There May Be a Bubble, But It Isn’t a Casino Economy
Posted by Bob Warfield on October 17, 2007
I’m stuck chasing Nick Carr around today it seems. He’s written about some dire predictions by economist Carlota Perez in the NY Times about the effects of companies spending so much money to acquire what are basically small startups. In Carlota’s view, the normal cycle would see these companies devalued by a bubble burst, and they could be acquired at much more reasonable prices. The problem is opportunity cost for the big guys. They have no idea which little companies of today will define the trillion dollar markets of tomorrow. Which ones are the nascent Googles? Hence, they entertain things like the recent valuation discussions around a Microsoft investment in Facebook.
The problem with all this, as Perez sees it, is straightforward:
The more complex explanations have to answer why the excess money and why so much of it has gone into a financial casino and into asset inflation rather than into widespread real investment, innovation and high-quality employment growth.
She’s willing to tolerate pricing bubbles as a way of reallocating capital if that capital results in “real investment, innovation, and high-quality employment growth.” She puts it well:
Asset price inflation was good in the late 90s when there was a need for overinvestment in telecoms and Internet, even before they could produce profits or dividends. Everybody was willing to put their money into the new high tech companies because they could get short-term capital gains (only a few invested because they wanted to hold on to the shares until they really became major companies paying dividends). That is how the capital was gathered to “fiber-wire” the whole world, to get everybody to learn the new paradigm and to test every imaginable dot.com idea.
Do you see the flaw? It has to do with testing “every imaginable dot.com idea.” Perez assumes the new bubble isn’t funding any meaningful new innovation. What do you think? Was everything interesting to do with computers and the Internet invented in the 90′s? I don’t think so.
Blogging, Social Networking, and a raft of other innovations on the web have seriously changed how individuals interact with each other. We’re still innovating, but as I mentioned in a comment on a Stowe Boyd article, we are near the end on the current crop of ideas, so the timing is ripe for key players to be picked off by bigger companies. Business software, likewise, is going through a huge revolution around SaaS, Open Source, and a host of other developments. Older ideas, such as Business Intelligence, are apparently commoditized enough that the big players are picking off the Hyperions and Business Objects. Interestingly, the Old School Enterprise world did encounter the downturn Perez likes to see so valuations over there are not as high.
We’re witnessing consolidation and commoditization of computer architectures. It’s harder and harder to justify Intel-incompatible cpus. Eventually Sun will give up on SPARC. We’re seeing massive centralization of data centers, and the shifting of large amounts of processing and data into the cloud. Digital photography has largely taken over since the 90′s, and we’ve seen an incredible rise in rich media and rich Internet user interfaces.
This seems to me an emminently reasonable set of investments to have made through over-valuation in these areas. To add insult to injury, Perez is making these statements in the newly opened up NY Times on a blog! Somehow that’s hugely entertaining to me, but I’m easily amused.
Here’s another factor Perez leaves aside in her analysis. She identifies bubble pricing by a relative pricing model that sounds reasonable to me, although it has limitations:
How many cars do you need to buy a house? How many laptops to buy a car? How many Starbucks cups of coffee to buy a laptop?
That’s all fine and well, but she leaves out an important relative valuation concept that most elementary real estate buyers and sellers realize. What’s happening in the market is less important if you’re simply making a lateral move. You pay more in an up market, but you sell your old house for more too. The same is true for these acquirers who we’re concerned may be paying too much. Look at Microsoft. I calculated their potential $500M investment in Facebook amounted to a little over a week of cash flow for them. The valuation sounded hugely inflated, but in real terms to Microsoft, the chance an optional on what might be the next Google was almost immaterial. Take the Yahoo-Zimbra acquisition.
$350M for a $15M revenue stream? Preposterous. Yet, Zimbra is growing much faster than Yahoo, which needs to average its growth up. Zimbra is highly strategic to Yahoo’s business interests. It was arguably the best-of-breed for it’s kind. To compare it to the Microsoft deal, Yahoo paid more dearly, as $350M is about 3 months of Yahoo’s cash flow. OTOH, Yahoo gets over 2x the valuation per dollar of earnings, so if it can make the Zimbra acquisition profitable, those profit dollars add more to Yahoo’s stock price than they would to Microsoft’s.
Let’s try another comparison. Think of these different companies as different currencies. Some currencies are quite undervalued. It would be very expensive for Ford to buy Facebook. Their currency just isn’t worth nearly what Microsoft’s is. Given Ford’s cash flow, it would take them 2 years to pay for a $500M investment in Facebook while Microsoft lays off the bet in a little over a week.
We may have a bubble here, but I can see no ominous scenario of the kind Perez describes. Quite the opposite. We’re limiting speculation on these properties to companies in the business who acquire them, and not to private investors betting their retirement money on them the way we did last time.