In the summer of 1999, Warren Buffett stood in front of a group of business leaders to share his views on the “new economy.” He believed that the exceptional rate of return on the stock market at the time was unsustainable. His audience wasn’t impressed.
A year later the Dotcom Bubble burst and Buffett was proved right. His “outdated views” had substance. After all, he had history on his side. Anytime innovation created a booming new industry it was followed by a collapse.
I thought it would be instructive to go back and look at a couple of industries that transformed this country much earlier in this century: automobiles and aviation. Take automobiles first: I have here a page, out of 70 in total, of car and truck manufacturers that have operated in this country…
All told, there appear to have been at least 2,000 car makes, in an industry that had an incredible impact on people’s lives. If you had foreseen in the early days of cars how this industry would develop, you would have said, “Here is the road to riches.” So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three U.S. car companies — themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America — and also an enormous impact, though not the anticipated one, on investors.
Sometimes, incidentally, it’s much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make money.
Buffett’s tale of the airplane industry was similar. The number of airplane companies ballooned to roughly 300 by 1939 before declining to a handful today. Picking the winners from the outset was practically impossible.
A similar pattern has played out numerous times since. The examples below are from a Michael Mauboussin piece titled Fill and Kill. It shows the rise and fall in the number of companies created to seize on the potential in the auto, television, disk drive, and personal computer industries.
The four charts paint a clear picture of the boom and bust cycle of new industries. The cycle begins with a spike in new businesses as money rushes in to seize on the growth potential. Yet, for most businesses, the potential is short-lived. The fall in competitors is just as sudden because of bankruptcy at first and acquisitions later on.
No surprise that a similar pattern plays out in investor sentiment and valuations — a sharp rise in optimism in the new industry, with a matching rise in stock prices, that turns to pessimism as the bankruptcies pile up.
Oddly enough, the rush of capital into a new industry creates an interesting dynamic. It accelerates research, innovation, and growth in the space while the highly competitive environment puts pressure on prices. It becomes a boon for consumers.
Yet, the excess capital makes it more difficult on investors since it sets the stage for the industry’s inevitable collapse (the lessons of the disk drive industry are a great example of this).
As Buffett said, and the charts show, picking the ultimate winners at the start is a crapshoot. The best opportunities are likely found at the height of industry turmoil and bust.
Business failure and consolidation is the result of companies unable to keep pace with an accelerated pace of technological change. However, at the end of the process a handful of super competitors emerge, which continue to dominate the industry. For example, both the disk drive and personal computer saw brutal competition as they matured, but the select few that managed to survive went on to create satisfactory, if not significant, shareholder value.
Leading companies emerge from the crucible of intense competition equipped with products and processes that can keep them a step ahead of their competition. These companies often prosper for many years following the critical point in the industry shakeout.
The surviving companies are not only fewer in numbers, but management likely made a series of right decisions, had the right amount of luck, and emerged financially stable.
The question investors should ask is why did the industry collapse? Was the potential for growth less than expected or did investor pessimism drive the bust? The key is to look for continued high industry-wide sales growth despite the decline in competing businesses. That gives investors the green light to dig further.
The challenge for investors is in avoiding the initial mad rush to stocks at the start of the cycle. Investors need to realize that they rarely have only one chance at buying a good investment. Patiently waiting might offer better odds of success.
That said, it’s important to point out that just because a new industry goes through a boom and bust does not mean it will produce worthy long-term investments.
The car industry produced mediocre returns for decades despite declining competition. The airplane and airline industries were notoriously bad investments as well. However, a basket of the surviving disk drive companies turned out better than expected. And thanks to hindsight, we know that the best time to buy Dotcom stocks was over the few years after that bubble burst.
It takes a special company with certain advantages to become a great long-term performer. Surviving the initial boom/bust cycle of a new industry might plant the seeds for that type of moat. But a new industry is hardly guaranteed to produce such a wonderful business. It might turn out to be more beneficial for consumers than investors.
Mr. Buffett on the Stock Market, Fortune 1999
Fill and Kill, Credit Suisse 2000
- Assured Misery – M. Housel
- Paradoxes of Life – The Curiosity Chronicle
- As Passive Investing Spreads, Overall Market Becomes Less Competitive – UCLA Review
- How Important are Intangibles? Very! – Klement on Investing
- Lies, Damn Lies, and Investment Statistics – Breaking the Market
- Marks Memo: The Winds of Change (pdf) – Oaktree
- Bill Miller’s Journey (Part II): Lessons of Triumph and Tragedy – Nechar’s Insecurity Analysis
- The Incredible Tale of the Greatest Toy Man You’ve Never Known – Inc.
- The History of WD-40 – Tedium
- The Financialization of Everything – The Atlantic