There is always something new in investing. New products, new assets classes and new investment opportunities spring up constantly. Those with a financial stake in the success of these ‘new’ things are incentivised to extol their virtues. Yet if we ignore history we are doomed to repeat it.

While the tulip mania of the 1600s and the internet bubble of the late 1990s are indeed different the underlying human emotions and tendencies that often drive markets in the short-term are anything but new.

If there is one lesson that history can teach us about investing it is to be wary when too much investor capital chases an opportunity. This process has long been known as the capital cycle and has four distinct phases:

Phase 1: The advent of a compelling narrative

Phase 2: Irrational exuberance

Phase 3: Bust

Phase 4: Deep pessimism and the pathway to recovery

The same thing happens over and over. Like lemmings we throw ourselves off the investment cliff and see our dreams of life-changing returns dashed against the rocks. It is challenging to resist these opportunities because of the power of the human emotions at play. Yet a healthy scepticism serves us well as investors.

To help investors understand the capital cycle and hopefully develop some scepticism in the future I’ve outlined several historical examples of this phenomenon. In part 2 of this article I will suggest several areas that could currently pose a risk to investors.

Buy now pay later ("BNPL")

This was a great narrative. Young people don’t want to use credit cards but still want to buy things when they don’t have enough cash. Retailers want to sell more products. BNPL seemed to be the answer. BNPL let people spread their purchase over four payments and charged the retailers for the privilege of accessing their customer base.  

Did this narrative hold up to scrutiny? Not really. Borrowing money through a credit card and a BNPL provider with penalties didn’t seem that different. Yet for at least a while it worked on regulators who didn’t require BNPL to adhere to the same standards as credit card companies. It also worked on investors.   

As investors poured more money into BNPL it encouraged more entrants into the space. Those new entrants were richly funded as investors wanted to find the next ZIP and Afterpay in hopes of capturing similar returns.

The traditional payment providers started to take notice and jumped into the game. Banks and American Express started BNPL-like products. Even Apple joined the party with a BNPL option on Apple Pay.

This led to a fundamental problem for BNPL companies. The firms made most of their money from retailers that paid fees on purchases using BNPL. But the power of the BNPL companies came from having more users. That gave them the ability to negotiate higher fees with retailers and it increased the volume of purchases.

More entrants, a seemingly unlimited amount of investor capital to spend and the need to acquire as many users as possible set the industry up for a ruinous competitive environment. BNPL companies spent lavishly on marketing and the cost to acquire a new user increased.

The firms were buying revenue growth with marketing dollars. At first investors didn’t seem to care. They saw fast top line growth and ignored the fact that there were no profits.

We can use ZIP as an example. Between 2019 and 2020 ZIP grew revenue by close to 90%. In 2021 revenue growth had accelerated to 152%. Investors were ecstatic and the share price rose from roughly $3 in 2019 to over $10 a share in early 2021.

During this period of rapid revenue growth profits shrank. In 2019 ZIP lost 3.5 cents a share. In 2020 those loses had deepened to 5.3 cents a share. Finally in 2021 as the share price hit an all-time high ZIP lost $1.27 a share.

The problem was as clear as day on the income statement. ZIP grew earnings by 90% between 2019 and 2020 by increasing marketing spend by 175%. To grow revenue by 152% the next year they had to increase marketing spend 648%.  

Ruinous competition is what we want to avoid as investors. This is why we want to buy a company with a moat. A moat provides protection from competition. But there was clearly no moat in BNPL because there were no switching costs or brand loyalty from customers and retailers.

If you wanted to use a competing product you just downloaded another app on your phone. It was easy to do because there were no credit checks. And retailers would just accept another BNPL provider and slap another sticker on their window.

Both consumers and retailers were happy to let the BNPL providers fight for their business which lowered fees and increased marketing spend. And the BNPL providers didn’t mind because they could just tap investors for more money. In that period between 2019 and 2021 ZIP increased the share count by 62%.

ZIP

This was clearly unsustainable. And in late 2021 and early 2022 the party was over. Investors finally noticed this was not a sustainable business model. In the case of ZIP the shares were trading under $1 by June 2022. We saw consolidation and bankruptcies as the BNPL companies desperately tried to put an end to this backbreaking competition.

It is unclear if this will work out. ZIP losses blew out in 2022 when the company lost $1.81 a share. Losses have since moderated significantly and the share price has risen to over $2.00. Still a fraction of the highs. Yet after all this the company still has never turned a profit. Afterpay shareholders were bailed out when Block acquired the firm. Many of the other entrants have disappeared.  

BNPL is a textbook recent example of the capital cycle. There was a compelling narrative which led to irrational exuberance and money pouring into the space. The inevitable bust occurred and now potentially the seeds of a recovery.

It is easy to look at this situation in hindsight and see the issues. But that doesn’t mean it wasn’t predictable when looking at the world through the lens of the capital cycle. In fact, in March of 2021 Shani and I released a podcast using the research of Morningstar Analyst Shaun Ler to warn investors about the prospects for ZIP. We were nervous about releasing the episode given how well ZIP was doing. Turned out to be almost perfect timing since the share price started a long decline afterwards. This didn’t show any genius. Just an appreciation for the capital cycle. Hopefully people took that to heart.

Listen to the BNPL episode:

The .com bubble....and bust

Everything that was associated with the internet took off during the .com bubble. Anything associated with AI has taken off in the last few years. In both cases it was/is fairly clear that the new technology will in fact change the world. The question we have to ask ourselves is how.

New technology is both an opportunity and a threat. But it can be difficult to discern who the winners and losers will be. Sometimes the winners are the companies that provide access to the technology. Sometimes the winners are the companies that provide inputs to those providers. In some cases the winners are the consumers of that technology. But all along this chain there is the risk that the irrational exuberance driving capital flows will lead to ruinous competition.

The .com bubble provides some lessons. Nobody owns the internet. Instead, companies could make money providing access to the internet for businesses and consumers. And internet providers took off during the .com bubble like America Online.

To facilitate internet access companies like Worldcom and Global Crossing laid fibre-optic cable across the world and Cisco provided the networking hardware and software. And then new companies emerged who wanted to use the internet to sell products. Enter Pets.com and Amazon.

To buy things on the internet consumers had to be able to find the retailers. Lycos and Yahoo were early search engines.

Since anything associated with the internet got waterfalls of money all these companies had ample funding to build their empires. That is when things started to go wrong.

Worldcom and Global Crossing were very good at laying fibre and spending money. They invested $30 billion to build 90 million miles of fibre. They made a slight over-estimation of demand. By 2001 it was estimated that just 5 percent of their capacity was being used. They both went bankrupt.

American Online made big waves as consumers and businesses clamoured to get on the internet. They got so much money their ambitions expanded to media and we saw the disastrous merger with Time Warner who owned some of the biggest film, TV and print assets in the US. Access to the internet quickly became a commodity as broadband prices plummeted.

It turns out that people were not ready to buy pet food over the internet in the late 1990s. But books held some appeal. Pets.com went bankrupt and Amazon diversified from books and is the case study that the internet is in fact a good place to sell stuff to people.

As more people bought things on the internet search turned out to be quite lucrative. Just not for the likes of Lycos and Yahoo who watched as Google came along with a better way to get pet supplies shipped to your home from Amazon.

Through bankruptcies and investor losses during the .com bust the underlying technology of the internet has in fact changed the world as predicted. Emerging from this carnage were some interesting winners. Worldcom and Global Crossing may be bankrupt but all the excess fiber-optic capacity led to cheap broadband prices which meant that people could do things like watch videos on the internet. Now we have YouTube, Netflix and social media.

The internet infrastructure provided by Cisco is still needed and the company remains a giant. However, owning winners did not guarantee riches. Shareholders who got in at the top were in for a disappointing ride. Cisco shares peaked at $82 in March of 2000 when it became the most valuable company in the world. 24 years later and it has never approached those levels despite growing revenue from $19 billion in 2000 to $57 billion in 2023.

CSCO

There are many lessons we can take from the .com boom and bust.

Lesson one: While emerging technology can be exciting it is also incredibly disruptive to the existing order. The competitive structures that may have been in place for decades can quickly change for existing companies. And even if the technology does in fact change the world it is hard to pick the winners from the new entrants that make up the value chain of providing and enabling the new technology. In most cases it takes time to generate a moat while means there are rapid shifts in the competitive environment.

Lesson two: New technology generally costs a lot to roll out and commercialise. While capitalism is designed to funnel investment to these opportunities it also tends to overly fund certain opportunities given the tendency for irrational exuberance from investors. To put it bluntly great ideas and dumb ideas are both funded excessively. And not every opportunity will come to fruition. This is natural in business. But when funding is easy to get companies can hang on and even appear to be successful for long periods of time. Investors that jump on this bandwagon can get burnt.

Lesson three: Even when an investor manages to pick a winner the price paid for the company matters. Cisco is the classic example but Microsoft is also illustrative. Microsoft shares peaked during the .com bubble in December of 1999 at just above $60 a share. The shares next hit $60 in late 2016. We often illustrate bubbles with the Pets.com of the world and this gives investors the impression that if they avoid the comically dumb business models they will be fine. Microsoft and Cisco were, and are, great companies. They kept growing revenue and earnings through the .com bust to today. However, investor expectations were so far removed from reality that it took a long time for the share prices to recover – in Cisco’s case 24 years and counting.

Lesson four: The ultimate beneficiaries are not necessarily the ones investor’s initially suspect. We’ve covered individual companies in the first lesson but new technology can spurn whole new industries that couldn’t even be imagined at the time. Also in many cases new technology ends up benefiting all businesses through increased efficiency.

Lesson five: Execution matters. A lack of capital requires disciplined decision making on what projects to fund. A period of limitless capital removes all that discipline. Fibre-optic cable and fast internet were needed to support the internet revolution. It was smart to build this infrastructure. WorldCom and Global Crossing creating 20 times more capacity than the world needed wasn’t so smart. It takes more than a good idea to run a successful business. After a bubble we tend to focus on the superficial – excessive remuneration, lavish parties and employee perks. Don’t forget about too much capacity and funding initiatives that never should have been undertaken.         

Final thoughts

It was hard to choose the two examples I selected for this article. I considered the telegraph and railroad examples from the 1800s. I thought about the countless instances in the mining space which is rife with examples of over investment in capacity leading to plummeting prices. Lithium is a recent example. There are just too many examples throughout history.  

Investing is ultimately an optimistic endeavour. Returns and growth are a by-product of humans overcoming challenges and moving the economy forward. There are always risks to contemplate and too much of a focus on the doom and gloom of each news cycle can make an investor too risk adverse.

Yet scepticism still has a place in investing. There is a line that we have crossed countless times when optimism become irrational and when prices no longer reflect reality. This is the beauty of passive investing and John Bogle’s admonishment that we should stop searching for the needle and instead buy the haystack. It is the beauty of investing in boring companies who use technology as an enabler of success instead of a primary product. Whatever approach you take it pays to be wary of the dangers of the capital cycle.  

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