THE
 TECHNOLOGY
STOCK BUBBLE
  Review and Outlook




  David S. Carr
  Contemporary Topics in Finance
  MBA –8439
  Prof....
Introduction



The last several years will go down as one of the most volatile periods to invest in stocks.

Nowhere is t...
How did it all Start?



Arguably, it all began with Netscape in 1995. The IPO was extremely successful as the

stock pric...
Thomas Weisel partners initiated a strong buy on the stock, predicting that the company

is likely worth $10 billion, and ...
1999, the company reported $13 million in revenues and $144 million in losses (See

CHART 1 below). But unlike many other ...
WebVan now has roughly $200 million in cash and at its current run rate will burn

through the cash in two quarters. Furth...
They did stupid things.      Million dollar Super Bowls were run by many of these

companies that ultimately produced litt...
free shipping or significant discounts, but it never amounted to any kind of customer

loyalty. Customers would simply mov...
companies without doing their due diligence. There was a herd mentality and they

invested irrationally.



The rest of th...
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
...
Beginning in March 2000, that all started to change. As many e-commerce companies

were no longer in the landscape, other ...
CHART 5 – NASDAQ COMPOSITE 5 YEAR TREND




To exacerbate the matter, the Federal Reserve continued in its fight against i...
little too late, as the hiked rates in 2000, and December earnings warnings dampened the

climate, squelched additional co...
Consider the following chart (CHART 6) of the highest ever one day gains from IPO’s

and look and the sharp decline in sto...
CHART 7 – Investment Banking Firms IPO’s Underwritten

Firm                             IPO’s -   Amt Raised       IPO’s  ...
Last year, VC firms financed an estimated $100 billion worth of start-up companies and

entrepreneurs.   This year, the be...
The Skeptics



•   In December 1999, Burton Malkiel, Author of “A Random Walk Down Wall Street,”

    indicated that the ...
exposure is making an enormous leap of faith.” He also downgraded the then hot

    telecom sector in April 2000 based on ...
•   In March of 2000, now Merrill Lynch mutual fund manager James McCall stated,

    “We don’t get too hung up on valuati...
•   Sycamore Networks is in the optical networking field. In March 2000, Sycamore’s
    outstanding stock was worth $40.1 ...
•   A Fundamental Economic Revolution. The internet has opened up so many

    opportunities by changing the way consumers...
•   For the more professional players, there was the lure of the internet-based “new

       economy” of perpetual low inf...
sector’s decline in 2000. Eric Guftason, Managing Partner of a prominent fund portfolio

indicated in a February 2001 inte...
unlimited access to free content. But at the same time, it was supposed to offer hugely

profitable investment opportuniti...
The automobile industry had more than 500 public companies at the beginning of the 20 th

century and ultimately shook out...
While the entry barrier for internet companies appears to have been far lower than it was

for the PC or automobile indust...
Thus, earnings of high tech companies (where options are most prevalent) may

       actually be inflated due to this phen...
begins. The industry will sell more hardware, software and services in the next ten years

than what was sold in the past ...
any time soon. The internet is spreading at high speed throughout the world is also not

going away. The revolution is rea...
Bibliography
Barry, Andrew (2001, March 19) “Trashed – Is it Time to Go dumpster-diving for tech
stocks?” Barron’s, pp. 25...
Bibliography (cont.)

HTTP: Hundley, Kris (and Jeff Harington) “Technology Companies Struggle to Survive
in Wake of Econom...
Bibliography (cont.)

HTTP: Pfeiffer, Eric W (2001, April 2) “Professor of P/E” Forbes ASAP [Online] Dow
Jones Interactive...
Bibliography (cont.)

HTTP: Varian, Hal (2001, February 8) “Comparing the Nasdaq bubble to tulipmania is
unfair to the flo...
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THE TECHNOLOGY STOCK BUBBLE

  1. 1. THE TECHNOLOGY STOCK BUBBLE Review and Outlook David S. Carr Contemporary Topics in Finance MBA –8439 Prof. W. Delva April 25, 2001 1
  2. 2. 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
  3. 3. 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 3
  4. 4. 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. 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 4
  5. 5. 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 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 e- commerce into view. CHART 1 – Webvan Income Statement Data Webvan Income Statement In Thousands In Thousands 2000 1999 Net Sales $178,456 $13,305 Gross Profit $47,217 $2,016 Net Loss $(453,289) $(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, plan- ahead method of shopping for groceries. That hasn’t happened. 5
  6. 6. 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 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
  7. 7. 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 7
  8. 8. free shipping or significant discounts, but it never amounted to any kind of customer 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. Dot- coms 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 8
  9. 9. companies without doing their due diligence. There was a herd mentality and they invested irrationally. 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
  10. 10. 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- Jan- 87 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% 1 5% 1 0% 5% 0% 1 991 1 992 1 993 1 994 1 995 1 996 1 997 1 998 1 999 2000 2001 10
  11. 11. 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
  12. 12. 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 12
  13. 13. little too late, as the hiked rates in 2000, and December earnings warnings dampened the 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. 13
  14. 14. 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 Public Date Offer Price Day 1 Close 4/5/01 Price VA Linux Systems 12/1999 $30 $ 239.25 $ 1.94 Theglobe.com 11/1998 $9 $ 63.50 $ 0.19 Foundry Networks 09/1999 $12.50 $ 78.13 $ 7.19 Webmethods, Inc. 02/2000 $35 $ 212.63 $19.00 Freemarkets, Inc. 12/1999 $48 $ 280.00 $ 8.69 MarketWatch.com 01/1999 $17 $ 97.50 $ 3.88 Akamai Technol. 10/1999 $26 $ 145.19 $ 7.50 CacheFlow Inc. 11/1999 $24 $ 126.38 $ 4.00 Crayfish Co. 03/2000 $240 $1,126.00 $ 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
  15. 15. CHART 7 – Investment Banking Firms IPO’s Underwritten Firm IPO’s - Amt Raised IPO’s - Amt March 2001 Raised March 2000 Morgan Stanley Dean Witter 4 - $5.8 billion 22 - $ 8.0 billion Goldman Sachs 3 - $0.4 billion 19 - $12.8 billion Merrill Lynch 4 - $1.4 billion 9 - $ 3.3 billion Lehman Brothers 2 - $0.2 billion 7 - $ 2.1 billion Deutsche Bank Alex Brown 1 - $0.1 billion 10 - $ 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
  16. 16. 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. 16
  17. 17. The Skeptics • 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 17
  18. 18. 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 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. 18
  19. 19. • 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. 19
  20. 20. • 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 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: 20
  21. 21. • 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. 21
  22. 22. • For the more professional players, there was the lure of the internet-based “new economy” of perpetual low inflation, increasing productivity, and banishment of 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 22
  23. 23. 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 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 23
  24. 24. 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. 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. 24
  25. 25. The automobile industry had more than 500 public companies at the beginning of the 20 th 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. 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 25
  26. 26. 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 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. 26
  27. 27. 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. • 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 27
  28. 28. 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, 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 28
  29. 29. 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 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 dust- settling, the technology sector as a whole should be a profitable place to be for the long term. 29
  30. 30. Bibliography Barry, Andrew (2001, March 19) “Trashed – Is it Time to Go dumpster-diving for tech stocks?” Barron’s, pp. 25-29 HTTP: Bransten, Lisa (2001, March 26) “E-Business – Starting Gate” The Wall Street Journal [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=J010850037’WSJ01-985564836 HTTP: Chevreau, Jonathon (2000, February 3) “How to Avoid a Net Stock shakeout” Financial Post [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Colvin, Geoffrey (2001, April 2) “Livin’ El Dia Loco” Fortune [Online] Dow Jones Interactive Available: www.fortune.com/indext.jhtml?channel=print_article.jhtml&doc_id 201090 HTTP: Corcoran, Elizabeth) (1999, July 26) “The E-Gang” Forbes [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=FB9919300000’MNS01-932947377 HTTP: Couzin, Jennifer (2000, June 13) “E-Toys Gets $100 Million To Play With” The Standard [Online] http:www.thestandard.com/article/display HTTP: Couzin, Jennifer (2001, January 4) “Etoys Slashes Staff by 70%” The Standard [Online] http:www.thestandard.com/article/display HTTP: Crawford, Liz (2001, April 4) “ Why Webvan’s out of Gas” CBS MarketWatch http://www.yahoofinance.com HTTP: Dreman, David (1999, July 7) “Internet Myth and Reality” Forbes [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Farnsworth, Chris (2001, March 21) “Hope Glimmers for fiber optic firms..” The Orange County Register [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=J0101500006’WSJ01-979516806 HTTP: Greenblat, Eli (2000, February 5) “Positive Precedent for Internet Bubble” The Age [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp 30
  31. 31. Bibliography (cont.) HTTP: Hundley, Kris (and Jeff Harington) “Technology Companies Struggle to Survive in Wake of Economic Boom” St. Petersburg Times [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: IP, Greg (2001, January 22) “New Investing Rules May Still Have Merits” Th Wall Street Journal [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp Kleintop, Jeffrey (2001, March 12) “The Resilient Consumer” PNC Advisors Newsletter HTTP: Krantz, Matt (&James Kim) (2000, February 16) Bear stages sneak attack on net stocks, Nasty swipe bursts bubble, leaves e-stocks bleeding” Money Magazine [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: McCartney, Jim (2001, April 1) “Minnesota Venture Capitalist Addresses the Changing Market Environment” Saint Paul Pioneer Press [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: McGarvey, Robert (2001, January) “Ding” Entrepreneur Magazine [Online] Yahoo Small Business http: www.smallbusiness.yahoo.com/entrepreneur.html?s=smallbiz/articles/20010330 Meyer, James M (2001, March 5) “Market Commentary” Janney Montgomery Scott Market Commentary HTTP: Moore, John Frederick (1999, May 26) “Is the Net Bubble Bursting?” CNNfn [Online] Available:http:cgi.cnnfn.com/output/pfv/1999/05/26/technology/netstocks HTTP: Morris, Charles R (1999, August 8) “The Bubble Economy” Los Angeles Times [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=LATM9922000645’LAT01-934070735 HTTP: Naughton, John (2001, January 4) “Much More than a bubble: The lesson of history is that the web’s flaky start need not be fatal” The Observer [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Perkins, Anthony (2001, January 15) “New Hope for The New Economy” The Wall Street Journal [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=J0101500006’WSJ01-979516806 31
  32. 32. Bibliography (cont.) HTTP: Pfeiffer, Eric W (2001, April 2) “Professor of P/E” Forbes ASAP [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Rajwade, AV (2000, January 17) “The Internet Bubble” Business Standard [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Scheschuk, Brice (2001, January 15) “The next Net Fortunes” Macleans [Online] DowJones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Serwer, Andy (2001, March 19) “It’s My Party I can Cry if I want To” Fortune [Online] Dow Jones Interactive http:/www.fortune.com/index.jhtml HTTP: Sparks, Debra (1999, August 16) “The Great Net Stock Sell-Off” Business Week [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=BW9922400109’MNS01934761709 HTTP: Stoughton, Stephanie (2001, February 12) “Executives Mull Brutal Change in Web Climate” The Boston Globe [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Stross, Randall (2001, February 2) “Only A Bold Gamble Can Save Webvan Now” The Wall StreetJournal [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=J0103300000’WSJ01-981072000 HTTP: Swanson, K.C. (2001, March) “Lessons From the Folly: Opening the March 2000 Time Capsule” The Street.com [Online] Yahoo Finance http:biz.yahoo.com/ts/010309/fund2_010309.html HTTP: Tapscott, Don (2001, February 23) “Despite the dot-com carnage, the net based transformation of business has only just begun” The Globe and Mail [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Toffler, Alvin and Heidi (2001, March 29) “New Economy? You Ain’t Seen Nothin’ Yet” [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=J0101500006’WSJ01-979516806 32
  33. 33. Bibliography (cont.) HTTP: Varian, Hal (2001, February 8) “Comparing the Nasdaq bubble to tulipmania is unfair to the flowers” The New York Times [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Ward, Jacob (1999, May 20) E-Toys Blows Past the Competition” The Standard http:www.the standard.com/article/display Wherry, Rob (2001, April 16) “Bubbles & Busts” Forbes Magazine, p216 HTTP: Willoughby, Jack (2000, March 20) “Burning Up: Warning: Internet Companies are running out of cash –fast” Barron’s [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp HTTP: Wingfield, Nick (2001, January 25) “Can These Dot-coms Be Saved?” The Wall Street Journal [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=J01025500044’WSJ01-980380843 HTTP: Woo, Vivian (2001, April 16) “Fifteen Minutes of Fame.” Forbes [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=FB0108900446’MNS01-987379239 HTTP: Zuckerman, Gregory (also BL Cassell, Lisa Bransten) (2001, March 9), It’s the New Economy Stupid!” The Wall Street Journal [Online] Dow Jones Interactive Available: http/story_cleancpy.asp?articles=J0101500006’WSJ01-984096121 HTTP: (2001, January 22) “Nasdaq Crashed. The New Economy Didn’t” Business Week [Online] Dow Jones Interactive Available: http/ptg.djnr.com/croot/asp/publib/story.asp http://www.hoovers.com/ipo/statistics/0,1334,183,00.html http://www.ipo.com/year-in-review/ http:www.123jump.com/live/ 33

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