What the Bubble Got Right -->
September 2004
(This essay is derived from an invited talk at ICFP 2004.)
I had a front row seat for the Internet Bubble,<br>because I worked at Yahoo during 1998 and 1999. One day,<br>when the stock was trading around $200, I sat down and calculated<br>what I thought the price should be. The<br>answer I got was $12. I went to<br>the next cubicle and told my friend Trevor. "Twelve!" he said.<br>He tried to sound indignant, but he didn't quite manage it. He<br>knew as well as I did that our valuation was crazy.
Yahoo was a special case. It was not just our price to earnings<br>ratio that was bogus. Half our earnings were too. Not in<br>the Enron way, of course. The finance guys seemed<br>scrupulous about reporting earnings. What made our<br>earnings bogus was that Yahoo was, in effect, the center of<br>a Ponzi scheme. Investors looked at Yahoo's earnings<br>and said to themselves, here is proof that Internet companies can make<br>money. So they invested in new<br>startups that promised to be the next Yahoo. And as soon as these startups<br>got the money, what did they do with it?<br>Buy millions of dollars worth of advertising on Yahoo to promote<br>their brand. Result: a capital investment in a startup this<br>quarter shows up as Yahoo earnings next quarter—stimulating<br>another round of investments in startups.
As in a Ponzi scheme, what seemed to be the returns of this system<br>were simply the latest round of investments in it.<br>What made it not a Ponzi scheme was that it was unintentional.<br>At least, I think it was. The venture capital business is pretty incestuous,<br>and there were presumably people in a position, if not to create<br>this situation, to realize what was happening and to milk it.
A year later the game was up. Starting in January 2000, Yahoo's<br>stock price began to crash, ultimately losing 95% of its<br>value.
Notice, though, that even with all the fat trimmed off its market<br>cap, Yahoo was still worth a lot. Even at the morning-after<br>valuations of March and April 2001, the people at Yahoo had managed<br>to create a company worth about $8 billion in just six years.
The fact is, despite all the nonsense we heard<br>during the Bubble about the "new economy," there was a<br>core of truth. You need<br>that to get a really big bubble: you need to have something<br>solid at the center, so that even smart people are sucked in.<br>(Isaac Newton and Jonathan Swift both lost money<br>in the South Sea Bubble of 1720.)
Now the pendulum has swung the other way. Now anything that<br>became fashionable during the Bubble is ipso facto unfashionable.<br>But that's a mistake—an even bigger mistake than believing<br>what everyone was saying in 1999. Over the long term,<br>what the Bubble got right will be more important than what<br>it got wrong.
1. Retail VC
After the excesses of the Bubble, it's now<br>considered dubious to take companies public before they have earnings.<br>But there is nothing intrinsically wrong with<br>that idea. Taking a company public at an early stage is simply<br>retail VC: instead of going to venture capital firms for the last round of<br>funding, you go to the public markets.
By the end of the Bubble, companies going public with no<br>earnings were being derided as "concept stocks," as if it<br>were inherently stupid to invest in them.<br>But investing in concepts isn't stupid; it's what VCs do,<br>and the best of them are far from stupid.
The stock of a company that doesn't yet have earnings is<br>worth something.<br>It may take a while for the market to learn<br>how to value such companies, just as it had to learn to<br>value common stocks in the early 20th century. But markets<br>are good at solving that kind of problem. I wouldn't be<br>surprised if the market ultimately did a better<br>job than VCs do now.
Going public early will not be the right plan<br>for every company.<br>And it can of course be<br>disruptive—by distracting the management, or by making the early<br>employees suddenly rich. But just as the market will learn<br>how to value startups, startups will learn how to minimize<br>the damage of going public.
2. The Internet
The Internet genuinely is a big deal. That was one reason<br>even smart people were fooled by the Bubble. Obviously<br>it was going to have a huge effect. Enough of an effect to<br>triple the value of Nasdaq companies in two years? No, as it<br>turned out. But it was hard to say for certain at the time. [1]
The same thing happened during the Mississippi and South Sea Bubbles.<br>What drove them was the invention of organized public finance<br>(the South Sea Company, despite its name, was really a competitor<br>of the Bank of England). And that did turn out to be<br>a big deal, in the long run.
Recognizing an important trend turns out to be easier than<br>figuring out how to profit from it. The mistake<br>investors always seem to make is to take the trend too literally.<br>Since the Internet was the big new thing, investors supposed<br>that the more Internettish the company, the better. Hence<br>such parodies as Pets.Com.
In fact most of the money to be made from big trends is made<br>indirectly. It was not the...