Market Bubbles

During the Internet bubble, managers and investors lost sight of what drove return on invested capital; indeed, many forgot the importance of this ratio entirely. When Netscape Communications went public in 1995, the company saw its market capitalization soar to $6 billion on an annual revenue base of just $85 million, an astonishing valuation. This phenomenon convinced the financial world that the Internet could change the way business was done and value created in every sector, setting off a race to create Internet-related companies and take them public. Between 1995 and 2000, more than 4,700 companies went public in the United States and Europe, many with billion-dollar-plus market capitalizations. Market Bubbles

Many of the companies born in this era, including Amazon.com, eBay, and Yahoo!, have created and are likely to continue creating substantial profits and value. But for every solid, innovative new business idea, there were dozens of companies (including Netscape) that turned out to have nothing like the same ability to generate revenue or value in either the short or the long term. The initial stock market success of these flimsy companies represented a triumph of hype over experience.

Many executives and investors either forgot or threw out fundamental rules of economics in the rarefied air of the Internet revolution. Consider the concept of increasing returns to scale, also known as “network effects” or “demand-side economies of scale.” The idea enjoyed great popularity during the 1990s after Carl Shapiro and Hal Varian, professors at the University of California–Berkeley, described it in a book titled Information Rules: A Strategic Guide to the Network Economy1. Market Bubbles

The basic idea is this: In certain situations, as companies get bigger, they can earn higher margins and return on capital because their product becomes more valuable with each new customer. In most industries, competition forces returns back to reasonable levels. But in increasing-returns industries, competition is kept at bay by the low and decreasing unit costs of the market leader (hence the tag “winner takes all” for this kind of industry). Market Bubbles

Take Microsoft’s Office software, a product that provides word processing, spreadsheets, and graphics. As the installed base of Office users expands, it becomes ever more attractive for new customers to use Office for these tasks, because they can share their documents, calculations, and images with so many others. Potential customers become increasingly unwilling to purchase and use competing products. Because of this advantage, Microsoft made profit margins of more than 60 percent and earned operating profits of approximately $12 billion on Office software in 2009, making it one of the most profitable products of all time. Market Bubbles

As Microsoft’s experience illustrates, the concept of increasing returns to scale is sound economics. What was unsound during the Internet era was its misapplication to almost every product and service related to the Internet. At that time, the concept was misinterpreted to mean that merely getting big faster than your competitors in a given market would result in enormous profits. To illustrate, some analysts applied the idea to mobile-phone service providers, even though mobile customers can and do easily switch providers, forcing the providers to compete largely on price. With no sustainable competitive advantage, mobile-phone service providers were unlikely ever to earn the 45 percent returns on invested capital that were projected for them. Increasing-returns logic was also applied to Internet grocery delivery services, even though these firms had to invest (unsustainably, eventually) in more drivers, trucks, warehouses, and inventory when their customer base grew. Market Bubbles

The history of innovation shows how difficult it is to earn monopoly-sized returns on capital for any length of time except in very special circumstances. That did not matter to commentators who ignored history in their indiscriminate recommendation of Internet stocks. The Internet bubble left a sorry trail of intellectual shortcuts taken to justify absurd prices for technology company shares. Those who questioned the new economics were branded as people who simply “didn’t get it”—the new-economy equivalents of defenders of Ptolemaic astronomy.

When the laws of economics prevailed, as they always do, it was clear that many Internet businesses, including online pet food sales and grocery delivery companies, did not have the unassailable competitive advantages required to earn even modest returns on invested capital. The Internet has revolutionized the economy, as have other innovations, but it did not and could not render obsolete the rules of economics, competition, and value creation. Market Bubbles

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