Article from The Economist.
Irrational exuberance has returned to the internet world. Investors should beware.
SOME time after the dotcom boom turned into a spectacular bust in 2000, bumper stickers began appearing in Silicon Valley imploring: “Please God, just one more bubble.” That wish has now been granted. Compared with the rest of America, Silicon Valley feels like a boomtown. Corporate chefs are in demand again, office rents are soaring and the pay being offered to talented folk in fashionable fields like data science is reaching Hollywood levels. And no wonder, given the prices now being put on web companies.
Facebook and Twitter are not listed, but secondary-market trades value them at some $76 billion (more than Boeing or Ford) and $7.7 billion respectively. This week LinkedIn, a social network for professionals, said it hopes to be valued at up to $3.3 billion in an initial public offering (IPO). The next day Microsoft announced its purchase of Skype, an internet calling and video service, for a frothy-looking $8.5 billion—ten times its sales last year and 400 times its operating income. And those are all big-brand companies with customers around the world. Prices look even more excessive for fledgling firms in the private market (Color, a photo-sharing social network, was recently said to be worth $100m, even though it has an untested service) or for anything involving China. There has been a stampede for shares in Renren, hailed as “China’s Facebook”, and other Chinese web giants listed on American exchanges.
Same again, only different
So is history indeed about to repeat itself? Those who think not point out that the tech landscape has changed dramatically since the late 1990s. Back then few people were plugged into the internet; today there are 2 billion netizens, many of them in huge new wired markets such as China. A dozen years ago ultra-fast broadband connections were rare; today they are ubiquitous. And last time many start-ups (remember Webvan and Pets.com) had massive ambitions but puny revenues; today web stars such as Groupon, which offers its users online coupons, and Zynga, a social-gaming company, have phenomenal sales and already make respectable profits.
The this-time-it’s-different brigade also points out that the 1990s bubble expanded only after numerous web firms were floated on stockmarkets and naive investors pumped up the price of their shares to insane levels. This time, there have been relatively few big internet IPOs (though that is likely to change). And there is no sign of the widespread mania in the high-tech world that occurred last time around: the NASDAQ stockmarket index, a bellwether for the tech industry, has been rising but is still far below its peak of March 2000.
In one respect the optimists are right. This time is indeed different, though not because the boom-and-bust cycle has miraculously disappeared. It is different because the tech bubble-in-the-making is forming largely out of sight in private markets and has a global dimension that its predecessor lacked.
The bubble is being pumped partly by wealthy “angel” investors, some of whom made their fortunes in the late-1990s IPO boom. Their financial firepower has increased and they are battling one another for stakes in web start-ups (see article). In some cases angels are skimping on due diligence to win deals. When it comes to investing in more established companies like Facebook and the bigger web firms, traditional venture capitalists now face competition from private-equity companies and bank-led funds hunting for profits in a bleak investment environment. Gucci-shod leveraged-buy-out kings may appear to be more sophisticated than the waitresses buying dotcom shares a decade ago—but many of the newcomers are no more knowledgeable about technology.
This boom also has wider horizons than the previous one. It was arguably started by Russian investors. Skype was born in Estonia. Finland’s Rovio, which makes the popular Angry Birds smartphone game, recently raised $42m. And then there’s China. Renren and Youku, “China’s YouTube”, supposedly offer investors a chance to profit both from the country’s extraordinary growth and from the broader impact of the internet on commerce and society. Chinese web start-ups often command $15m-20m valuations in early financing rounds, far more than their peers in America.
These differences will have important consequences. The first is that the bubble forming in the private market could be pretty big by the time it floats into the public one. Facebook may turn out to be the next Google, and LinkedIn has a fairly solid revenue plan. But they will be followed by less robust outfits—the Facebook and LinkedIn wannabes—with prices that have been dangerously inflated by the angels’ antics.
The froth in China’s web industry could also lead to unrealistic valuations elsewhere. And it may be China that causes the web bubble eventually to burst. Few of those rushing to buy Chinese shares have thought through the political risks these companies face because of the sensitivity of their content. A clampdown on a prominent web firm could startle investors and prompt a broader sell-off, as could a financial scandal.
And after the angels have fallen?
With luck the latest web bubble will do less damage than its predecessor. In the 1990s internet euphoria caused a dramatic inflation in the price of telecoms firms, which were creating the infrastructure for the web. When internet firms’ share prices plummeted, telecoms investors suffered too. So far, there has been no sign of such a spillover effect this time around. But the globalisation of the internet industry means that many more people could be tempted to dabble in web stocks in the current boom, adding to the pain of the bust.
When will that be? This paper warned about both the last internet bubble and the American property bubble long before they burst. Irrational exuberance rarely gives way to rational scepticism quickly. So some bets on start-ups now will pay off. But investors should take a great deal of care when it comes to picking firms to back: they cannot just rely on somebody else paying even more later. And they might want to put another bumper sticker on their cars: “Thanks, God. Now give me the wisdom to sell before it’s too late.”
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