Bubble 2.0 investment advice from The Undercover Economist

Tim Harford’s book “The Undercover Economist” is a great read for those interested in everyday economics: from how the price of a cappuccino is set to why some aid projects in developing countries work and others fail and even dedicates a very readable chapter to one of my favourite topics: The 3G license auctions carried out in 2000-2001. But it’s his insights into the economics of transformational industries (like the internet) that I want to talk about here.

He talks about a particular transformational technology: the train, and about a bet he had with a fellow economist about the merits of investing in one of the major UK railway companies, Great Western Railways, when they went public in 1835. Tim thought you’d make more than a 10% annual return over the long term. The other economist believed the return would be lower than 10%. Tim lost the bet.

Not long after the Great Western Railway shares were put on sale for £100 a share in 1835, there was a tremendous burst of speculation in rail shares. Great Western shares peaked at £224 in 1845, ten years after the company was formed. Then they crashed and never reached that level again in the century-long life of the company.

Turns out you’d have got a 5% annual return over the long term. And this was in one of the successful companies.

So even the best rail companies weren’t great investments and the worst were financial disasters. But nobody disputes the fact that the railways completely transformed developed economies. Conservative estimates are that they added 5 – 15 per cent to the total value of the US economy by 1890 – a staggering amount when you think about it. But competition to build and operate railway lines kept profits modest. As long as competition is strong, the railways had little scarcity power.

Fast forward nearly 200 years and Tim goes on to ask 

whether, as [internet 1.0] bubble valuations suggested, company profits will really be so dramatically much higher in the next few years. It’s tempting to think that this is an argument about the power of the internet, mobile phones, computers and other recent technological advances. Many internet fans did indeed argue that it was reasonable to pay an enormous amount of money for a company like Amazon because the internet was ‘transforming everything.’

Unfortunately, that is not the point. Maybe the internet really is a transformational technology like electricity, mass chemical production or the railways. The answer will emerge over time but that answer does not actually matter much for the stock market. The hidden premise is that if we are in an economic revolution, shares should be valuable. This premise is wrong. Shares should rise in price only if there’s good reason to think that  future profits will be high. As we know, profits derive from scarcity; for instance, ownership of scarce land (protected by legal title), a scarce brand (protected by trademark) or an organisation with unique capabilities (protected by nothing more than the fact that most effective organisations are hard to copy). So share prices should rise only if economic transformation increases the degree to which organisations control scarce resources.”

The attempt to control scarce resources is why so many internet companies’ business plans revolve around getting as much market share as possible. Build the user base first and then figure out how to monetise it. (PayPal apparently used to pay $10 for each new member who signed up; their main competitor $5). This policy has worked for some companies but not for all. Business history is littered with usurpers taking over the crowns of previous incumbents. In 1996, Yahoo looked unassailable as the leading search provider. No-one could have foreseen Google eating their lunch. In more recent times MySpace was also a poster child for some time only to be eclipsed by Facebook.

Tim does make one concession to the tech space: eBay. A marketplace like eBay can only be successful if it collects many buyers and suppliers together in one place at the same time. That fact might make it very sticky as a business model. But even that should not be taken as read. Look at the eBay backlash going on at the moment  with former PowerSellers looking for alternatives like http://www.onlineauction.com/ and http://www.ecrater.com/ and http://www.amazon.com or even just relying on their own web presence and hoping for shopping search engines like Froogle and price comparison sites to send traffic their way.

Which brings me back to Tim’s analysis. The internet is transformational. Broadband is transformational. Web 2.0 is transformative. Web 3.0, 4.0, 5.0 and 94.0 will all doubtless be transformational. But that does not mean that the companies providing the transformational technology are themselves valuable. It might even mean that all investment in these transformational companies is  speculative and symptomatic of a bubble. That each new iteration of Web Something Point Zero will be accompanied with its own rapid boom and bust. That the real value is not going to be realised by the companies providing the transformational technologies. That the real value is going to be realised by the economy as a whole: By the freight company able to route trucks more efficiently; by the retailer able to source products faster and cheaper; by the bank that is able to target services better to its customers. Not by the company building the website technologies. Oh lookee here at Jeff from Venture Chronicles on VCs losing interest in Web 2.0 companies.  (An aside. Ariba:  The 800lb gorilla of “my” space – the B2B procurement space – have they ever actually been profitable?). 

This doesn’t make comfortable reading (or writing) for someone who works in the technology space. But I do think that Tim Harford’s analysis is worth taking the time to understand, rather than brushing it under the carpet because it is uncomfortable. Certainly it helps focus the mind that any company in the technology space that wants to be around for the long haul needs to figure out where the scarcity is in what it is doing, and how it is going to profit from that scarcity. Look at the list of exciting startups here and here and figure whether there really is some control of scarce resources behind the crazy names.

Enough doom-mongering for one day. Till next time.


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