The Dot-com bubble also known as the internet bubble or the information technology bubble was very much a speculative bubble formed between 1995 and 2000, ultimately leading to massive destruction of investors’ wealth during the start of the new millennium.
After witnessing an unprecedented boom in internet related stocks in mid 1990’s, the Nasdaq index crashed on March 10, 2000, falling to 5048.62, having touched an intraday high at 5132.52.
During this period, scores of companies were founded which mainly dealt in internet related businesses, also referred commonly as Dotcoms.
Just then, the fad over internet related business was so high among market participants that companies operating in this field only had to use ‘e’ prefix or ‘.com’ at their end of names, in order to set their stocks rolling in the market.
No questions were being raised on dubious business models, no one fretted over shockingly high stock valuations, as everybody in the market, be it a small investor or venture capitalist, wanted to jump on the dotcom bandwagon.
Thanks to overconfidence and hype that surrounded the technological advancements amid plethora venture capital funds, investors were even ready to overlook some conventional valuation metrics like P/E ratio method.
The dot-com bubble started to burst during 2000-2001. While companies like Pet.com completely vanished from the market, other companies lost large portion of their market capitalization but continued to remain stable and profitable.
For instance, Cisco shares declined by 86% at the height of dotcom crash, but it soon recovered and even surpassed its peak it reached during the dotcom boom. Similarly, Amazon stocks also fell sharply from $107 to $7 per share at that moment, however a decade afterwards, traded at $200 a share.
The Bubble Formation
As dotcom companies witnessed dramatic rise in stocks prices, venture capitalist seeking high growth projects, pumped in money on several startups without treading with any caution, thinking that diversification will mitigate risks while the market will decide which businesses will succeed in the long run. Besides, very low interest rates between 1996 and 1999 also encouraged many venture capitalists to invest in new projects.
Even though many entrepreneurs had sound administrative skills and realistic business models, the dot-com boom culminated disastrously due to those people, who in spite of lacking strong characteristics in business, were able to easily sell ideas to investors- benefitting from novelty that surrounded the dotcom concept.
Typically, dot-com companies’ business model centered on harnessing network effects. Companies were ready to suffer sustained losses in order to grab the market-share. Such companies used to offer services or their ‘end products’ for free, hoping that one day they could create enough brand awareness which will allow them to charge profitable rates in the long-run. Their strategy was to ‘get big fast’ even at the cost of continued losses.
As losses piled up, these “high growth” companies started relying more on venture capitalists along with initial public offerings to tap capital from market.
The novelty that surrounded these “new economy” stocks together with absence of any proper valuation methods, sent dotcom companies’ stocks to spectacular heights, making promoters of these tech startups millionaires in no time whatsoever.
In behavioral finance, stock market bubble is a phenomenon where stocks of particular industry soar at brisk pace much beyond its intrinsic value. Cognitive biases create a ‘herd mentality’ among investors- a situation where they fail to differentiate rational and irrational decisions. In normal circumstances, investors will sell overvalued shares and buy undervalued shares.
However, under the stock market bubble, speculators tend to buy stocks because of the rapid increment in their value amid anticipation of further increases, rather than buying shares when they are undervalued.
Accordingly, many companies turn grossly overvalued and when bubbles started to bursts, share prices dropped dramatically even as some companies went out of the business.
The dot-com business model was fundamentally flawed. Majority of companies during that era had the same business plan-which was to monopolize their particular sector through network effects. So, even if the business plan was sound, the fact that there could only be a single winner meant that most of the companies notwithstanding sustainable business plan would not succeed. As a matter of fact, many sectors could not sustain even one company powered entirely by network effects.
The U.S. media was also to be blamed for buoying up the dot-com bubble. Some well know business publications in America like Forbes, the Wall Street Journal encouraged investors to buy internet related stocks despite many companies failing to uphold even basic financial and legal principles.
Nevertheless, the dot-com bubble and subsequent bust is not all about investors burning their money. The era also witnessed few startup founders making vast fortunes as their companies were bought at an early stage of the dotcom boom. Such early success stories encouraged even more investments and speculations, making the bubble even larger.
Spending of Gigantic Proportions But No Returns
According to dot-com theory, the only way an internet company could have a survived was through rapidly expanding its customer base, even though it resulted in huge annual losses in the short to middle term. For example, Google and Amazon did not post profits for first few years.
While online retailer Amazon was spending millions of dollars to expand its customer base alongside creating its brand awareness, Google was more focused investing on powerful machine capacity to support its rapidly expanding search engine.
The adage used then was “get large or get lost”.
At the time of dot-com bubble, it was very easy for any internet related business to tap money from the public through initial public offerings (IPOs).
Founders and promoters of tech startups were able to generate substantial amount of money from the market even though they had failed to make any profits or earned any revenue whatsoever. The only matrix used at that time was the burn rate which helped differentiating good business models from average business models. A burn rate measures the speed at which non profitable companies with new business models runs through the capital.
In order to expand their customer base, dotcom companies were largely dependent on public awareness campaigns. These campaigns included TV ads, printings ads, alongside targeting major sporting events.
Whereas Super Bowl XXXIV in January 2000 had 17 dot-com companies with each sponsoring over $2 million for a 30-second spot, January 2001 Super Bowl XXXV featured just three dotcoms buying advertising spots.
Similarly, television broadcaster CBS presented $10 million to a winner of half time special program on April 15 2000 which was financed by iWon.com.
To attract investors’ attention, many dot-com promoters named their companies with onomatopoeic gibberish words, hoping that such words would be easily memorable and will not be confused with a competitor.
Obsession for rapid growth over profits and overconfidence on “new economy” and its unassailability led many companies to spend lavishly on marketing and publicity campaigns even though business models remained unsustainable.
Besides, some companies also spent exorbitantly on business facilities and financing vacations for its employees. Instead of cash, newly appointed executives and employees were given stock options, making them millionaires instantly when the stocks were floated in public via initial public offerings. The wealth created in this fashion was again invested in other dotcoms.
Just about every city in the United States wanted to become another ‘Silicon Valley”. All of them were focused on providing network enabled office rooms in order to catch the attention of internet related entrepreneurs. Several cities and states in the U.S. competed fiercely against each other in order to portray themselves as a technological hub. With the aim of attracting new dotcoms in their states and cities, local governments offered tax incentives/breaks, made favorable tax and business laws while some states used tax money to construct posh conference centers and technologically advanced infrastructures. For instance, Virginia’s “Technology Corridor” offered tailor-made ambiance to internet related companies
Looking at the brisk pace of development in this IT industry, communication providers thought that new age economy will need omnipresent broadband access. As a result, most communication companies started to make improvements in networks with high speed equipments and fiber optic cables. However, these companies also drowned themselves under deep debts.
Those companies specializing in communication equipments, for example Nortel, suffered huge losses due to overspending. Later in early 2009, Nortel filed for bankruptcy. However, those companies that did not have their own production facilities but sourced from other manufacturers, were able to exit the market quickly and performed rather well during the IT industry slow down
In Europe as well, several telecom operators spent large amount of money on developing 3G networks and obtaining licenses for the same. Operators in countries like Italy, Germany and Great Britain became heavily indebted owing to heavy spending and borrowing. The investments made on these projects were highly disproportionate compared to current and future cash flows from the telecom business. Surprisingly, this overspending was not acknowledged until as far as 2001 and 2002. In IT industry, equipment manufacturers are highly networked. Small companies manufacturing various equipments used in telecom-shelter/sites are heavily dependent on telecom operators. so, of telecom operators lose money, the whole IT industry also suffer.
Sonera, a Finnish mobile network company, paid enormous amount of money in a broadband auction in Germany to get a 3G license. However, the 3G network took several years to materialize and cash strapped Sonera was left with no option but to be acquired by TeliaSonera, at that time simply Telia.
The Bubbles Explode
After keeping interest rates at very low level, the Federal Reserve started to tighten up the monetary policy from1999. Between 1999 and 2001, the fed hiked the benchmark interest rates on six times and as a result the U.S. economy started to slow down. The dot-com boom which was fuelled by cheap money started to experience a bearish phase from March 10, 2000. On that day, the technology intense, the Nasdaq Composite Index soared to record 5,048.62, having touched intraday high of 5,132.52. But after peaking in March 2010 and almost doubling in market value within one year, the Nasdaq composite index started to face some down ward pressure. Market analysts played it down by saying it as stock market corrections.
However, the actual reason behind the sudden reversal and ensuing bearish phase was triggered by some fact findings in a case known as United States Vs the Microsoft. Although a federal court declared Microsoft as a monopoly on April 3 2000, the outcome was widely expected by investors long before the court’s verdict. Consequently, the sell-off pressure started to appear at the Nasadaq from March 2000.
Later on March 20, 2000, following NASDAQ’s sharp plunge of 10% from its peak, a financial publication, Barron’s, shook the financial markets with its cover story known as “Burning Up”. According to this article, the dot-com companies were heading towards a spectacular collapse. Barron’s Sean Parker warned that in next 12 months, many leading tech startups will run out of cash. The cover story pointed out that “America’s 371 publicly traded Internet companies have grown to the point that they are collectively valued at $1.3 trillion, which amounts to about 8% of the entire U.S. stock market”
From 2001, the dot-com bubble started to lose all the air. Scores of tech startups vanished from the market after burning all their cash while some companies even failed to make net profits.
While many dotcom startups and communication companies were on the course to file for bankruptcy, investors received yet another jolt on October 2003 when America Online and Time Warner merger deal was terminated. Earlier in January 11, 2001, America Online, a darling of most dot-com investors and a worldwide leader in dial up internet access merged with Time Warner, world’s largest media company. The M&A deal was the second biggest globally. However, this deal was later dubbed as the worst in the history of M&A. just two years after the merger agreement, the management boards of both companies were at loggerheads, leading to a split.
Even as deals went sour and companies vanished, weighed by excessive debt burden- large players like WorldCom were found involved in illegal accounting practices. The Company used to inflate its profits on annual basis. No sooner did the news go public; WorldCom’s stocks plummeted, eventually resulting in bankruptcy filing by the tainted company. In fact, the WorldCom bankruptcy was the third largest in the U.S. history. Some of the other companies that were involved in unethical practices include: North Point Communications, JDS Uniphase, Global Crossing, XO Communications and Covad Communications. On the other hand, companies like Nortel, Cisco and Corning felt the heat during dotcom bust because of their reliance on infrastructure that was by no means well developed. Corning stocks dropped significantly at that moment.
Many tech startups were also running out of capital, which required them to get liquidated while some other companies got acquired. The liquidated companies’ domain names were taken over by “old economy” companies or domain name investors. A number of companies and executives were either accused or found guilty of frauds. These companies not only grossly misused investor’s money but also concealed facts from the shareholders while artificially boosting net profits. U.S. stock market watchdog, the Securities and Exchange Commission (SEC) even levied hefty penalty on investment banks like Citigroup and Merrill Lynch, which ran over millions of dollars, for misleading investors.
The negative impact of dot-com collapse was also felt in some other industries. For example, advertising and shipping industries were forced to scale back their operation owing to sharp fall in demand for their services. Nevertheless, some companies, thanks to their sustainable business models, survived the tumultuous phase. Companies like Amazon.com, e-bay and Google not only ensured their survival in the long run but also went on to become market leaders in their respective spheres.
The dot-com meltdown and subsequent stock market freefall between 2000 and 2002 destroyed the market capitalization of several companies, amounting to $5 trillion. Later, the September 11 attacks on Twin Towers which killed nearly 700 employees of Cantor-Fitzgerald pushed the stock markets at new lows.
A deeper analysis shows that about 50% of the tech startup started during the dot-com boom survived through 2004. Nonetheless, this experience also showed those companies termed as “small players” were in better position than some huge IT giants to endure the aftereffects of dotcom collapse- a time when financial markets were in critical situation. Retail investors who bore the maximum brunt from dotcom collapse became more cautious.
The IT job market completely collapsed. Several technology experts, who were laid off, post dotcom collapse, saw supply outstripping the demand by a long way. In universities, courses related to IT, saw significant drop in enrollments. Many jobless programmers and IT experts went back to schools to become lawyers, accountants and management graduates.
Some of the Companies significant to the dotcom boom
Boo.com: Invested mindboggling $188 million within first six months. The Company intended to create a universal online fashion store. It went bust in May 2000.
Startups.com: Was dubbed as the “ultimate dotcom startup”, disappeared from the market in 2002.
e.Digital Corporation (EDIG): Founded in 1988 and formerly known as Norris Communications , this OTCBB traded company was non profitable for several years. This Company changed its name to e.Digital in January 1999 when stock traded at $0.06. The stock gained sharply in 1999, climbing up from a closing price of $2.91 on December 31, 1999 to intraday high of $24.50 on January 24, 2000. However, it promptly retreated and has traded between $0.07 and $0.165 in 2010.
Freeinternet.com: The Company filed for its bankruptcy in October 2000 shortly after cancelling its IPO. Just then, Freeinternet.com was the fifth largest ISP provider in the United States, having 3.2 million subscribers. Renowned for its mascot Baby Bob, Freeinternet.com net loss stood at $19 million in 1999 on revenues of less than $1 million.
GeoCities.com: this failed business was bought by Yahoo for $3.57 billion in January 1999. Later on October 26, 2009, Yahoo closed Geocities.com.
Pets.com: A failed business model where pet.com sold pets’ supplies to retail customers before filing for bankruptcy in 2000.
Open.com: The Company used to be a big software security maker, reseller and distributor. In 2001, open.com declared its bankruptcy.
InfoSpace: While on March 2000 this stock traded at mind-blowing $1,305 per share,by April 2001 its price ebbed down to $ 22 a share.
Lastminute.com: The Company’s IPO coincided with collapse of dotcom boom.
WorldCom: This long distance telephone and internet service provider company used deceptive accounting methods to inflate profits, aimed at boosting its stock prices. In 2002 the company filed for bankruptcy and its tainted CEO Bernard Ebbers was found guilty of fraud and reprehensible plotting.