
involve insiders unloading their shares on the public. This hurt companies because
instead of the cash raised going into company coffers, it was going straight into the
pockets of the selling executive/shareholders. So the general public was left holding the
bag, and was burdened with the massive subsequent declines in values.
Competition. There was no fundamental scarcity of new business models for dot-coms
and technology companies. The result was an intensely competitive environment, where
it has been extremely difficult to make money.
There was, ultimately an inherent
contradiction in the Internet hype of 1999 and 2000. The internet was supposed to
remove all barriers to entry, encourage competition, and create a frictionless market with
unlimited access to free content. But at the same time, it was supposed to offer hugely
profitable investment opportunities. You can’t have both at the same time.
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Historical Perspective & Outlook
Has such a boom and bust ever happened before? The answer is a definitive – yes –
many times. The truth is that cutting edge technologies take many unforeseen twists that
often obsolete the early industry leaders. New markets emerge out of nowhere dominated
by new companies that dwarf or knock out current industry leaders. Markets grow at an
enormous clip for which investors pay huge multiples, and then ultimately slow down.
For each industry, there are dozens of “me-too” companies that have mediocre business
plans and have little hope of long-term survival. Generally, few companies emerge from
the crash’s rubble, and market leaders frequently take advantage of the inroads made by
their predecessors (in many cases, which died in the crash).
In the 1870’s there was a 20-year railroad bubble. Tens of billions of dollars flowed in
from overseas to savvy promoters of the U.S. railroad system. But most investors lost
their shirt to these unscrupulous promoters who viewed the investors as sheep lining up to
be fleeced. But the railroads really did launch America into the industrial age, powering
the rise of steel and coal industries and the birth of factory farming. Investors were right
that some fundamental shift was happening, but it wasn’t until the hectic growth phase
was over that railroad investing became safe again.
The automobile industry had more than 500 public companies at the beginning of the 20th
century and ultimately shook out to a mere handful. Even the most visionary people
could not have foreseen the way the automobile dramatically changed people’s lives.
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In the 1920’s, radio emerged from military control after the First World War, and nobody
really knew what to do with the technology. It was initially perceived as a point-to-point
medium and thus a competitor to the telegraph. It took quite some time before people
figured out that it was best employed as a broadcast (few-to-many) medium. This led to
a scramble to build receivers and transmit content, which would permit people to
purchase them. But for a time, the only people who made money were the manufacturers
of receivers.
Nobody could work out how to profit from broadcasting itself, and
hundreds of companies “went under” in search for a viable business model that could
harness the potential of this new technology. In the end the problem was cracked and
audio broadcasting became a profitable business, which shaped the evolution of mass
culture based on national advertising. But it took a long time and there were many
casualties along the way.
The 1980’s was the advent of the PC revolution. Scores of PC companies went public,
prices soared in a great bubble that ended with the technology crash of 1983-84.
Although PC unit growth continued at more than 25%, for almost two decades, only one
participant in the original PC boom – Apple Computer survives today. Dell and Compaq
both developed after the PC bubble burst. And Microsoft, which dominates PC software,
only went public near the end of the original boom
While the entry barrier for internet companies appears to have been far lower than it was
for the PC or automobile industries, the internet bubble has similar characteristics to
bubbles of other generations. Few have yet to figure out how to make serious money
25
from it. The key for investors to realize is not to confuse revolutionary technology with
enormous profits.
Outlook for technology stocks
The long term for technology is bright. Given the dramatic developments in the internet
and technology, there will be more innovations and breakthroughs that no one would ever
imagine. But the short-term outlook is very questionable. The following factors continue
to weigh heavily on technology stocks:

P/E’s are coming down, but not entirely. While reverting back to the historical
S&P level of 15 may not be necessary, a Nasdaq P/E of roughly 35 still looks
high, as the true winners and losers have not yet been shaken out.

Higher Compensation Costs. Given that many of these technology stocks issued
enormous stock options to employees that are basically underwater, companies
will be forced to pay more in cash to retain top talent. This will ultimately be a
drain on the already battered earnings estimates.

Accounting Rules. Those stock options granted to employees are not considered
compensation expense according to the Financial Accounting Standards Board.
Thus, earnings of high tech companies (where options are most prevalent) may
actually be inflated due to this phenomenon. It therefore lowers a stocks P/E
ratio.
26

Technology Spending slowdown. This can only hurt technology companies. As
corporations “take a breather” and find ways to cut costs in a wobbly economic
environment.

The economy. Taking a top-down approach to stocks, if indeed the country is
headed into (or is already in) a recession, that dampens consumer confidence, and
places consumers and business in a wait-and-see mode.
After many investors got burned with their internet and technology stocks over the past
year and a half, everyone seems to be taking a big breath and assessing the landscape
before committing. For investors it’s committing to buying technology stocks. For U.S.
corporations it’s committing to additional technology spending.
The internet
infrastructure is being built. The next phase is the figure out how to profit from its
existence.
Long term prospects for technology are quite promising. The next great surge in the
market will likely be propelled by streaming audio and video. It is likely that everything
we call radio and television will migrate to the Web’s digital platform, because it offers
far richer capabilities and far more choice. Streaming audio and video will require
broadband connections to the Web, something that roughly 6 million users have now.
But as it grows in popularity, and that number approaches 20 million, then the real fun
begins. The industry will sell more hardware, software and services in the next ten years
than what was sold in the past 20 – that means more microprocessors, audio cards, chips,
27
disk drives, digital radios, broadband hardware, storage software systems and fiber optic
glass.
To say that the Internet and the technology sector was a big bust is extreme. Surely, the
plummeting stock market was disconcerting, but the web continues to redesign the way
business is done. The web has impacted even the least internet dependent corporations
by flattening hierarchies and customizing products.
Their skill requirements have
changed as muscle work declined and mind work increased. Alliances and complex
supply webs have reduced vertical integration, and more market niches have been
created. Companies have been forced to innovate and operate at a faster pace than ever
before. Consider the “Old Economy” company, Federal Express. The company has
totally re-designed its business around the web. Customers can track packages 24 hours a
day to pinpoint there whereabouts. In 1998, the company declared that its physical
distribution system of trucks and airplanes was less valuable than its information
resources. This is an example of how smart companies are using the web to achieve
goals they have been striving towards for years: focusing on core competencies, reducing
transaction costs, innovating more effectively and gaining new ways to achieve customer
relationships.
There are more than three million digital switches for every human being on the planet.
There are half a billion PC’s - one for every 13 human beings. They are not going away
any time soon. The internet is spreading at high speed throughout the world is also not
going away. The revolution is real, and the recent upheaval in the stock markets will be
28
looked back upon as a minor spike in the road of the new economy. While picking the
individual winners will be a challenge, and there may be some more short-term dustsettling, the technology sector as a whole should be a profitable place to be for the long
term.
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