“Most of the entrepreneurs today weren’t around in ’99. They have no muscle memory of it whatsoever.” Bill Gurley (September 2016)
Unlike the entrepreneurs Bill Gurley is talking about, I have a lot of muscle memory that resulted from the Internet bubble. There is no way you can fully convey in words the experience being in the lead car as an investor in that roller coaster. Looking at the cycle after the fact is nothing like looking ahead and not knowing what will happen next. The experience still impacts the way I think and act. It was a heck of a lot of fun in some ways. If you can’t learn from an experience like we had in the markets during roller-coaster ride that was the Dot-Com phenomenon, you were not paying attention. Good judgment comes from experience and often that experience comes from bad judgment. Most of the bad judgment associated with the Dot-Com era was observed but some of it was mistakes I made all by myself or as part of a herd. It is hard to describe how strong the feeling of FOMO was at the time. People were terrified of missing out on the upside and loss aversion and paper gains made them reluctant to act to cushion the downside.
Every story must have a starting point. The best time to begin this tale is probably 1993 when the business environment first started to change in way that would develop into a bubble. Changes that we would look back at later and say “that was crazy” did not happen in a huge way at first. The initial buildup was gradual and steady at the outset. But by 1994 the parties started getting better, the tchotchkes more lavish and paper wealth created at an impressive pace. Everyone was a frog in a pot of boiling water but they mostly did not feel it. By 1995 having in the Rolling Stones or The Eagles play at a private party hosted by a bigwig was becoming normalized in some circles in certain geographies.
One aspect of the abnormality of the period was the rapid jump in the number of IPOs. This chart shows the “IPO pig coming through the snake” in the mid to late 1990s. It also puts the current IPO market into perspective.
Venture backed IPOs looked like this chart below. One VC quoted on Bloomberg recently predicted 30-35 IPOs in 2017. As a benchmark for comparison, there were 21 tech IPOs in 2016, 23 in 15 and 55 in 2014 and 84 in 2013.
The amount of paper wealth that was being created did not start to accelerate to bonkers levels until ~1996. While 1996 had the most IPOs 1999 was the pivotal year in terms of the valuations and amounts of money raised:
One aspect of the IPO craziness of the Dot-Com era was the first day pop. Getting an allocation of “friends and family” shares for an IPO seemed to some people like a guaranteed way to make a profit in 1999. Like most bubble phenomenon that first day pop approach worked until it suddenly didn’t.
While the madness was going on there were people who predicted that a bubble was forming and that it would end badly; some of these people took their fund to $0 by shorting stocks too early. That experience illustrated how being early in making a prediction is indistinguishable from being wrong. By late 1999 I remember thinking “everyone can’t really be this rich. Or can they?” Some people became fabulously rich on paper in just months and the impact of that was that envy and jealousy which caused other people to lose their tie to reality. The environment was literally nuts. FOMO made people do things that in retrospect seem insane, but at the time seemed reasonable. Here’s a recap:
“Initial public offerings raised more than $69 billion in 1999, 39 percent more than 1996, the second-biggest year, according to Thomson Financial Securities Data. More eye-popping, however, may be the year’s record first-day gains. VA Linux jumped a record 733 percent in its first day of trading in early December. One hundred and seventeen, or 23 percent, of the year’s IPOs soared more than 100 percent in the first day of trading, according to WorldFinanceNet.com. The average first-day gains of 68 percent this year trounced last year’s average rise of 23 percent. The year registered nine of the top 10 first-day IPO gains of all-time, according to IPO.com.”
What happened to VA Linux?
Geeknet now sells classic items like:
A Salon article in April of 2000 article painted a picture of the party scene in the technology world that was produced by too much cash chasing too little value. What is most notable perhaps about the article is that it appeared after the bubble had popped. The party scene was operating on momentum still, but about to come to a calamitous halt.
“Jessica Crolick downs her free drink, grabs a black fleece jacket from the table and darts out of the dot-com party at the San Francisco Museum of Modern Art. She hops into a van with four strangers, who are on their way to another dot-com bash across town. The conversation moves from work to apartments, but conspicuously absent from the chatter is Digital Island the digital content delivery company that spent over $50,000 for food, drink and fleece to fete its new logo and announce a partnership with Apple. In fact, by the time Crolick and her posse reach the second party — a tropical-themed and more raucous affair hosted by Beenz an online currency company — few remember the first company’s name, and no one knows or cares what either company does. Dot-com valuations may have withered, but the enthusiasm for extravagant dot-com parties hasn’t, and party budgets show no signs of being trimmed. In any given week, technology companies throw 15 to 20 parties in the San Francisco Bay Area. On average, each costs $30,000 to $50,000, according to party planners and venue owners, although the $250,000 blowout is hardly rare. In March, for example, Salesforce an online sales automation service, and iCast which offers streaming media tools and content, each ran up tabs greater than $200,000, entertaining more than 1,000 guests each…. Marx, the president of Acteva — which brought 2,000 people to Treasure Island in December for a $200,000 party to announce its new name — agrees. More money, more people and more extravagant ideas are definitely the way to go. It’s no longer enough to just “get a few hundred people together and give them a drink,” he says, glancing around at the paltry WiredPlanet party.”
Clearly an abnormal number of IPOs and unprofitable companies doing an IPO was happening in 1999.
The level of schadenfreude and morbid curiosity was also unprecedented. The roll call of craziness is long:
A more complete list of companies that went public during the DotCom era can be seen in this document entitled: “A Prelude to the Dot-Com Bust” http://online.wsj.com/public/resources/documents/CovOriginal.pdf What is interesting is that a few companies like Amazon are on this list so some went on to bigger things. It would be interesting if the math revealed yet another power law.
One thing that is hard to describe is how quick things got really ugly. Some people froze like a deer in headlights. Other people acted and salvaged some value. Every day in the market even during less volatile times you are in the lead car of the a roller-coaster and can’t see anything ahead, but because the up and down motion were so very steep in the Dot-Com era the experience was particularly unnerving.
“On March 10, 2000 the combined values of stocks on the NASDAQ was at $6.71 trillion; the crash began March 11. By March 30, the NASDAQ was valued at $6.02 trillion. On April 6, 2000, it was $5.78 trillion.”
By the start of 2000 the investing and business environments weren’t quite as nutty as was the case in 1999 but times were still relatively good. But things went downhill fast that year:
“Unlike 1999, the new issues class of 2000 featured a lot of big losers,” says Richard Peterson, chief market strategist for Thomson Financial Securities Data. Peterson’s firm reports that of the 452 stocks that went public last year, 284, or 63%, trade below their offering prices and 68% are down from the first trading day’s close.
What caused the bubble to pop? In March of 2000 Barron’s carried a story that contained some sobering numbers that some people believe was pivotal in triggering the correction. I am of the views that what triggered the correction was a lack of cash. Was the Barron’s article the last straw on the camel’s back? It is impossible to prove but some people think so. I remember reading the Barron’s story but since I was seeing many Internet companies with little cash on hand the article’s conclusion was not really news. There were telecom companies on that list referred to in the Barron’s article but the telecom world did not see a collapse until early 2001. There were also companies on that list http://online.wsj.com/public/resources/documents/CovOriginal.pdf like Amazon, Ticketmaster, McAfee and Priceline that survived. In any event, regardless of whether you think the article as the cause of the change, the Barron’s story was very timely and correct:
“An exclusive study conducted for Barron’s by the Internet stock evaluation firm Pegasus Research International indicates that at least 51 ‘Net firms will burn through their cash within the next 12 months. This amounts to a quarter ofthe 207 companies included in our study. Among the outfits likely to run out of funds soon are CDNow, Secure Computing, drkoop, Medscape, Infonautics, Intraware and Peapod. To assess the Internet sector’s financial position, Pegasus assumed that the firms in the study would continue booking revenues and expenses at the same rate they did in last year’s fourth quarter. While this method cannot predict the future precisely, it helps answer a question that has been nagging many stock-market analysts: When will the crowded Internet industry begin to be winnowed? The ramifications are far-reaching. To begin with, America’s 371 publicly traded Internet companies have grown to the point that they are collectively valued at $1.3 trillion, which amounts to about 8% of the entire U.S. stock market.”
These charts of the NASDAQ tell a graphical story about what happened and when. It is important to note that it went down as fast as it went up. One company as I recall ended up stuck with $1B in FPGA chips sitting in warehouses. Everything changed. Quickly. The telecom bubble took at bit longer to correct, but that is another story.
By December 2000:
“What a difference a year makes. The Nasdaq sank. Stock tips have been replaced with talk of recession. Many pioneering dot-coms are out of business or barely surviving. The Dow Jones Internet Index, made up of dot-com blue chips, is down more than 72 percent since March. Online retailers Priceline and eToys, former Wall Street darlings, have seen their stock prices fall more than 99 percent from their highs.”
Philip J. “Pud” Kaplan’s operated a web site that published stories, internal memos and leaked documents of failed startups that still can be found at http://web.archive.org/web/20011201061308/http://fuckedcompany.com/ You can change the date to simulate what it was like to look at the dead pool every day. Posts looked like this:
In terms of my own decisions related to the end of the bubble, the summer of 1999 was when I hedged the market by selling some shares and buying some puts as a proxy hedge after reading a lot of material on the views of Buffett and Munger. I decided that year I would put away enough money in safe bets so I could live comfortably regardless of what happened. There are times in life when the world will not make much sense, at least to you. As an example, the Internet bubble of 1999-2001 was a time like that. The share sales and proxy hedging ensured that I would not be a burden to anyone in my retirement and that my children would be able to go to college with my financial assistance. I did leave a lot of money on the table by not selling everything, but my “barbell portfolio” did what it was designed to do. My decisions were not perfect but they were sound.
Little Risk (cash and safe bonds) Lots of Risk (startups and tech stocks)
So you may ask, are we in a bubble now? Well we can say that things are very different. The situation today is not the same it was in March 2000. The Economist writes;
“the base of today’s success is broader. In 2000 some 400m people around the world had access to the internet; by the end of 2015 3.2 billion people will. And the internet reaches into these people’s lives in many more ways than it could 15 years ago. ‘Technology is no longer a vertical industry, as it’s been understood by everyone for four decades,’ says John Battelle, a journalist and entrepreneur who launched the Industry Standard, a magazine which reported on the dotcom boom before itself going bankrupt in 2001. ‘Technology is now a horizontal, enabling force throughout the whole economy.’”
I fall in the camp of people who say that we do not have a valuation bubble today but rather a risk bubble. The big lesson to take away from the 2000 bust is that the cash spigot can close really fast. One day you can raise hundreds of millions of dollars and the next day you can’t raise five cents. From the end of the Internet bubble into 2003 cash was indeed king. I remember Greg Maffei telling me that when he was still Microsoft’s CFO as early as 1998. Risk and valuation are not the same. There are many thing that are different now a few of which are noted in this article http://www.valuewalk.com/2017/05/nasdaq-6000-now-infographic/ by Burt White, Chief Investment Officer for LPL Financial
- Price to Earnings Ratio (PE). The PE ratio for the Nasdaq in March 2000 on current year estimates was 107, versus 23 today. Even using the consensus forward (next 12 months) earnings estimates, the PE stood at 75 back in March 2000 compared with 22 today. The cash flow multiples also tell the same story: near 100 then compared with mid-20s now.
- Price-to-book ratio. Valuation measures based on the value of company assets minus liabilities, or book value, also reveal a much more expensive Nasdaq in 2000 versus now. The lack of assets supporting valuations was a big problem during the dotcom bubble (page views, eyeballs, and clicks were not enough). The price-to-book ratio at the peak in March 2000 was over 7, compared with 3.9 now (as of April 28, 2017). And those assets today produce far more profits.
- Market trajectory. Another way to compare today’s Nasdaq to the 2000 version is looking at the steepness of the two rallies, which reveals a dramatic difference. The Nasdaq has gained 22% over the past two years, compared to its 189% surge during the two years leading up to the March 10, 2000 peak. Clearly today’s technology rally lacks the parabolic nature of the dotcom bubble.
Good things can come from bad experience. Many ideas that failed then are succeeding now. Capitalism requires failure and it is an understatement to say that a lot of things failed as a result of the Internet bubble. One good example is described here by CB Insights: “In 1996, Louis Borders, founder of Borders bookstores (a famous casualty of the modern e-commerce era), had the crazy idea to let people order their groceries online and have them delivered to their homes. To achieve this, Louis Borders raised $396 million through an IPO in late 1999. After several years of sustained losses, though, the company finally crashed in 2001. But Borders’ dream of people never having to leave their homes for groceries has since been adopted by Amazon.” I know several people who loved WebVan as customers and they mourned its demise. But they could not cover their costs (venture philanthropy does not scale) and ran out of cash.