Guest Speaker: The Truth About Investment Bubbles
Yes, you can get hurt when they burst. But you can also make a bundle.
Published June 2007
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COMMENT ON THIS ARTICLEWayne Gretzky, the legendary hockey player, was never the strongest guy on the ice. What he lacked in heft, however, he made up for with a canny ability to remain alert and calm and to trust his instincts in the midst of a frequently violent frenzy. These qualities allowed Gretzky to become the greatest practitioner of the Canadian national pastime.
Similarly, people who remain alert and calm and who trust their instincts in the midst of a frequently violent frenzy excel at what has become something of America's national pastime: trying to build a fortune in an economy marked by investment bubbles. Bubbles are generally viewed as the invisible hand's way of dashing entrepreneurial gains that came too easy, but the opposite is often true. By their nature bubbles present opportunities for entrepreneurs to make big profits.
And we've certainly got our share of bubbles today. It's impossible to open the business pages without reading about bubbles (real or imagined) in real estate, Web 2.0, and clean technology. Of course, a bubble's narrative arc--a burst of frantic building and excess capacity, followed by outlandish hype and cutthroat price competition, and finally bankruptcy and consolidation--is nothing new. It happened in telegraph and railroads in the 19th century, in stocks and credit in the 1920s, and, of course, in the dot-com world in the 1990s.
Every generation or so, a hot new technology comes along or theorists develop a new set of economic assumptions that supposedly change the rules governing economic and commercial behavior. As government policy encourages investment in a particular sector, promoters concoct pro forma numbers that extrapolate impressive short-term trends indefinitely into the future. (Remember the 1999 book Dow 36,000? It was something of a remake. In the fall of 1929, Yale economist Irving Fisher proclaimed that "stock prices have reached what looks like a permanently high plateau.")
Drawn in by the promise of unfathomably vast markets, many bubble participants get hurt--especially large corporations, which have a knack for making giant bets at precisely the wrong time. In America, a good business idea gets funded--and funded again. Entrepreneurs stake out ground, and deep-pocketed investors and corporations follow. The result: Capacity always expands faster than demand. Three telegraphs connected New York City and Boston in the 1840s. A half-dozen transcontinental railroads were built in the years after the Civil War. Enough fiber-optic cable was laid by behemoths like WorldCom and Global Crossing (NASDAQ:GLBC) in the 1990s to last two generations. In each instance, unfortunately, there simply wasn't enough traffic to go around.
Looking at bubbles through history, it becomes apparent that the best long-term business opportunities don't arise during a bubble but after the bubble bursts. Timing a crash is a difficult, perhaps impossible, proposition. Having studied the dynamics of bubbles and what usually follows, I believe entrepreneurs can draw some important lessons about when and how to expand businesses in booming fields that appear to be headed for a bust. They are:
1. Bubbles are bipolar. The frenzy and irrational optimism that break out during an upswing swiftly morph into paralysis and irrational pessimism come the bust. Corporations, embarrassed by the huge investments they made--often right at the top--are eager to write down their devalued assets and move on. When they do, the building blocks of good businesses are suddenly available on the cheap. Consider the case of Charles Merrill. He fled the retail brokerage business in the early 1930s. But in 1940, when Wall Street was still trying to shake off the Great Depression, Merrill was able to merge his company with E.A. Pierce Co., the nation's largest brokerage firm at the time, for less than $2 million. By 1944, Merrill Lynch (NYSE:MER) had dozens of offices across the country serving 250,000 customer accounts. And in the postwar years, as more investors cautiously dipped their toes back into the markets, guess who was there to welcome them?
More recently, after the dot-com bust, the price of everything associated with Web technology and the Internet plunged, from servers to Bay Area real estate. In 2000, the median annual lease price for a 155 MBPS unit of fiber-optic capacity from Los Angeles to New York was $1.8 million; by 2005, it had fallen to $76,800. San Francisco office space went from $77 per square foot in 2000 to $29 in 2004. It then follows that at the beginning of the decade, Philip Rosedale's vision of creating an online world that could be inhabited by thousands of players simultaneously would have seemed prohibitively expensive. But after the bubble popped, the prices of that world's main costs--a massive server grid, office space in San Francisco, and data transmission, Web hosting, and programming capacity--had fallen so sharply that it made sense. Thus the success of Second Life (see Inc.'s February cover story), which has emerged as one of the most popular and intriguing online destinations.
