Lessons from the dotcom

When you hear the term “dotcom”, you probably think about websites you find on the internet. For most people over the age of 30, the term dotcom will bring up memories of the period when the internet was the hot new topic in the late 1990s. Many businesses were keen on starting a new chapter with the turn of the millennium and leveraging all of the wonders the internet would bring. But, it didn’t really pan out as planned. Here’s what happened.

What was the ‘dotcom era'?

The onset of the new internet economy, by and large, fully unlocked the limits once placed on our imagination; in short, anything seemed possible. This was the vision that these new and highly-speculative internet-based companies – which showed little to no potential for profitability – were selling to investors.

As the ‘internet era’ broadened people’s imaginations, the value of these so-called dotcom companies increased as their share prices soared amid a buying frenzy. Essentially, FOMO kicked-in with investor and speculator demand pushing prices of these growth-orientated technology stocks higher. Their shares were priced at unsustainable levels, which analysts found increasingly difficult to justify based on business fundamentals.

Sharemarket bubbles and the dotcom pop

In a sharemarket ‘bubble’, speculation and even euphoria can take over with investor behaviour overriding company fundamentals. A sharemarket ‘bubble’ is considered a run-up in share prices without a corresponding increase in the value of the company.

While it can be argued that the sharemarket contains a certain degree of speculation, in a sharemarket ‘bubble’, this level of speculation is heightened to the point where investors turn a blind eye to, or ignore, basic company fundamentals. Investors continue to bid stock prices higher, without realising that the value of the company itself hasn’t increased by a corresponding amount.

Equity analysts and portfolio managers will often argue that a company’s valuation should be determined by fundamentals, such as the company profits, earnings, the quality of the management team as well as growth profile of the industry in which it operates.  

In the late 1990s, the line between ‘investment’ and ‘speculation’ blurred, the ‘bubble’ grew and investors continued to buy stocks of companies that had obvious red flags. Naturally, some of these companies eventually went out of business. When investors truly realised the irrationality of their behaviour, many sold their holdings, pushing down the share prices of these tech companies. This led to the ‘bubble’ popping – a whopping 56.3 per cent fall in the tech-heavy US Nasdaq index in the year to March 2001.

But not every surge in a tech company’s share prices is considered a ‘bubble’. Amazon is a classic example of a company that has seen its share price soar well over 1,600 per cent in the past decade. But, importantly, the company’s earnings have kept pace with the share price, growing as its competitive advantage in the online marketplace strengthened.

Diversify, diversify, diversify

From an investor perspective, ‘bubbles’ are difficult to avoid and even trickier to time. A useful starting point to navigate these ‘bubbles’ would be to consider the lessons learnt from the dotcom era, and how investors can better position their portfolios. 

How? Simple but crucial: don’t put all your eggs in one basket.

As an investor, it’s important to spread your risk over a number of different investments so that if a certain investment or asset class was to underperform, the losses as a percentage of your whole portfolio will be smaller. But just as losses can be minimised from the view of the whole portfolio, it’s also important to remember that gains from individual investments will also be diminished.

You can diversify across asset classes by purchasing bonds, real estate, commodities or currencies, or within equities themselves by selecting investments in different industries, sectors or countries.

Trust research, not the hype

It’s quite common for sentiment to drive prices in the short term. In the long run however, prices are usually dictated by the fundamental strength of the company, which can be determined through research.

If investors do due diligence on companies, they may be able to avoid purchasing shares of highly speculative companies that are trading at extremely high valuations.

So, the rule before you purchase a stock: know exactly what’s driving you to purchase it. Do your research such as - what the company does, its risks, its growth drivers and its earnings potential.