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By Jason Zweig
Nov. 13, 2014
I don’t often look back at what I’ve written and think: I nailed it. One of my columns, however, does seem to hold up pretty well more than 15 years later.
In May 1999, I looked at Internet stocks and counseled readers not to buy them. Knowing, as you probably do, that Internet stocks lost approximately 90% from their peak in early 2000 to their low point in 2002, you might think this column made points that had to be howlingly obvious at the time, but you’d be wrong.
They weren’t obvious.
Don’t let yourself be blinded by hindsight bias. The whole reason there was a bubble in the first place is that people really did believe Internet companies would grow faster than any other companies had grown in human history — and never slow down, let alone stop.
In mid-1999, after earning a 117.3% return in just the first five months of the year, Monument Internet Fund portfolio manager Alexander Cheung predicted that his fund would gain 50% a year over the next three to five years and an annual average of 35% “over the next 20 years.”
Like all bubbles, this one wasn’t completely irrational. When the potential growth of a transformative innovation is high enough, excitement about the future is what gets the idea funded. That has been true for almost every “new era” bubble in financial history: the South Sea in 1720 (transoceanic trade), the British railway boom, the craze for electric-utility and radio stocks in the 1920s, and so on.
The Internet was transforming the world, and it is even more pervasive today than many of its most enthusiastic boosters in 1999 expected it to be. The people buying dot.com stocks turned out to be absolutely right about the industry’s potential. But they paid too much to participate in it. History proves that growth rates are finite and that they decay over time. Just as growth is limited in the natural world — trees can’t grow to the sky, because they would collapse under their own weight long before they got there — it is limited in the financial world. No company, no industry, no strategy can grow far faster than average for long; if they did, they would run out of new customers and sources of profit. History also shows that the early leaders in a new industry often don’t turn out to be the long-term winners.
As Benjamin Graham wrote in 1934 about the bull market that peaked in 1929:
The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a…stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the preboom standard, the conclusion to be drawn was not that the stock was now too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell but even upon the price at which it would deserve to sell. This fantastic reasoning actually led to the purchase at $100 a share of common stocks earning $2.50 a share. The identical reasoning would support the purchase of these same shares at $200, at $1,000, or at any conceivable price.
In 1999, the identical reasoning was extended to companies that had no earnings at all, on the theory that their future profits were virtually infinite.
Pointing out, as I did here, that none of this made any sense made me about as popular as someone who eats too many baked beans right before a wedding. Every day for months, I received dozens of emails calling me an idiot, a moron, a dinosaur, and a seemingly endless variety of anatomical obscenities.
Around the middle of 2000, those emails stopped coming.
The lesson I learned: When a transformative investing idea first emerges, the people who believe in it are regarded as crazy by everyone else. Once the idea takes hold, becomes ever more popular, it can turn into orthodoxy — which is the mindset from which bubbles are made. And, finally, when those who question it are regarded as crazy, then the bubble is getting ready to burst.
Here’s the column. If you read it, let me know whether you think it has held up over time.
Money magazine, May 1999
For the next few months, perhaps even for a year or two, this may seem like one of the stupidest investing columns ever written. That’s because I’ve been asked to answer the question “Can you get rich by buying an Internet stock fund?” and my answer is no.
Yes, I know: The Internet Fund was up 196% in 1998 and another 84% through March; Munder NetNet Fund was up 98% last year and 42% more so far in 1999; and Monument Internet Fund, launched just last November, has returned 135% in its first four months of life.
Who can resist returns like these? Maybe no one, but I think you should. In the long run, the Internet stocks and the funds that buy them have no more chance of living up to their hype than Mike Tyson has of winning a Nobel Peace Prize. Many people investing in the Internet are basing their decision on a complete misunderstanding of how industries grow and investors prosper. The notion that a long-term investor can become rich simply by “buying early” into a revolutionary new industry — like the Internet — is flat-out wrong.
Of course, that’s not what the bulls say. At a recent conference on Internet stocks sponsored by PaineWebber, Greg Jones, chief executive of uBid, an Internet auction site, told me, “The Internet will change your life. It’s the next frontier, as radio once was. This is the wave of the future, this is the business. You need to invest in the companies that will be part of the future.”
And the people who invest in these companies are at least as bullish as the people who run them. “I firmly believe the Internet companies will be among the great growth companies of the future,” says Monument Internet Fund co-manager David Kugler. “There’s no stoppin’ ’em.”
But let’s look at why Internet stocks are really so hot: It has less to do with their actual growth prospects than you may think. And let’s see what past revolutions can tell us about this one.
The thrill seekers
Peter Lynch, the legendary former manager of Fidelity Magellan Fund, has long advised investors to “buy what you know.” Advocating “the amateur’s edge” that comes from “the power of common knowledge,” Lynch has famously recommended buying the stock of companies whose products or services you like. For instance, after his wife told him how great L’eggs pantyhose were, Lynch bought the stock. Likewise, with a few clicks of a mouse, you can buy books on Amazon.com; with just a couple more clicks, you can buy Amazon’s stock through an online brokerage. “E-commerce” is easy, economical and exhilarating. And that’s part of the reason so many people believe it’s inevitable that Internet stocks will pay off big — and why they think their high prices are justified.
But as Lynch has pointed out, you can’t just invest in what’s familiar; you must also research it. There’s a world of difference between a great company and a great stock. Just because you love shopping online doesn’t mean that online retailers will turn out to be good investments. One big reason online shoppers love “e-tailers” so much is because their prices are low — so low, in fact, that it’s not clear how some of these companies can ever turn a profit. That’s great for you as a shopper — but maybe not as an investor.
Internet stocks are also hot because their share prices are so high and because of the throngs of thrill-seeking day-traders who chase them. If you’ve got $1,000 invested in a stock priced at $1, and it goes up to $2, you’ve doubled your money. But you probably won’t be as excited as someone who has $1,000 invested in a stock that jumps from $100 to $200 — even though you both have the same 100% gain. That’s because people tend to focus on the absolute size of a price change, not its relative value. Because big price swings make it seem “something important and exciting has occurred,” Harvard psychologist Paul Andreassen has written, “large price movements cause increased trading.”
And, as anybody who has ever been a teenager knows, people are much more willing to take risks when they’re in groups than when they’re alone. Marvin Zuckerman, a psychologist at the University of Delaware, has noted that merely joining a group of “sensation seekers” can make risks seem less scary — and that the worry of being seen as a wimp can become scarier than almost any physical or financial risk. That’s why the visitors to online chat rooms and message boards egg one another on so wildly as Internet stocks surge up or down. And it helps explain why the price of these shares is so often divorced from their business prospects.
If only I had bought Microsoft…
Investors also have a bad habit of beating themselves up over past mistakes. How many times have you heard someone groan, “If only I had bought Microsoft when it went public…”? It now seems obvious that in 1986 Microsoft was sure to be a big winner. But in a series of brilliant experiments, psychologist Baruch Fischhoff of Carnegie Mellon University has shown that the knowledge of how an event actually turned out changes our original opinion of how likely it was to occur in the first place. Looking back, says Fischhoff, a given outcome seems “more likely than it actually was.” Thus Microsoft now appears to have been a sure thing — but, in fact, it was considered a controversial and risky stock at the time, and many professional money managers wouldn’t touch it until 1991.
Microsoft’s spectacular gain makes picking long-term winners seem much easier than it really is, because it makes us forget that in 1986 several other companies, such as Novell and Borland, looked just as likely as Microsoft to dominate the software business. When you’re looking for “the next Microsoft,” you need to ask whether you could have recognized the first Microsoft. Most people — including most mutual fund managers — did not.
Don’t know much about history
There’s a phrase used by Internet bulls: “first-mover advantage.” That’s Netspeak for “the early bird catches the worm,” and it expresses the belief that the companies that grow the biggest, the fastest — like, say, Amazon, AOL, eBay and Yahoo! — will obliterate the competition over time.
But 200 years of corporate history show that the early leaders in a dynamic industry almost never turn out to be the victors in the end. This is not some antiquated rule of how companies used to behave in the days when men wore powdered wigs and wooden dentures; it’s more like a universal law that governs how companies evolve in any industry, at any time. Nor does the fact that everything moves faster on the Internet nullify this law; actually, the high velocity of “Net time” is likely to enforce this law of corporate destruction even faster and more forcefully.
“Thinking today’s market leaders will prevail in the future is probably a great mistake — especially when their stocks are at such high valuations,” says Alan Meckler, who runs www.internet.com, one of the best Websites for monitoring the online world, and who took his first Internet company, Mecklermedia, public five full years ago, raising $6 million — and then selling it last year for $274 million. Back in 1982, Meckler points out, two leading software programs were Wordstar and Visicalc–packages that ended up on the ash heap of computing history.
Time after time, history has shown it’s the companies that come later — in our case, meaning Internet companies not yet extant — that end up making the real money. Far from being easy, the game of picking long-term winners among Internet stocks is probably as tough a challenge as any investor will face — so tough that most investors are doomed to fail.
Ye olde information superhighway
Today’s information superhighway is all about moving data, goods and money — so let’s compare the Internet to the first great wave of change in transportation. If you think the Internet has transformed human life more than anything else, here’s some quick history. Before 1800, it took a week to travel from Boston to New York City over crude and crooked roads, and you would have arrived exhausted, aching and cloaked in dust. If you rode by coach instead of on horseback, you endured broken axles, shattered wheels and the ordeal of helping lift the wagon over ruts or out of mud.
Then came a quantum leap in transportation technology: turnpike companies that cleared straight, smooth swaths through the woods, laying down roadbeds of gravel or timber. These new highways struck many as one of the greatest improvements in the quality of life ever seen. Between most cities, the travel time was suddenly cut in half — with more comfort and safety. So great was the miracle of rapid transit that new users of the turnpikes often burst into spontaneous prayers of gratitude when they arrived at their destination. By 1822, the cost of shipping a ton of goods had dropped from as high as 60 cents per mile to just 12 cents — much as Amazon.com and Shopping.com are slashing prices today.
Over the corpses
Only a dunce could have looked at the phenomenal transformation the turnpikes had wrought and not have wanted to invest in them. And, in fact, they were the most popular stocks of their time. By 1800 two of every three companies in the U.S. — 219 in all — were in the transport business, and by the end of the highway boom in the 1830s roughly 500 had sprung up. All told, investors put up roughly a billion dollars in today’s money. The initial public offerings of the early transportation companies were often oversubscribed, with demand for shares often exceeding supply by nearly 100 to 1. Sound familiar?
Unfortunately, while the turnpikes were incredibly beneficial for the people who used them, they were a disaster for the people who invested in them. Only six of New England’s 230 turnpikes ended up earning positive long-term returns, and 3% to 5% a year turned out to be the best they could muster — at a time when government bonds yielded 5% to 7%. Price competition, then newer technologies like canals and steamboats (also hot stocks for a few years), crushed the rest of the turnpikes. Finally, around 1835, came the railroads, which not only finished the last of the turnpikes but put the canals and steamboats out of business too.
Most poignantly, the railroads were often able to lay their tracks with remarkable ease over readymade rights of way, through the clearings that had been made, years before, by the turnpikes. It’s hard to think of a more poetic irony: The transportation revolution was consummated on top of the corpses of the companies that invented it.
These waves of entrepreneurial energy and technological innovation — which Austrian economist Joseph Schumpeter called “creative destruction” — seem to apply to every newborn industry. Imagine that 90 years ago you had foreseen that the automobile industry, then in its infancy, would change the world. You would have been absolutely right — but your investments would have been absolutely wrong. You couldn’t have bought Ford, even though the company was already 10 years old: Ford didn’t go public until 1956. Chrysler did not yet exist. General Motors was only a year old. Instead, you would have bought the industry’s dominant companies: hot stocks like Hupp, Packard, Pierce-Arrow, Road-Runner Auto and Stanley Motor. But other companies — like Hudson, Nash, REO and Studebaker, not to mention GM and Ford — quickly zoomed past the early leaders. Over the next 20 years you would have lost nearly all your money — even as the auto business was going through one of the great booms of all time. The same thing happened with radio in the 1920s.
Now imagine that it’s 1982, and you sense that the PC will become the hottest technology product of all time. Which stocks would you buy? Not Compaq, which didn’t go public until 1983; not Dell, which wasn’t founded until 1984; not Microsoft, which was privately owned until 1986. No, you would have bought one of the computer industry’s early leaders — Commodore, for example. Nearly all of these companies, despite their “first-mover advantages,” went bust; investors in several of these stocks lost nearly all their money.
The price is not right
The question is not whether the Internet will be a great growth industry — even I have no doubt about that–but whether it’s worth paying up to 100 times the price of the average stock to participate in that growth. At Home Corp., for instance, is trading at 269 times its sales over the past year, with Broadcast.com, CMGI, eBay, Inktomi and Yahoo! at 128, 53, 284, 105 and 149 times their sales, respectively. Meanwhile, the average stock can be bought for just two times its sales.
That means there’s no margin for error. Unless the Internet companies grow vastly faster than the average stock — and sustain that growth for many years to come — they will turn out to have been terribly overpriced. While a handful of Internet stocks will go on to earn gigantic returns, I would not be at all surprised to see most of them lose at least 90% of their value.
Of course, I’d rather see you invest in the Internet through a long-term holding in a fund than by trading a few Internet stocks at a time. Funds are a lot safer. But the best approach — a broadly diversified index fund that would own nearly every available Internet stock — doesn’t exist yet. And Paul Cook, lead manager of the $1.2 billion Munder NetNet Fund, tells me he’s got only 15% of his personal assets invested in his own fund. More than that, says Cook, “would not be a prudent allocation for me.” That’s a wake-up call if I’ve ever heard one, and one more reason why regular folks should consider a 5% position the absolute limit in this kind of fund. Personally, I’m keeping my position at zero for the foreseeable future.
Original article in PDF format (in two parts; files may take a while to load; you might need to right-click, Ctrl+click, or hold down your cursor):
Source: Jason Zweig, “Baloney.com,” Money Magazine, May 1999