Down in the trenches, Bill Gurley finds that a transition has begun where investors and executives alike are unlearning bad habits left over from the waning moments of the most recent age of excess.
Although this is unlikely to provide reprieve to the dispirited, we should note that the financial markets of the past five years will undoubtedly have a special place in history.
The markets we have just experienced were nothing if not historic--historic in their ascent; historic in their stamina and strength; historic in their widespread effect on both human and corporate philosophy; and historic in the speed and severity of their correction.
The rise of the Internet was most certainly the ignition that jump-started the financial markets. The sudden arrival of the long-anticipated information superhighway created enormous uncertainty and opportunity in almost every industry. No one was safe, and many markets were considered up for grabs, creating an awkward prisoner's dilemma for all corporate executives: Commit major dollars to this risky new world or risk being left behind.
If the Internet was the ignition, the underlying economy was the fuel. The American economy has performed spectacularly over the past five years. Unemployment fell, earnings rose, the government deficit became a surplus, and America's leadership position in the world economy moved from presumed to undeniable. The average annual return of the Standard & Poor's 500 for the five years before 2000 was an unprecedented 26 percent (the Nasdaq a fiery 42 percent). To put this in perspective, the average annual return of the S&P 500 from 1926 to 1997 was a formerly respectable 11 percent.
That no one found it odd that the Nasdaq averaged a 42 percent annual return is likely the most important ex post facto discovery. The true rarity of what occurred was the wholesale and widespread belief that "it really was different this time." And now that the party is over, blame is certainly in the air. The fund managers blame the investment bankers, the venture capitalists blame the markets, the bankers blame the day traders, and the media blame everyone. But no one should cast stones, for everyone's house is made of glass. Valuation bubbles occur when everyone accepts the new reality, and for the most part, everyone did.
A great investor once told me that a mania never ends until every last person believes it is for real. It is likely that the same is true for a major economic recovery. As long as enough people hold up hope for a quick fix, a true, sustainable recovery is unlikely. Of course, this could soon correct, as the same emotional swing that reinforced the upward momentum of the markets is now working against them. The newspaper headlines are increasingly dire and are slowly squelching any remaining optimism.
Perhaps the bigger issue is raw economics. As the markets soared, many participants enjoyed excessive economic returns. These remarkable returns invited not a trickle, but rather a waterfall of new capital. VCs increased their fund sizes, successful entrepreneurs evolved into "angels," and major corporations simultaneously launched venture funds and Internet joint ventures--all in record numbers. Markets were designed to be self-correcting, and as such, this excess capital inevitably led to excess capacity--too many players competing in markets that just weren't big enough.
To make matters worse, just as the up market coincided with a strong overall economy, this down market appears to be dancing hand in hand with a deteriorating one. The breadth of industries that reported quite robust third-quarter numbers, only to be followed by widespread disappointment in the fourth quarter, is both alarming and seemingly unprecedented. The shock of this contraction is causing corporations to slice their 2001 capital expenditures, directly affecting the earning capabilities of the technology stocks that now represent an even larger percentage of the S&P 500.
Another sign to watch for is the inevitable call of the value investor. Well-rested from a five-year hibernation, these beasts are eager to see stock prices reach levels that tempt their long-built hunger. However, it is unclear if we have reached that point. Some of the larger high-volume stocks, such as Intel, Microsoft, Cisco Systems and Dell Computer, trade at reasonable valuations that are beginning to border on inexpensive--even from a historical perspective. However, several enterprise software stocks are still trading at a price-to-earnings ratio of over 100 times earnings--numbers that are unlikely to stimulate even the eagerest of value investors.
Down at ground level a transition has begun. Investors and executives alike are unlearning the bad habits created during this historic, yet unsustainable, economy. In the late '80s and early '90s, the average start-up grew for five to seven years before an IPO. Erasing the expectation of 18 to 36 months will take some time. Without unlimited access to capital, "growth at all cost" mentalities must eventually fade away. But getting from point A to point B is quite difficult. Transitioning a company from one built for speed into one built for efficiency is no easy task; corporate culture is not that pliable. It is likely that some companies will fail simply as a result of fate and timing. The shift is simply too dramatic.
Ultimately, this will be a much healthier market for building long-term, lasting companies. A return to sound business fundamentals is unmistakably constructive, and the potential opportunities for innovation are still quite numerous. The only real problem is transitioning internal expectations quickly and surviving the external transition as the markets self-correct. Patience is once again a virtue.
J. William Gurley 2001. All rights reserved. Above the Crowd is a monthly publication focusing on the evolution and economics of high-technology business and strategy. This column can also be found on CNET online and in Fortune magazine. The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice. The author is a general partner of Benchmark Capital, a venture capital firm in Menlo Park, Calif. Benchmark Capital and its affiliated companies and/or individuals may, from time to time, have positions in the securities discussed herein. ABOVE THE CROWD is a service mark of J. William Gurley.
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