Fool's Eye View

[ March 9, 2000 ]

Two-Tier Bubble

By Bruce Jackson (TMFGoogly)

I've written before, and will probably do so again, about the two-tier stock market we're now experiencing. Technology shares of almost all ilks are flying high, whilst staid old companies in sectors such as Banking & Engineering are being left in their wake. Poor buggers.

But, there's no evidence of things changing. In this highly competitive and low inflationary environment, pure organic growth is hard to come by. I mean, how many more bank accounts and mortgages does a person need? And how many more tungsten carbide drills does the mining industry require? Compare that to the pure and unadulterated growth of mobile phones and the Internet. Is it any wonder that the latter companies are flying high? It makes perfect sense.

What doesn't make a lot of sense, however, is the valuations of many of these companies. They have many, many years of explosive growth already priced into them. The market is often assuming a company has a competitive advantage period of 10 years or more. In reality, that is extremely rare. If one company is making obscenely high returns, competitors will instantly be drawn to that business.

For example, Freeserve (LSE: FRE) saw the high returns which AOL (Nasdaq: AOL) was making due to the dominant position in the US market. Due to the low barriers to entry, they were able to set up an admittedly revolutionary free Internet Service Provider (ISP) service, and the rest is history. Or is it?

Freeserve's very business model is currently under threat as British Telecommunications (LSE: BT.A) moves away from the arrangement whereby 'free' ISPs receive a proportion of telephone revenues generated by calls to their service. In that particular aspect of their business, how long was Freeserve's competitive advantage period? About 18 months. In these fast-moving, fast-changing industries, short competitive advantage periods aren't about to justify valuations which are looking 10 years and more out into the future.

I often get asked when the bubble is going to burst. By making that comment, these people are automatically assuming there is a bubble. But is there one? Well, I know that many poor companies are extremely overvalued. Given the fullness of time, they will again trade at a fair valuation, which could be 90% of their current valuation. I'm not going to name names here, but a trawl through the companies calling themselves "e-commerce incubator funds" would throw up a few prime candidates. Does that mean there's a bubble? Yes and no. We're looking at a two-tier bubble. As investors, it's up to you to make sure you're walking on the right level.

Related links
• BT latest quote & summary
• Freeserve latest quote & summary
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