3 Critical Lessons Investor Today Can Learn From the Dotcom Crash

Know why and how the Dotcom crash happened, so you can avoid being unknowingly trapped in a bubble.

As the acclaimed german philosopher, Karl Marx once said,

"History repeats itself, first as tragedy, second as farce."

The aforementioned quote by Karl Marx reminds me of the "Dotcom" crisis that occurred back in the 1990s. With discussions across several spectra of investors and economists, they lead us to debate whether the stock market today is truly in a "bubble".

After all, the stock market has rebounded since the crash in March 2020(even hitting an all-time high!) when the global economy is still recovering from the recession.

To evaluate where the stock market currently stands- is it too overvalued? Does the future promise of technological advancements justify the current valuation? Are we possibly in a "bubble"?- in terms of its sustainability, we can delve deep into the "Dotcom" crisis back in the 1990s to gain some insights and lessons to prevent the occurrence of such a devastating phenomenon.

BACKGROUND OF THE DOTCOM CRASH

In the 1990s, the internet boomed when an internet browser, known as "Mosaic", was developed. As a result, the population of internet traffic grew exponentially by ten-thousandfold! As people's perception of the internet gradually transits from "luxury" to "essential", they started to witness the potential of the internet.

The ubiquity of the internet gave rise to entrepreneurs who exploited the internet to craft their own "Dotcom" businesses. It ranged from a myriad of businesses; Search Engines like Yahoo.com, Streaming platforms like Broadcast.com, and even online retailers like Pets.com.

That led to the creation of "Netscape", a web browser similar to "Mosaic"'s. However, it proved to be a superior navigator and surpasses "Mosaic" in its user interface. Surely enough, the popularity of "Netscape" skyrocketed and gave its founders the confidence to initiate its IPO(Initial Public Offering) on the equity market.

On the day of IPO, the stock price of "Netscape" doubled from the opening price of $28 to $58! It was a truly puzzling phenomenon. However, the gripping issue with this was, then, "Netscape" was not a profitable business yet. For long, the common requisite among investors when investing in companies would be the measure of profitability. Therefore, the phenomenon abolishes those traditional criteria.

Consequentially, investors disregarded the importance of profitability and focused on the growth of sales instead. Moreover, with interest rates being kept low then, investors had more capital to make speculative investments. These factors, coupled with the huge upside potential in those IPO stocks, incentivized many investors to make risky plays in the stock market.

On the companies' end, more and more of them launched their own IPOs when they were not even profitable yet. Moreover, in an attempt to boost sales, some businesses went the extra mile to sell their own units at a loss, bolster marketing efforts, and even made acquisitions. These channeled efforts were to raise funds through the IPO.

That was when the euphoria among investors and companies spiraled out of control. Just within 5 years, from the year 1995 to 2000, the Nasdaq grew an astonishing 408%(since the launch of Netscape's IPO on the 9th of August 1995) and reached an all-time high of 5048 points.

However, it all came crashing down after Japan announced that its country is going through a recession on March 13. Then, Japan was the world's second-largest economy. Hence, panic-selling struck the market as investors worried that it would impact their investments in technology companies that were reliant on exports. Furthermore, with the Federal Reserve's increasing interest rates, insiders cashing out on their investments, the impetus to sell was definite among retail investors.

By the 9th of October 2002, the Nasdaq index bottomed out at 1114 points, a decline of 77.8% from its peak. The great rally within those 5 years all got wiped out in half duration. Those who truly bore the brunt of the crash were the retail investors. Those who left their hard-earned cash in the stock market, in hopes of growing their money, got scarred badly. Meanwhile, the insiders(E.G the institutional investors, venture capitalists), who knew more about the businesses and economy, saw the crisis coming and cashed out early on for profit-taking.

“It is ludicrous to believe that asset bubbles can only be recognized in hindsight.” — Michael Burry, Founder of hedge fund Scion Capital

Well, I agree with the quote from Dr. Burry. Amidst such a crazy and bullish environment, it is extremely difficult to distinguish between what is considered a lucrative investment and a risky, speculative bet. However, the "Dotcom" crash incident can serve as a point of reference during an investor's decision-making process.

So...What are they exactly?

1. Invest In Businesses with Good Fundamentals

Before investing in a business, ALWAYS look at its financial statements. They can be found in their annual or quarterly reports which are under "Investor's Relations".

In a financial statement, there are mainly three things to keep an eye on:

A) Revenue

Revenue is the income generated from normal business operations and includes discounts and deductions for returned merchandise. 

Firstly, a business will never be profitable if it does not generate revenue. If the business fails to acquire customers for their goods and services, they are unworthy of any cents of investment. It does not make cents(sense) to do that.

Secondly, pay attention to the revenue growth. Is it increasing quarterly or annually? How is the trajectory- upward or downward- of revenue? Great businesses should be expected to have increased revenue unless of external reasons like a recession or a pandemic that disrupts the economy. If the answer to those questions is " The revenue is increasing every quarter and trajectory seems promising.", that's a great start and leads to a possibly lucrative business.

But here comes the question that distinguishes the fakes from the authentic. Is the revenue growth sustainable in the long run? Could the current revenue gained be due to external events spurring sudden demand in that business?

"The fundamental basis of above-average performance, in the long run, is a sustainable competitive advantage." — Warren Buffett, CEO, and Chairman of Berkshire Hathaway, American Investor

The main takeaway from his quote is the phrase: "sustainable competitive advantage". Firstly, Buffett believes that a company's prosperity is ultimately due to its strong competitive advantage in its niche. Secondly, he believes that the competitive advantage has to sustainable too. Why?

Throughout the past, we have seen countless leading companies crumble due to harsh competition. While they may reign dominance over other competitors over a period of time, their prosperity cannot be guaranteed in the future. In fact, from 1955 to 2014, 88% of companies in the Fortune 500 failed to be sustainable. Henceforth, companies ought to constantly innovate to maintain their competitive edge to survive.

The prosperity of businesses can be reflected in their revenue. Thus, the same question can be asked about the apparent upswing in revenue. Is it sustainable in the long run?

B) Debt

Debt is an amount of money borrowed by one party from another. It is common for businesses to get leverage from the central bank or through issues of corporate bonds to finance and upgrade their operations.

With falling interest rates in March 2020 due to the pandemic crisis, it became relatively cheap for businesses to borrow credit. As a result, more and more companies begin to take on debt to expand their businesses. But is that necessarily a good thing for the business?

Generally, debt is not advantageous for the prosperity of businesses. Problems surface when the company fails to repay the debt on time.

That being said, bad debt demobilizes the flexibility of a business.

For example, when debt gets overwhelming, it rocks the financial stability of the business. Businesses get hindered by debt. Rather than focusing on progression towards their goals, their utmost priority shifts to the repayment of debt. In the process, the business' desired developments may get halted.

That leads to several severe complications:

• Loss in consumer's trust
• Loss of reputation
• Unable to secure loans as easily as before
• Stagnation of business or worst yet, Bankruptcy

However, debt, sometimes, can be beneficial.

Taking on good debt is wise as it increases the purchasing power of companies.

For instance, a farmer takes on debt to buy a tractor which can help bolster harvesting efforts, boosting productivity. With greater financial capability granted to businesses, more resources can be funneled into productive assets or research&development(R&D)for the betterment of the business.

Henceforth, with the introduction of good debt, business improves in:

• Efficiency
• Cost-effectiveness
• Earnings

So, always question the usage of debt in companies that you have invested in. Are they good or bad debt?

C) Free Cash flow

FCF is a non-GAAP calculation of the amount of cash available for the company after subtracting capital expenditure from CFO. It is essentially cash leftover from operations.

There are 3 good ways companies can utilize FCF.

Firstly, they could invest in research&development to improve upon their systems and perhaps develop new products for sale.

Secondly, they could use it to pay their shareholders. Many established companies like Coca-Cola, Exxon Mobil, pay their investors a portion of their wealth as a sort of reward for being an investor. This act of giving back helps retain trust between them and the stakeholders, thus more investors will stay invested.

Lastly, companies execute share buybacks with their spare cash. Share buybacks lower the outstanding shares in the market, which in turn drive down the Earnings Per Share(EPS). With greater financial ratios due to lesser shares in circulations, the company's share looks more attractive. That produces a wondrous effect on the stock price.

Historically, companies who bought back their own shares have fared better in the stock market. Back in 1984, Chrysler Corp., an automobile company, decided to conduct share buybacks of up to 20% of its shares within two years. Just a disclaimer, they had over $1.6 Billion cash at hand, which was excessive compared to the cost of $720 million from those share buybacks(so it will not hinder their operations at all!)

Surely enough, the stock price of Chrysler Corp. went through the roof from approximately $12 in 1984 to $32 in 1986.

Henceforth, companies should have a substantial amount of free cash flow to be able to upgrade themselves and stay competitive in their industry.

2. Do Not FOMO(Fear Of Missing Out)

FOMO stands for "Fear Of Missing Out". It's the feeling when your friends are bunched up together whispering among themselves on a topic that only you are not part of. It's essentially pressure from society or your peers to do something that you may or may not like. Yes, that herd mentality.

The stock market is akin to a rambunctious child causing a ruckus regardless of the toys he received. Just like how the stock prices move in tandem with the financial news. Read that again.

According to research done, historical stock market movements can be driven by emotions and psychology rather than rationality.

From the research findings, one of the main drivers of financial decisions is regret. According to Shefrin and Statman, investors are more likely to realize gains than losses. The fear of regret leads investors to postpone losses whereas, symmetrically, the desire for pride leads to the realization of gains. An individual experiences regret when closing a position with a loss because of a poor investment decision. Conversely, an individual feels pride or elation when closing a position with a gain because his financial decision resulted in a profit. 

Back in the 1990s, retail investors put their money into internet stocks without any considerations. Why? They were fearful of the missed opportunities for gains if they do not hop onto the hype behind the IPOs of Dotcom companies. That fear of regret eventually led to a bubble, too big to handle for the stock market, and burst.

However, if people had just ignored the "noise" and focussed on acquiring good businesses that are within their circle of competence. The devastation could have been avoided.

One person, in particular, avoided the Dotcom crash. He is, none other than, Warren Buffett.

Adhering to his strict rule of investing in what he understands, he avoided the crisis as he focused on old-fashioned value stocks like Bank of America(BAC), Coca-Cola(KO), etc.

From the year 2000 to 2001, Berkshire's stock had slumped to a one-year low of $41,800 and soared to $71,500 on the strength of investments in proven, old-economy companies. Meanwhile, the Nasdaq technology-based index has fallen by more than half from its high.

Not implying that internet stocks should be shunned by investors but rather, be more scrutinized. The flaw of the investors during the Dotcom crash lies with their impulsiveness. The fear of missing out on potential gains blinded the objectivity and scrutiny among investors. So, moving forwards, investors should understand what they invest in and make sure it is an optimum choice.

3. Proof of Concept

Proof of concept is a test to see if an idea could execute its practicality in reality. If companies cannot execute their ideas, they are selling you a dream.

During the crisis, many investors neglected this criterion. Companies that went public without proof of concept could receive meteoric gains in their stock price.

Take Webvan as a case study. Webvan was in the grocery business. It delivered products to customers' homes within a 30-minute window of their choosing. The company launched its IPO in efforts to expand upon its operations into 26 markets in the United States. That enthusiasm led to their downfall. One of their biggest mistakes was to execute expansion when its business model was not steady yet.

In retrospect, As Mike Moritz, a Webvan board member and partner at Sequoia Capital told Reuters,

Webvan "committed the cardinal sin of retail, which is to expand into new territory -- in our case several territories -- before we had demonstrated success in the first market."

Webvan is just one of the companies that got caught up in the exuberance during the 1990s. A company without a feasible and sustainable service cannot survive in the long run and let alone scaling it to greater domains.

I hope you understand the vitality of proof of concept as it governs the longevity and prosperity of a business.

Conclusion

To summarise, 3 things to note before investing:

1. Business's fundamentals
2. Do not FOMO
3. Proof of concept

In today's volatile, uncertain, complex, and ambiguous world, investors ought to prepare themselves against sudden crashes before it is too late. There is a constant need to reflect upon the past and learn the mistakes of our predecessors to prevent similar phenomena. Wrapping up, I conclude by referring to a quote from one of the richest men on earth.

 "With a good perspective on history, we can have a better understanding of the past and present, and thus a clear vision of the future." — Carlos Slim Helu, Mexican business magnate, investor, and philanthropist

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