What Didn't Work During The Tech Bubble

Tech bubble carnage was not limited to internet stocks — In bubbles, even diversified investors are exposed — All investors must re-assess the risks in their portfolios.

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WHAT DIDN’T WORK DURING THE TECH BUBBLE

Tech Bubble carnage was not limited to internet stocks. The lasting fame of the bubble is partially due to the losses experienced by conservative, diversified investors. When looking back, we focus on internet stocks, but this narrow view of the turmoil belies the struggles experienced by all investors during the period.

While internet stocks were valued at lofty multiples, boring, well-run businesses in other sectors also saw their valuations rise. Investor optimism is often contagious and the bullishness of the bubble was no exception.

This phenomenon resulted in losses for nearly all investors, whether or not they participated in the internet mania. A combination of the September 11th attacks on the US, US energy industry deregulation, and the discovery of multiple unethical business operations (including Enron and WorldCom) conspired to sink not only the NASDAQ but broader markets as well.

So, where did rational investors, who avoided many of the internet names of the day, go wrong?

Unprofitable Stocks

During the Tech Bubble, many IPOs operated cash-burning business models. At the height of the bubble, over 80% of IPOs were losing money.¹ These IPOs found their way into indexes held by conservative, diversified investors.

In normal markets these businesses are able to raise debt or issue more equity to fund their operations. In a market crisis, though, a lack of profit brings substantial risk.

Fama and French found that nearly 40% of IPOs from 1980-1991 were delisted within 10 years.² For internet-focused, cash-burning IPOs in the late 1990s this failure rate must have been far higher.

Many of the headline-grabbing losses from the Tech Bubble shared this fate. Pets.com IPOd at $11 in February of 2000 and delisted less than 12 months later, after its share price dropped 98%.

Today, nearly 40% of the constituents in the Russell 2000 are unprofitable. Russell 2000 investors, who believe they hold diversified exposure to small US businesses, may be in for a surprise in the next period of turmoil.

The Safest Investments

Utilities are the most boring of listed equities. In the US, this sector offers many unique attributes, all contributing to the safety and reliability of (generally dull) investor returns.

Economic returns for utilities are capped by government regulation. The businesses are capital intensive, frequently raising equity to drive growth via new infrastructure investments. Dividends are generous given the non-cyclical end market demand and stable cash flows of the industry. These dynamics combine to create one of the most stable investment environments possible.

Yet utility investors were scorched during the investment bubble. From 1998—2002, investors in AES Corporation and PG&E (yes, the same PG&E struggling with recent California wildfires) lost 87% and 51% of their capital, respectively. Notably, both businesses underperformed the NASDAQ 100 during this period.

While headlines focused on internet mania, factors such as energy deregulation, volatile energy pricing, international expansion, and currency fluctuations were catastrophic for even the most stable investments.

Today, the S&P 500 Utility Sector trades at over 20x earnings as energy demand is expected to grow significantly to support AI investments.

 Quality Compounders

Even Warren Buffett couldn’t completely avoid the tech bubble.³ From 1998—2002, The Walt Disney Company fell 43% and Coca-Cola dropped 30%, both large Berkshire holdings.

Many quality compounders, businesses that investors thought offered protection in all markets, suffered. McDonald’s plummeted 56%, JP Morgan Chase dropped 43%, and Microsoft fell 25%.

For incredibly long-term investors these stocks have recovered, but it is a good reminder that even growing businesses with high returns on capital can trade at prices that fail to deliver investor returns.

Today, it seems we’ve forgotten with Costco, Eli Lilly, and Walmart trading at 54x, 46x, and 45x 2025 adjusted earnings estimates.

The Depressing Nature of Bursting Bubbles

For individuals contributing to their 401(k)s in 1998 or saving excess earnings, what were the available options?

They avoided tech names and IPOs in favor of diversified indexes. They skipped utilities that, in retrospect, offered the risk of equities and the returns of bonds. They followed Warren Buffett’s advice to buy and hold high-quality businesses. And they saw their capital decline for 4 years straight.

Market bubbles are infamous because of the losses experienced by those who did not participate in the mania but still experienced gut-wrenching losses for years afterwards.

Navigating Bubbly Waters

When markets are excited about new technology, this optimism tends to seep into valuations across all sectors and geographies. This is justified as the “picks and shovels” to support the mania generally come from non-technology sectors. In this scenario, valuations are reflexively driven higher in a vicious cycle.

Bursting investment bubbles impact far more than the frothy sectors that capture media headlines. An unfortunate side effect of bubbles is the impact they have on prudent, conservative investors.

 ¹ CNBC 

² Eugene Fama & Kenneth French 

³ Although Buffett  made a masterful move in 1998 to diversify out of equities with his acquisition of General Re. I recommend Chris Bloomstran’s writing on the topic to understand why this acquisition, paid for with cash and (at the time) expensive Berkshire shares, was such a brilliant strategic decision.