Thursday 19 March 2020 7:53 am

Boom or bust: The risk of a repeat of the dot-com bubble

On 10 March 2000, the US Nasdaq stock market peaked at 5,048.62. By October 2002, the index had lost 78 per cent of its value, or about $5 trillion.

The Nasdaq had swelled due to the proliferation of internet-related companies aiming to make money from this nascent technology. In fact, between 1995 and 2000, the Nasdaq rose by 400 per cent. This boom and bust has come to be known as the dot-com bubble.

Over the past 20 years, tech has clearly recovered, and now forms a cornerstone of society. It’s hard to find someone who doesn’t own a smartphone or have an email account. The FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google) have helped to drive markets to fresh all-time highs.

At the moment, of course, stock markets are looking bedraggled. Share prices have taken a beating due to fears surrounding the coronavirus epidemic. But it is still worth looking back to the 2000s to ask what led to this bubble, and whether it could pop again?

Robin Brown is managing director of technology at Stephens Investment Bank. He was working in Silicon Valley during the dot-com years as a consultant for the tech company Worldcom. Prior to the bubble bursting, Brown describes it as a “time of plenty”.

“Orders were coming in via fax machine. One person described it as shooting fish in a barrel,” he recalls. “It was a different world — people didn’t understand the internet at the time.” 

Brown recalls that it was an exciting time, but also a time of hubris.

“It fuelled a mental state that this would carry on forever. A lot of the people around me were relatively young and hadn’t seen a large recession, and the internet was a new thing — it was the panacea that was going to change how everything worked and how all businesses transacted. That was a bit premature, and people overinvested, thinking the market would grow quicker than it did,” he says. “The hubris and extravagance of those internet companies and investors led into a big, big growth phase, which resulted in a crash.”

Part of the problem was that few people really understood what the internet could be used for. People piled money into overhyped stocks of companies that claimed it could do things that simply weren’t possible at the time. 

“A lot of the technologies (being proposed at the time) are only now coming into full and proper use — they’ve slowly developed over time.”

Some companies focused on growing their market share, even if that meant running at a loss. Others aimed to build brand awareness, so offered products and services for free or at large discounts. As a result, the scene was full of companies making no profit and becoming highly indebted, so rising interest rates — as well as a recession in Japan — were a major problem.  

“Investors were captivated by the ‘unlimited potential’ offered by the internet and it did not seem to matter that many companies had never made a profit — nor had a credible plan to ever become profitable,” recalls Larry Puglia, portfolio manager of the T. Rowe Price US blue chip equity fund. “Many were also run by young entrepreneurs, with little managerial experience. Nevertheless, each new tech-oriented IPO seemingly had little trouble raising capital.”

Puglia also blames the media in part for the bubble, suggesting that some companies were rewriting the rules of business, even as their valuations became detached from any rational financial underpinnings.

But perhaps the biggest problem was a sense that the internet was a way to get rich quick.

“Businesses, clients, friends in the pub and even family were coming up with ideas and saying it would revolutionise their personal circumstances — it was just very naive,” says Brown.

“I tried to explain to people that you couldn’t just build an internet business overnight, but they were adamant that all you needed was a website and the money would come rolling in. 

“You look back now. None of us had mobile phones, except for a select few. At Worldcom at the time, none of us had work mobiles. I had a personal one, but it was nothing like a smartphone. The office gave us Blackberries, but we left them in a drawer thinking ‘why on earth would you want email when you’re out of the office?’”

So what has changed? A major difference now is that the business models based around tech and the internet are more sophisticated. 

Two decades ago, many firms simply focused on selling products and equipment, but this was cyclical and businesses had to start from scratch each year to find new business. 

Today, several businesses have adopted the “as-a-service” model, where customers subscribe to use a software or piece of equipment that is maintained by the owning company. This model means that the company can generate regular income.

“Businesses have adapted to ensure that the services they supply are literally that: a service. We see that in software, infrastructure, data, public cloud hosting — everything is now ‘as a service’, generating recurring revenue,” says Brown. “Companies that are still tied to historic, short-term and one-off sales are significantly less valuable.”   

It’s certainly possible to find similarities between the dot-com bubble 20 years ago and today. Some stocks still get hyped up by investors and the media even though it’s unclear how they’ll ever be profitable — just look at Tesla, which briefly had a valuation higher than Ford or General Motors, despite selling a fraction of the number of cars as those companies, or Netflix, which is billions of dollars in debt.

But these examples aside, we have a much more grounded — and realistic — understanding of what technology is capable of. As Franz Doerr, founder and chief executive of fintech firm Flatfair, points out: “Fundamentally, the sector is now a part of many investors’ core strategies and — perhaps more importantly — is key to so many industries and sectors, meaning that funding will be allocated to tech as it is a key piece in too many ecosystems to be ignored.”

So is today’s tech sector at risk of bursting once again? In some ways, it already has — the tech-heavy Nasdaq is currently down around almost 30 per cent since its peak due to the coronavirus pandemic. 

A better question to ask is whether the tech sector will recover once the crisis is behind us. And in these uncertain times, who knows what the future holds?

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