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Bill’s Point of View
These words may well be the most dangerous words one could use to describe the stock market. Although we have seen bubbles come and go over the years, euphoria inevitably expands at the high point and we start to believe that perhaps things really are different, that this time the gains are here to stay. But then the inevitable meltdown occurs, and the damage always seems more pervasive than we could have imagined. While it is always difficult to predict when the bubble will burst, some event usually brings us to our senses. In the tulip-mania in the 1600’s, it was a sailor who ate a bulb that had just traded for $1 million. In March of 2000, Jack Willoughby’s article in Barron’s on the Death List of Internet companies running out of money was probably this market’s version of eating the tulip bulb. So, once again, the cycle appears to have followed its course, this time with an unprecedented run-up making the meltdown even more painful. Indeed, the wisdom of hindsight makes it tempting to interpret this as one more bubble that will recede into history. However, as we sift through the aftermath, I think it is appropriate to explore the premise that perhaps this time it really is different. I believe it could be for two primary reasons. First, productivity gains. The recent bubble was created by an unusual set of circumstances. The Internet exploded on our collective consciousness at the same time that productivity numbers started to show dramatic improvement, signaling a new era in which the corporate world looked like it was getting a payback for its aggressive spending on new technology. The Internet, with its potential to disrupt expensive distribution channels, promised even more dramatic gains. So, what happened? Although there was clearly some growth in productivity, projected numbers turned out to be too high, and were subsequently re-stated downward. The boom also created cost pressures, with developers charging $500 per hour, and time pressures for the larger companies to ‘catch up’ to the Internet. This high-pitch environment fostered many mistakes, clearly demonstrating that the new era was not immune to challenges of the past. Despite the now-tempered expectations, I maintain that the Internet and other new technologies are powerful productivity tools that will continue to have major impacts on the economy. I believe that our own firm, which has used the new technologies in innovative ways to reach an increasingly large market, is testimony to the potential for greater productivity. So, although I still have to rely on mostly anecdotal evidence, I believe the thesis of productivity gains is still valid, even though dislodging existing business processes will take longer, and higher margins may not necessarily result in the short-term. Second, the impact of the meltdown on technology companies has not been as devastating as in the past. In the meltdowns of 1974-1975 and 1983-1985, the disappearance of equity markets drove many companies to bankruptcy. Money they had raised had been invested in plants, equipment, and inventories, and when they failed to meet revenue projections, they could not adjust their overheads. At first glance, the Internet meltdown looked like the same story all over again, with over 800 dot-coms having gone out of business in the last 18 months. But, the rate of IT spending slowed, and while some casualties resulted, particularly in the consulting area, little permanent damage has occurred in the software industry as a whole. Instead, the major casualties appear to have been Internet start-ups that went public too soon and had not firmly established a sustainable business model. Thus, despite the recent traumas in the technology sector, we are starting to see the emergence of some attractive business models that resemble the software model of:
The proliferation of such business models could have profound implications. For instance, although Microsoft is a unique company, it is nevertheless interesting to note that in the last four quarters of slower economic activity, Microsoft reported $7 billion in earnings while its cash grew $11 billion to $36 billion. In other words, a successful intellectual property company creates an unusually attractive business model. Thus, although the bubble has popped, I would argue that the current market recovery, particularly in the software and Internet sectors, indicates that the wild enthusiasm for technology was not entirely misplaced. Increased Internet usage, bandwidth demands, enhanced wireless services, and enterprise-wide technology adoption continue to demand new and better infrastructure. Indeed, the Internet revolution seems to have evolved along the lines of the major technology booms of the past several decades. The first stage identifies the early leaders (Netscape, AOL, Yahoo, Amazon, etc.) and their success creates opportunities for raising capital for the second stage, when there is a piling-on effect to attack the obvious applications. The third stage evolves when the threatened part of the economy responds, the inevitable duplications get sifted out, and the real leadership usually emerges with new companies that develop applications that allow something to be done that could not have been done before. eBay is probably the most dramatic example, as real-time auctions involving millions of geographically dispersed participants were simply not possible before the Internet. We believe other new-model companies will continue to emerge, leveraging technologies to invent new industries in which they will enjoy, at least temporarily, no competition from established players. The intensity of the Internet mania, however, bred an unprecedented number of new companies in a brief time period, all hoping to exploit the Internet but many grossly underestimating the problems of penetrating established distribution channels. Market projections were, for the most part, based on immediate market acceptance and great emphasis was placed on establishing market share. When it became clear that intimate knowledge of an industry was still crucial, and Internet and Web-based talent was available, owners of existing distribution channels allowed a more gradual integration of the Internet into their businesses, and new companies that are succeeding adjusted to a smaller available market and a more gradual growth-rate. So, what do these developments mean for investors? First, we truly believe that technology is here to stay and there is no turning back. Moore’s Law and new software will continue to allow new and more efficient applications. Companies will either have to start spending again or risk their competitive position. Although the growth in spending in the late ‘90s was clearly unsustainable and probably unhealthy, we expect IT spending to return to the historical rate of 8-12 percent sometime this year and to once again grow at about twice the rate of the rest of the economy. We also believe the Internet will continue to grow, both from increased usage by existing users and the inclusion of new users around the world. This third stage of development will be lead by the true innovators who solve problems, or create businesses that were not possible before the arrival of this incredible communication tool. Many applications companies will fail, but others will adjust to smaller and slower markets and will develop attractive niche businesses or consolidate. Identifying these survivors will not be easy. While many new companies are based on great ideas, in a slower and smaller market, staying power and enterprise risk become all-important. When the balance sheet stabilizes, the odds of success greatly increase. For the past three years, we have been trying various quantitative methods to identify these types of companies, ones that are capable of not only leveraging new technologies but also weathering market forces. We have learned a lot and have had some success, mostly by focusing on balance sheets. Over the next few months, we will work to translate our approach into a tool that is useful for individual investors as well. Combined with our analysts’ qualitative research, we believe this tool will help investors more effectively search the depth and breadth of the market. In short, we believe the current market offers new and attractive opportunities to invest in the fastest growth part of our economy – technology. Although yet another bubble has popped, there is still great opportunity and, because there is no turning back to old ways of doing business, we think it’s safe to say: “This time it’s at least a little different.” |
