A good article on Virtual economy

by SandSpringRes

14 February 2000 15:54 UTC

Virtual Reality The new economy works the same old way

By Thomas G. Donlan

Is the Internet economy virtual, or real? This is getting to be a really big question. Internet.com's Internet Stock List of publicly traded firms that receive more than half their revenues because of the Internet counts about 270 firms, with total market capitalization in excess of $1.5 trillion. Those in the list that were public three years earlier had a combined market cap of $50 billion.

If by virtual we mean that the business is illusory, in the sense that images seen in virtual reality goggles aren't really there when you reach out to touch them, then the dot.com companies are as real as their brick and mortar competitors. They are selling products and services; they have revenues, cost of goods sold, SG&A expenses, and all that. At the end of the day they even have a bottom line, even if the numbers are in red ink.

If by virtual we mean that the companies' pursuit of profit is illusory, or their stock-market valuations will not be there when we reach out to cash in, we must be more careful. Much more careful.

How do these companies fit into the economy? Look at their names. There are a lot of companies with .com at the end of their names, or with e-hyphen at the front, but the most striking thing is that the rest of their names are things we already know about. There's trade and auction and grocer and toy and what-have-you? These new outlets are all in the same old economy trading the same old goods and ervices, just in a new way.

Valuation Madness

One explanation for the pricing of Internet stocks is the classic analogy from the classic value investor, Benjamin Graham. He said the market is like a manic-depressive. Sometimes Mr. Market believes anything good he hears about a stock or a class of stocks and he buys anything he can get his hands on. Of course, sometimes he is so morose that he just wants to sell, sell, sell.

The idea that markets are mad gives rise to the conclusion that Internet stocks defy any rules of valuation.

But markets need not be mad. John Hand, a business professor at the University of North Carolina, commented in a recent paper that, as Polonius said, "If this be madness, yet there's method in it."

The method may lie in the limits of accounting. Accounting rules consider advertising and marketing as expenses; Hand theorizes that investors in Internet stocks are valuing advertising and marketing as investment assets. Large R&D costs of Internet companies are also priced by the market as if they were investments in intangible assets.

As often happens when investors' theories outpace the rules of accountants, Internet stock prices are responding to the new theories. They go up when losses increase because the losses spring from increased spending on advertising, promotion and R&D.

Managers of brick-and-mortar-and-machine companies are also responding to the new theories. It says a lot about the reality of dot.com businesses when old-fashioned businesses feel compelled to have their own Websites, even at the cost of cannibalizing sales in the stores.

But it also says a lot about the unreality of the stock market theories. Companies are not just creating Web presences to compete, they are whipping up new securities to sell in the markets as spinoffs and tracking stocks.

General Motors, which gave birth to the first tracking stock -- for its acquisition of EDS back in the mid-1980s -- recently demonstrated how lucrative it can be to have securities for such a business.

As an automobile company owning Hughes Aerospace and its DirecTV satellite broadcasting business, GM still would have been a doggy car company with a TV tail in the minds of most investors. But since Hughes was covered with a tracking stock, investors could buy the tail, rather than the dog.

Recently, of course, the tail has been wagging the dog: GMH tracking stock has a higher value in the market than General Motors' common stock.

The discrepancy in value is virtual, rather than real. Creation of a tracking stock is much more like a stock split than a spinoff. Investors are ignoring the fact that both GM stock and GMH stock are shares of the whole of GM; the owners of GMH have no special claim to ownership of equity in DirecTV or any other part of Hughes. Although bookkeeping is separate, management is the same, and no matter how many shares of GMH stock the company issues, it continues to own 100% of Hughes.

Exploiting the high price of GMH, the company recently said it will contribute $7 billion worth of GMH shares to its pension fund -- an abuse it also pioneered with GME stock -- and exchange some GMH stock for some GM stock at current market prices.

All Too Cheap

If playing games like these will bump the stock-market valuation of a company by a factor of two or three, that's a powerful incentive to abandon the patterns of the past. If it's raining cheap capital over there at the dot.com trading post, expect to see managers of apital-intensive businesses running up with buckets.

Nothing is more attractive than cheap capital, but we should always ask if cheap capital is really good for the companies in which we invest.

Look, for example, at the Japanese experience in the 'Eighties and 'Nineties. A high domestic savings rate and high profits in export industries drove interest rates down to rock-bottom and equity prices way up. Japanese companies borrowed enthusiastically to invest in real estate and in plant and equipment. At the turn of the decade, though, the party came to an end. It turned out that much of the new buildings and plants and equipment were superfluous, so investments in these assets were unproductive. It has taken Japanese industry and finance 10 years to work off the over investment in office buildings, chip factories and other things that had seemed like great opportunities.

Other examples of the pernicious effects of cheap capital can be found closer to home. Remember the Texas real-estate boom? Savings and loans had unlimited access to cheap capital. After they had made too many investments, they discovered that the capital was gone and could not be replenished.

Not too many years ago, any idea in biotechnology was worth a bundle of startup capital, and every idea got its own company. The result, unfortunately, was to cast each idea adrift in a shallow boat of cheap capital, without regard for the time it might take to test the idea and bring a product to market. Too many ideas sank.

Wages of Competition

Now the U.S. is going through one of those easy-money phases again, and the consequences are likely to be all too familiar.

After all, the realest thing about e-commerce is the competition. If, as the headline in USA Today had it, "e-commerce saves business billions" in the cost of buying supplies, parts, raw materials and services, then it's probably also true that e-commerce is costing businesses billions in lower revenues and profits when they sell supplies, parts, raw materials and services.

If the great thing about e-commerce is that it makes markets more efficient, there's one thing we know about efficient markets. They squeeze out economic rents and extraordinary profits. Pick your favorite industry, hard or soft, old or new, and the thing that makes the best company in that industry a better investment is that is does something better or cheaper than the competition so it can either charge more or make more profit at the same price. At the speed of e-commerce, innovations are rapidly diffused through whole industries, and it's much harder to get an edge and keep it.

Look at the changes in the Internet economy itself over the past 10 years. A decade ago, it was a bold new stroke to be an Internet Service provider; suddenly the market was full of ISPs.

Now plain-vanilla ISP is free, and employers like Ford and Delta Airlines are offering Internet service as an employee benefit. The eBay auction was a great idea; now there are so many auction sites that the new great idea is a Website that searches auction sites for the best price.

Oh yes, the Internet economy is real. It's the same old economy, but faster and cheaper. The dot.com economy will spread competition over the whole world. If that's what we wish for, we must also remember that it's sometimes dangerous to get your wish. A global marketplace of, by and for the Internet could turn out to be too real for our own good.

-- Spoonfed (spoonfed@spoonfeddd.xcom), February 14, 2000