The Laws of Gravity and the Dot.Com Balloon

The Internet has seen some strange phenomena. The strangest is the rise of the stock-price of a number of Internet companies to stratospheric heights in the global stock market. The Internet is creating instant billionaires; kids barely out of high school, are now worth millions. And in India, home-grown Adim Premji of Wipro and Narayan Murthy of Infosys took the shine off the NRI businessmen, with Premji becoming the second richest man in the world after Bill Gates.

What are the billions that Bill Gates that Premji are supposed to own? Normally, when we talk of wealth, we mean assets; for the businessman, this has generally meant productive assets: factories, offices and of course people who are employed in their companies. However, the kind of wealth that Bill Gates or Adim Premji possesses, has little to do with such tangible assets. Their “assets” are the market value of their stock holdings. Thus, hypothetically, if Microsoft has 100 million stock shares and Microsoft stock is trading on the stock exchanger at $10 a share, Microsoft’s market capitalisation (market cap) is $1 billion. If its stock now trades at $100 a share, Microsoft’s market capitalisation increases to $10 billion. If it goes upto $1000 a share then Microsoft’s market cap goes to $100 billion. And if Bill Gates owns 40 % of this stock, he is now said to be worth $40 billion. Today, Microsoft’s market capitalisation is  $473 billion and Bill Gates, by virtue of his holdings is worth $102 billion.

The Wipro stock is very similar except that the rise of Wipro’s stock price has been even steeper. Wipro was trading last year at Rs. 604 per share. It rose to a high of Rs.10,350 — a dizzying growth of 15 times its stock value in less than a year. And Premji, by virtue of his 75% holding in Wipro, is now “worth” an astounding $37.5 billion. Narayan Murthy and his company Infosys’s growth have also been similar, if not as large as Wipro’s.

While the growth of software companies such as Microsoft and Infosys have been spectacular, their turnover is nowhere near their market cap. Thus, Microsoft, with a market cap of $473 billion, has a turn over of only $20 billion. Similarly, Infosys, with a turnover of $220 million, has a market cap of a couple of billion. Their large market cap comes from the high profitability of software ventures and the belief that this profitability will translate into future dividend payments for the stockholders. However, it has been argued that the future profitability of this order is unlikely to be true and these stocks are highly over valued.

Microsoft, in trouble over its monopoly practices in the US courts, is seeing a sharp fall in its stock price. It lost a whopping $79 billion in one day (Monday, 3rd April), dragging all information technology stocks down as the talks between it and the Justice Department broke down.

Software companies have at least some “assets”: their software and the skill of their employees. Their monopoly profits protected now by stringent Intellectual Property Rights under the new WTO regime, they can claim continuous future earnings. The Dot.com companies are, however, a completely different kettle of fish.

The Internet allows individuals and small companies to construct “sites” in cyber space. This means registering a name for the entity — company, individual or product — and then creating pages of information that can be put on a computer connected to the Internet. This becomes a “site” that can be accessed through the Internet by anybody. There are “Search Engines” on the Internet (also called the web from its name of World Wide Web), which can use certain key words and site information to locate this site for the interested users.

The entire development of the net came initially from researchers in institutes who wanted to exchange information amongst themselves. Instead of sending information back and forth, Tim Berners-Lee, the creator of the Web, hit upon the idea that the information could be put up in cyber space on computers connected to the net; people could then download whatever they found interesting. Of course, the actual process was nowhere near as simple as its is made out here. However, this idea is the essence of the Internet or the World Wide Web.

The commercial use of the net followed soon after it was realised that the World Wide Web was growing exponentially. The dizzying growth of the net made it possible to use the net to market products and services. Two of the biggest commercial success stories are Amazon.com and Ebay, both of which have grown to tens of billion dollars in market caps within the last two years. Amazon.com is essentially an internet bookshop, which allow you to search through their list of books and purchase on-line whatever you want. Once the transaction is complete — you pay through your credit card number — the book is shipped to you within a few days. Amazon.com could store far more titles on its virtual shop then any bookshop in the real world; search tools on its site tells you what other books are similar in content, the other books of the author, lets you search by subject or using key words. As the books reached the buyers quickly enough, Amazon.com did booming business. When it went public, the market cap of Amazon.com rapidly rose to $35 billion.

Ebay has a different profile. It started as a auction house: it would make possible a whole range of goods — from Hitler and Marilyn Monroe memorabilia to more mundane goods — to be exchanged without storing any goods unlike a physical auction house. Ebay’s market capital is also in the range of $17 billion.

While Amazon.com and Ebay are the most successful companies, there are a whole range of companies who have netted a windfall on the net. Thus, Yahoo.com used the popularity of its search engine to launch an electronic magazine and provided advertisers with “space” on their site. Yahoo.com has also a market cap in billions. Samir Bhatia, the person who sold Hotmail to Microsoft for a whopping 400 million missed out by not going into the stock market. If he had tapped into the stock market, he would certainly become another of the new net billionaires, instead of sitting on a paltry hundreds of millions!
The Dot.com, called so because all commercial sites on the web have to end with a  .com in their address, thus has become the drivers of the new economy, funnelling in venture capital on a very large scale. Currently, it is very much like the California gold rush, where everybody who had a spade thought they were going to become instant millionaires. The Indian Dot.com companies are also rushing in — providing content that hook people on to their sites thus allowing them to sell “space” to advertisers, or “cyber markets” such as Jaldi.com which sell a variety of goods on-line.

The key issue is if the market caps of these companies are in billions, what are they going to earn in the future to justify these share prices? At some point in the future, the shareholders that are buying these stocks today, will expect dividend payments that justify the price they are currently paying. None of these internet companies have made any profits; most of them have already totted up huge losses. The argument is if they have market share today, this will translate into profits in the future. However, all calculations done show that there is no possibility of ever recording profits to justify their current huge market caps.

It is important to note that unlike the software companies, who own some software products, the Dot.com companies only “own” real estate in cyber space. Thus, while the software companies own intangible assets which may be overpriced and make super profits in terms of monopoly rent, the Dot.com companies do not have even that. They do not add any value to the products that they sell — they facilitate transfer goods from producers to buyers and therefore act essentially as traders. They are just giant super markets in cyber space marketing a whole range of goods with virtually no overheads.

To understand the success of the Dot.com companies, one must understand the nature of mark ups in retail trade in the US and the advertising budgets. It is well known that goods, which are priced at $50 to 60 in the US, cost $5-6 to manufacture (for example Nike shoes). Thus whole sale and retail trade have huge margins. A product of a country such as India is bought by a US company for $5 and sold at $50.

The retail mark up of say 25-30%, could then be worth as much as $15 or three times what the producers get. Marketing in cyber space does away with costly retail traders and allows greater margins to be retained by the US company marketing the product.

The advertising budget of companies in US alone was $33 billion in 1996, the major share going to television. In contrast, Internet advertising had a share of less than $250 million that year. Considering that the number of users visiting a site is comparable to that of television viewers, there is considerable scope of tapping into these huge advertising budgets.

However, can cyber trade provide future profits of this magnitude? Various experts have already computed the cash flows that these Dot.com companies will need in order to survive. If this is financed through either loans or through new capital infusion, there is no way that these companies can earn the profits that justify the current stock prices.

If the future earnings are nowhere near the requirement to sustain current stock prices boom in these companies, why did these prices rise to these levels in the first place? Here the role of venture capital and mutual funds is important. These are essentially speculative capital that comes in to fund new companies. If accompanied by the type of hype that we have seen associated with the net, this can then lead to huge number of small investors all trying to make a killing. Once the market has reached new heights, the speculative capital leaves by selling its stocks at 10 to 100 times their initial value. In the end, it is the small investor that is left holding the sack when the stock market bubble bursts.

This is exactly what is happening today. The gold rush has taken the information technology (infotech) stocks to 10 to 15 times their worth in a few months. Some of the Dot.com companies with no real assets have seen their stock value go up 10 to100 times. All the get rich stories in the media pull in investors eager to make money from the net. When the market starts to fall as it is doing now, the speculative capital has already made its exit leaving the small investors holding pieces of junk paper.

Ultimately, it is productive assets and products that limit growth in the virtual world as well. The new economic “pundits” have been preaching that the “new” economy has new economics and that growth in cyber space is not limited by the amounts of goods produced in the “old” economy. However, the truth is that the virtual world of cyber space does not add any value: it only allows a transaction that must be accompanied by transfer of goods from the producer to the users. Thus, the limits to cyber growth come from the limits in the real world. If the economy is not growing in real terms, the virtual world will reflect this, sooner rather than later. The infotech stocks, the darling of the global stock markets, are now falling rapidly. The law of gravity — whatever goes up must come down — is finally catching up even in the cyber world. While the economic pundits will call it a market corrective, one thing is sure. It is the small investor who will be burnt; the smart money, which created the internet hype in the first place, has already pulled out of the infotech stocks.