Buying into the hype

By BRENT SHEATHER

After week's look at how technology manias have periodically consumed sharemarkets, it's time to learn the lessons of history.

The following are among the findings that emerge from an analysis of past manias, as detailed in a book* by veteran investor Dr Sandy Nairn:

Lesson 1

Investing in early stage technology companies is a loser's game because most new companies fail (even Henry Ford went bust twice before he made it).

If the technology is revolutionary and takes market share away from existing businesses, then new entrants will quickly enter the market, often with lower costs and better technology than the original company. In the 20 years following the invention of the car, some 1000 car companies began in the United States alone.

Lesson 2

The only surefire way to make money from new technologies over any extended period is through monopoly protection.

Even with the most successful inventions, commercial success may be short-lived.

"Unless the companies involved have patent protection for their products, or are shielded from competition by other powerful barriers to entry, the degree of effective competition is probably the single most critical factor in determining how profitable investment in new technologies is going to be," says Nairn.

Lesson 3

It is much easier to spot the losers from technological change than the winners.

"Losing technologies often have a barrier that makes it impossible for them to react to their new competitors. Canals, for example, simply could not achieve the speeds that railways could. The telephone allowed voice transmission, the telegraph did not."

Lesson 4

Investing in new technologies is a high-risk business.

"What all these factors underline is that there is and should be a substantial risk premium attached to long-term share investments in most new technology companies."

In other words, they should pay more than investing in more established firms.

The evidence shows that it is the application of technology - what you do with it, not how wonderful it may be - that is vital. This typically takes time to emerge.

"History suggests that leadership rarely remains with so-called first movers."

Lesson 5

Many big breakthroughs in new technology are derided when they first appear.

This is largely because new technology threatens the existing order of things, generating responses such as:

* "Rail travel at high speed is not possible because the passengers, unable to breathe, would die of asphyxia." Professor of Astronomy, University College, London.

* "Who the hell wants to see actors talk?"

Harry Warner, 1927.

Lesson 6

The inventors of new technology often do not appreciate its commercial applications. When radio appeared it was widely assumed its main application would be interpersonal communication, not broadcasting.

Lesson 7

The best technology doesn't always win.

Anticipating how the market will develop, and developing a marketing strategy, are just as important as the technology itself.

Lesson 8

Insiders usually make the best returns from new technologies and outside investors have typically not fared as well.

Lesson 9

A new technology alone is not enough to create a bubble in financial markets.

For that, you need some or all of the following: low interest rates, a previous period of prosperity, the emergence of an uncritical trade press to raise expectations (think how many specialist technology and telecoms investment websites there were a year or so ago) and a general climate of optimism and overconfidence. The timing of the bubble has more to do with these factors than with the state of technological development.

All right, so we are not going to get fooled next time, but if you recognise that the sharemarket has gone silly, can you make money from this knowledge?

In the ying/yang financial world, whenever there is a sector or two that is overhyped, there is invariably another sector which is underpriced because of a lack of interest.

This nuance of markets can be exploited to make money from a mania - by buying the boring areas.

Back in early 2000, when technology was in its ascendancy, property was one area that was out of favour. In the United States, shares in listed real estate trusts were trading at discounts of 20 per cent or more.

At this time the popular view was that internet retailers such as Amazon.com would make shopping centres redundant overnight.

At brokers' offices, real-estate analysts were being laid off in droves while about half the research budget was allocated to internet analysts.

Since then, the real estate sector in the US has gone on to give investors extraordinary returns - 59 per cent in 2000 and 19 per cent last year - as the discount induced by the internet mania more or less disappeared.

Typically, in the aftermath of a sharemarket mania, competition intensifies among fund managers, nowhere more so than in the long-running competition between active and passive managers.

After the internet mania, both sides have declared themselves to have won the war.

Active value-style managers (those who aim to pick "cheap" shares) have highlighted the fact that they had a relatively small portion of their portfolios in technology shares.

Index fund advocates point out that by owning the whole market you are guaranteed to have at least some money in non-manic sectors.

And all those active managers pursuing a growth style (aiming to pick shares whose earnings were rising), and who floated new specialist technology funds, have gone rather quiet.

As might be expected, value managers such as Templeton come out rather well from this analysis, as many fund managers got heavily into technology. Index funds also had high weightings in technology at the top.

One solution, if you have active managers, is to ensure that there is a mix of value and growth styles, to cover all the bases - and preferably an index fund or two as well, just in case your value manager changes his or her spots at the top of the market.

* Engines that Move Markets: Technology Investing from Railroads to the Internet and Beyond, by Alasdair Nairn, published by John Wiley & Sons.

* Brent Sheather is a Whakatane investment adviser and sharebroker.