The dot-com bubble is a warning from the past

Tony Yarrow reflects on working as a fund manager during the dot-com bubble, and sees parallels in the mindset of investors then, and now.

At the start of the 1990s, there were just two TMT (technology, media and telecoms) companies in the FTSE 100 index - BT and Vodafone. By the end of the decade, there were more than 20, including the likes of the soon-to-be-forgotten Telewest, and former minnow, Kingston Communications, the Kingston-on-Hull telecom provider, which never again reached a fraction of its QI 2000 value.

By 2000, the technology sector had outperformed the overall market on both sides of the Atlantic for 15 consecutive years. What could possibly go wrong?

The frenzy began when people began to realise - correctly - that the internet was going to change the way we all live. There was a desperate sense of urgency in the air – it was important to get established before the competition arrived. Glamorous internet clothes retailer boo.com, famous for its virtual model Miss Boo, set out to corner the market. Unfortunately, boo’s platform never worked properly, and the company went under as investors refused to stump up more cash. Other retailers included clickmango.com and lastminute.com, which became one of the few survivors.

For me as a value investor, 1999 up to March 2000 was the most difficult period of my career to date. In those days, investors were more concerned with returns than with risk. Everyone knew that returns came from tech, and particularly the internet, everyone wanted tech, and we didn’t own it. Anything as dull as a bus company, a brewer or a housebuilder that wasn’t an obvious beneficiary from the internet, was “old economy” and to be avoided. We bought these stocks as they got cheaper, and cheaper - and cheaper. Our fund performance was consistently bottom decile in that period.

Blue skies darken

It wasn’t just pure tech funds that did well at the time. You could tell from their performance that most growth funds were full of tech names, and the majority of smaller company funds were, too. One day in late January 2000, I went to a presentation given by a particularly exuberant UK smaller companies fund manager who was extolling the virtues of the internet stocks in his portfolio that had given investors a 250% return in the past year.

I managed to catch up with him afterwards and asked whether he could see any value in housebuilders, which were then trading on average PE ratios of 4x. “No, they’re old economy,” he replied with a smirk. That evening, my partner for a men’s doubles tennis match arrived late. As I waited, I listened as one of the pair from the other team (Brackley A) told his partner how he’d bought a certain internet stock on the previous Friday morning and it had already (by Monday evening) appreciated by 40%. I wondered how much longer this could go on.

The answer was about five weeks. The first sign of trouble came in early March when the tech sector fell by around 10% in two days. It then recovered over the summer, until the true collapse began in early September. 

Interestingly, the unloved “old economy” sectors began a quiet recovery at the end of January, before the end of the bubble in TMT, a pattern I have noticed on several occasions since.

After that, the value sectors enjoyed a sustained period of outperformance, comfortably beating the overall market for the following seven years in a row. Our worst period for relative performance was followed by our best, another pattern that tends to recur.

History repeating?

I also noticed how badly index-tracking funds did at the time. Having failed to capture the gains in the early stages of the bubble, when only two stocks were big enough to qualify for the trackers, the funds were fully weighted in TMT at the height of the bubble and suffered proportionately. I concluded that index-tracking is fundamentally a momentum strategy that does well in trending markets, but badly at major turning points.

A couple of years after the bust, I got talking to a woman over supper in a ski chalet who’d been working for Cisco Systems at the height of the boom. The company had given its employees share options. She told me that she’d been a millionaire – for just two weeks.

TMT was the outstanding bubble of the last 50 years, a time when prices lost all contact with reality – but very few people saw it at the time. Is there a parallel with today? Has QE created an asset bubble, or could we be in the early stages of a bubble? 

What hasn’t changed in 20 years are investors’ mindsets. We all think that bubbles happen at other times, and to other people. Our shares may look expensive, but they are the best companies in the market and will always be in demand. Our bonds may look expensive, but they are the risk-free asset, and can’t default. Our clean energy assets are the future and give us a long-term inflation-proofed income stream. In any case, the assets we own are liquid and we’ll get out long before the trouble starts. Bubbles grow quietly while we content ourselves with such comforting thoughts.

Tony Yarrow is fund manager at Wise Funds.