Moments of madness

The internet boom was an old story dressed up in new language. The sharemarket has form for losing its head over seductive new technology, writes BRENT SHEATHER*.

The theory says the sharemarket is all about long-term investment - buy, hold and she'll be right.

This logic pays dividends most of the time, but two extraordinary phenomena can test the resolve of even the most patient of investors:

* Depressions, where economic activity contracts and shares take years to recover (the last good one occurred in 1929 and even with dividends the sharemarket took 16 years to get back to its August 1929 high point).

* Manias, where investors become irrationally exuberant about the growth prospects of one sector of the sharemarket and push prices to unrealistically high levels.

For example, how long will it take for investors who bought a portfolio of internet stocks in February 2000 to get their money back? Twenty years? Thirty years? Never?

Of the two conditions, manias probably pose the biggest threat to one's savings today, as they occur more frequently.

And once they start they can suck more and more of one's financial assets into their vortex; after all, it's all too easy to assume that if a particular investment worked with $10,000, it will work 10 times as well with $100,000.

Depressions are much less common - one might even assume that the improved expertise of central bankers has rendered them extinct. Furthermore, even depressions have a bright side; while your share portfolio takes a turn for the worse, quality bond investments soar.

Stockmarket manias are interesting from practical and a historical perspectives.

Armed with some of the lessons learned from past excesses, we may be able to avoid repeating the same mistakes.

But this might be a forlorn hope. The veteran investor Sir John Templeton has famously commented that the four most dangerous words in investing are "this time it's different".

While almost everyone now declares that we all knew it was nonsense, a large number of distinguished business people, fund managers and lawyers are now seriously embarrassed, (not to mention a good deal poorer) by their behaviour during the internet boom.

Although New Zealanders are accustomed to our local business icons acting the goat, overseas executives had, in the main, retained reasonable reputations.

All this changed with the internet. Australian superheroes such as Rupert Murdoch and Kerry Packer each lost a few hundred million on technology/media/telecom ventures which blew up, and blue chip companies like Marconi and Cisco spent billions on worthless acquisitions.

In the US and UK a number of high profile investment bankers left their jobs and blew their careers to briefly lead new internet ventures, and hundreds of thousands of small investors lost hundreds of millions of dollars, much of it invested in companies which now look rather silly.

For a short period even the London Financial Times marketed itself as the world's "e-business" newspaper.

Sharemarket analysts who focussed on the internet sector became household names, constantly on television and making ever more positive pronouncements on the price targets of their favourite stocks.

Several of the more prominent ones in the US have recently resigned their positions as lawsuits brought by clients were settled out of court.

All in all, a lot of losers and not too many winners. The magnitude of the mistakes suggests that any lessons that can be learnt from past manias will be time well spent.

Dr Sandy Nairn, a former director of "value" fund manager Templeton in the UK, has written a book* on the psychology and market dynamics of technology-based stockmarket manias, having grown increasingly frustrated with the valuations assigned to the tech sector in 1999-2000.

Nairn was motivated to undertake the study by his inability to understand the huge valuations assigned to various internet stocks in 1999.

The last straw for him apparently was seeing the shares in an internet-based dog food delivery company double on their first day of trading.

What is particularly interesting about Nairn's book is that he shows that what happened with the internet had happened many times before when potentially transforming new technologies such as railways, wireless and cars arrived on the scene.

The investment performance of the railways sector in the British Isles from 1820 to 1850 is typical.

From 1820 to1840, railway shares performed strongly as they took market share from the more expensive and less flexible canal systems (themselves the subject of a speculative frenzy about 20 years earlier).

But after a four-fold price increase from 1820 to 1843, the bubble burst and in the next 10 years railways shares fell by 75 per cent.

Long term investors in 1826 just got their money back 30 years later.

The reasons railway was a successful technology but a bad investment have many parallels with the internet boom.

First and foremost, the supply of new companies expanded unexpectedly to meet investor demand.

Before 1843, the average annual investment in new railways was $6.81 billion in today's dollars. By 1846 this had grown to $215.5 billion a year.

Such was the success of, and enthusiasm for, the railways that more and more lines were built.

The British Government set a deadline of November 30, 1845 for plans for new railway lines to be submitted, and riots broke out as 800 groups of promoters sought to reach London in time.

As with the dot.com companies 150 years later, the rush to get to market meant business plans were not well thought out and the euphoric environment attracted scam artists and con men.

Nairn observes that the parallel with 1999-2000 could not be clearer.

The scramble for new lines more or less marked the peak of the railway bubble, just as the United Kingdom's auction of third generation mobile phone spectrum marked the peak of the bubble in the telecommunications, media and technology business.

In both cases the degree of optimism of investors pushed share prices to unrealistic levels, but the optimism bought with it extra capital and thus competition.

High prices effectively lowered the manic sector's cost of capital, meaning that many projects with low rates of economic return - which in normal times would have been rejected - got the go ahead.

The over-capitalisation of the industry (like the telecommunications sector a year ago) pushed prices down and meant no-one earned a decent return on their investment.

Nairn concludes that often, such is the popularity of a new technology, that investors - apart from the initial promoter - seldom earn superior returns. Negative returns are more the rule.

Nairn reports this conclusion for railways, electric light, the telephone, the car, the computer and many other new technologies.

He shows that, almost without exception, the winners from the implementation of new technology often emerge in the period of recession and restructuring that inevitably follows the euphoria.

But who wants to buy internet stocks today? No-one, and no wonder. Last year's cheerleaders, stockbrokers and financial planners who previously touted Cisco and the Nasdaq tracking stocks have gone quiet or are preaching, with equal fervour, the benefits of defensive stocks and bonds.

But Nairn's research suggests we should probably be buying tech shares now.

*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.