Why Internet shares will fall
From The Economist
30 Jan 99
INDEX TERMS Internet|overvalued shares, inevitability of fall;
Shares|Internet, overvaluation, inevitability of fall;
Stockmarkets|Internet shares' overvaluation, inevitability of fall; DATE
30-Jan-99 WORDS 1014
Why Internet shares will fall "THE electric light is very probably a
great invention, and . . . let us take it for granted that its future
development will be vast. But this, unhappily, cannot be urged as a
reason why the pioneer companies should be prosperous." Time and
technology have moved on since 1882, when these words appeared in The
Economist (as recently spotted by the Wall Street Journal, assiduously
reading our back copies). But the same sentiments apply to today's great
invention, the Internet. Because it is a potent and entirely new medium,
the net will change the way the world works and plays. Even so, today's
pioneering Internet companies are unlikely ever to earn the vast profits
needed to justify their current share prices. Indeed, future historians
may well add Internet shares to a long list of industrial
assets-including biotechnology firms in the 1990s, radio companies in
the 1920s, electric-light companies and railways in the 19th
century-that have come spectacularly crashing to earth.
This newspaper has long argued that shares in general are overvalued,
especially in America. And, because American consumers have used their
new-found paper wealth to justify spending more and saving less, the
economy looks vulnerable to a collapse in share prices. But the
inflation of Internet shares is, in many respects, quite different.
Whereas investors on Wall Street are merely exuberant, the casino
capitalists who spend seven or eight hours a day at their PC s trading
Internet shares appear to be stark, staring mad.
Most of those who have watched enviously from the sidelines sense that
gravity will assert itself sooner or later. Many of the online gamblers
who have earned a fortune in paper profits betting their savings on
shares in Yahoo!, Amazon and the rest will never get their money out.
For the very features that have led to a near-vertical climb of Internet
share prices also favour its precipitous collapse.
Most Internet companies go public by selling only a handful of shares:
only 34% of Amazon's equity is publicly traded, and a mere 9% of that of
eBay, an online auctioneer. The few available shares are greedily
snapped up by a cyber-army of online "day traders" via electronic
brokerages, such as E*Trade. Amazon's entire float changes hands twice a
week. Hedge funds that sold what they thought were already overvalued
shares they did not actually own have scrambled to buy back as prices
rose. Just as tulips only became truly manic when ordinary people
started trading bulbs in Dutch taverns, so the trebling of Internet
values since September has been accompanied by a surge of trading among
people unskilled in the art of valuation and unburnt by past losses.
All this is likely to reverse with brutal rapidity. A thin market
exaggerates falls as well as rises. The new online brokerages may not be
able to handle large volumes. Suddenly, hedge funds will start selling.
As losses mount, and buyers disappear, inexperienced investors could
well panic.
Nobody can predict the extent of the fall. Even the experts do not know
how to value Internet shares. Bill Sharpe, for example, who won the
Nobel prize in economics for work on pricing financial assets, is enough
of an Internet believer to have founded an online financial-advice
company. Even he admits that "we are all pretty much flying blind."
The problem is not merely that few Internet companies actually make a
profit (though this makes traditional measures of value somewhat
redundant). Although few now doubt that electronic commerce has a
thrilling future, reasonable people differ over what, and how
profitable, that future will be. Some venture capitalists and executives
reckon that the biggest profits will be earned by companies that
establish a strong brand by virtue of being first in a market. They
believe the coming collapse will affect only second-and third-tier
firms.
Even this may be optimistic. In the end, valuation comes down to one
simple fact. To justify today's share prices, Internet companies will
have to enjoy unprecedented growth in sales and margins. It would take
average annual profits of over $1 billion to make sense of Amazon's
current $20 billion-odd market value. Yet Amazon's total sales in 1998
were only $600m. The sales of many of today's Internet stars will never
soar that high. If anything, the Internet will give consumers more power
and make it hard even for firms with a large market share to raise their
margins for long (see<DEST="SF1217.ETG" ref = article ) .
And after the fall
Much will depend on whether the bigger stockmarket bubble bursts too. If
it does, concerns about Internet shares will be lost amid worries about
the world economy as a whole. If Internet share-values topple in
isolation, however, the effects might actually be salutary.
Venture capitalists in Silicon Valley have more money than they know
what to do with. Even after an Internet crash, there would be enough
wealth to back good ideas. Because current valuations have inflated what
Internet entrepreneurs think they and their ideas are worth, it would
become cheaper for venture capitalists to invest in them. The temptation
today is to sell up and move on without having taken the trouble to
build a real business. Lower share prices would force entrepreneurs to
lower their expectations and restore sanity to the net's job market, in
which people spend much of their day looking for employers offering
juicier share options. Investment in Internet businesses would suffer
only if venture capitalists lost faith in electronic commerce itself-as
opposed to particular firms or the judgment of online traders.
The prospect of an Internet share-bust holds a warning for other
investors. Today's appetite for equities rests on an erroneous belief
that they are a one-way bet: that, in the long run, they always pay
higher returns than other assets. Disappointing profits are dismissed
with a wave of the hand and the promise of a better tomorrow. When Wall
Street crashes it is unlikely to fall so far or so spectacularly as will
Internet shares. All the same, when Internet shares plunge, the screams
should strike fear into investors everywhere.
|
