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From these points follows Leithner & Co.’s basic position with respect to technology in general and the Internet and “Internet companies” in particular.
Given Technology’s Fundamental Attributes, Tech Companies – Like Wildcat Mining Companies – Tend To Be Playthings of Speculators
We have seen that information technology possesses several distinctive economic attributes. Most notably, its consumption violates the principles of exclusion and rivalry. Computer and Internet technology enable the reproduction and transmission of explicit information and software at virtually zero cost and almost anywhere in the world, threatening their price with collapse.
Hence the establishment and enforcement of clear e-property rights are not easy; barriers to entry into e-business and e-commerce are very low and in some instances virtually non-existent; price decreases in these industries are the norm and it is commonplace for one firm to steal a march on its competitors, only to lose it soon thereafter. As the Australian Financial Review’s Silicon Valley Observed column reported on 5 January 2000: “[Internet] companies face more competition than ever. New ideas come with less intrinsic worth these days, unless they are patented network designs... Concepts are cheap when it comes to online shopfronts, software [and] internet services... As soon as an internet idea arrives, copies follow so quickly that no one can be sure if there was ever an original... In today’s internet business, speed is the biggest product differentiator.”
In addition to these fundamentals are several commercial realities: few technological innovations (Internet or other) become commercially successful; very few people can thoroughly understand and keep fully abreast of new technological developments; technology advances spontaneously and unpredictably; and for non-tech businesses (e.g., retailers, media and transport companies) the possession of superior purchased technology contributes towards – but is neither a necessary nor a sufficient condition for – the creation of wealth for shareholders. Given these attributes and realities, it is not surprising that technology companies tend to be financially precarious and have short life spans. And those which beat the odds and successfully develop and market a particular technology are often unable to translate its benefits into solid returns for their shareholders.
These characteristics of technology have important implications for Internet companies’ (and, more generally, technology companies’) quoted market prices. Because there exist no established means to estimate the value of an e-business or e-commerce stock, investment per se becomes impossible and speculation inevitable. Technology companies are therefore (in Benjamin Graham’s usage of these terms) clearly unsuitable for investment and made-to-order for speculation.In contrast, value investors have a strong bias towards the hard numbers in financial statements and a retrospective record of wealth creation which can be used (using suitably cautious and pessimistic scenarios) to make projections into the future. Value investors also have a strong bias against soft rhetoric and the absence of a successful track record. Alas, for many and perhaps most Internet companies and technologies, hard numbers and financial statements are absent and lofty rhetoric is in superabundance.
Consequences of Speculation
Speculation plays an important and positive role in a market economy. Most importantly, speculators accept (at a price) risks of one sort or another which non-speculators do not wish to bear. Trouble, however, arises when speculation seems effortlessly to generate paper gains. This raises expectations to unsustainable levels, obscures the risks which inhere in speculation, clouds the distinction between investment and speculation and encourages market participants to accept speculative risks which they cannot afford to bear. This process, as set out in my report of 15 November, almost inevitably ends in tears.
Given technology’s fundamental attributes, Internet and technology companies are much more often appraised in terms of hype, emotion and reckless abandon than caution, reason and risk. They are currently priced as if (in the case of e-infrastructure companies) they have already achieved network critical mass, or (in the case of e-business and e-commerce firms) their most favourable profit forecasts have already occurred or will certainly eventuate. A shift in tolerance of risk – or perhaps a change in the conception and recognition of risk – has prompted more and more participants to spurn “Old Economy” (i.e., physical capital) companies and embrace “New Economy” (i.e., intangible capital) companies. Indeed, many speculators proceed as if risk does not attach to these companies. As Byron Wien noted in Barron’s Online on 19 February: “the ‘New Economy’ stocks are being priced as if there is no risk, and the ‘Old Economy’ stocks are being priced as if there is no opportunity.”
But It’s Different This Time!
To a value investor, “It Is Different This Time” should be regarded as the five most dangerous words in investing. They are dangerous because even a casual perusal of economic history is sufficient to indicate that the current preoccupation with Internet and technology stocks bears a striking resemblance to a series of financial market events (“bubbles”) which have recurred during the past 400 years. By this analogy, it is quite possible that few of these companies will survive – let alone maintain their stratospheric market capitalisations. Promise, hype and speculation attract competition. And competition cuts profit margins, such that it is very difficult for upstarts to obtain – and for incumbents to maintain – sustainable margins. Hence only a few of the innovators survive, and survivors continue as much-chastened entities. At no time have these competitive dynamics exempted particular technologies.
The most reasoned dissent to this view has been written by Alan Kohler and appeared in the Australian Financial Review in July of last year. Kohler observes correctly that the Internet is not a commodity. Indeed,
“It is not even a ‘thing’ at all. If it is anything, the Internet is a mechanism for businesses to reduce their costs. That’s because it is, in essence, little more than a cheap way to distribute data between a lot of computers. That’s the difference between the Internet boom and the commodity price booms that have come before: it’s about costs, not prices. That means two things: it is being pushed by corporate executives, not pulled by consumers; and it’s more permanent, because costs tend to stay down when they are cut whereas when a price goes up, it usually falls again.”
Each of these points is well-taken. From none of them, however, does it follow that e-infrastructure, e-business and e-commerce will be bonanzas for all businesses; and still less do they imply that Internet technology companies will benefit disproportionately from the Net’s expansion and elaboration. Indeed, given the characteristics of the Internet and of technology more generally, it is equally plausible to expect that in an increasingly competitive environment the ’Net’s undoubted benefits will eventually diffuse so widely that it becomes part of the basic commercial infrastructure which all enterprises must use in one way or another in order to remain in business.
Two Lessons
What, then, is the overarching message posed by the Internet for value investors in general and Leithner & Company Pty. Ltd. in particular?
First, I have no idea (nor, I believe, has anybody else any credible idea) how long Internet- and technology-inspired excesses will last. Nor do I know what will change the behaviour of the governments, lenders and speculators which are fuelling them. The fact that these and other actors are motivated by greed, fear and folly is predictable; but the timing and sequence of these emotions are not. Hence the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct ours.
Second, the key to successful investing ultimately has nothing whatever to do with predicting the demand for and growth of a particular technology (Internet, biotech, pharmaceutical or whatever). Still less has it anything to do with predicting how a particular technology is going to affect the economy or society at large, or which company will emerge as its principal or most profitable provider.
The keys to successful investing – as Benjamin Graham outlined them during the 1930s and as Warren Buffett, Walter Schloss and others have practised them since the 1950s – remain the estimation (using cautious and conservative assumptions) of individual companies’ intrinsic value, and the purchase of their securities when they are available at a discount to that value. The advent of Internet and other technologies do not affect – and still less do they upset – these principles.
 
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