Lessons from History's Technology Booms
You can read this article in Spanish here or Russian here.
Today, I will share part three of what has become a five-part summer letter to IMA clients. The letter is quite lengthy, so for easier reading, I have divided it into smaller parts that I will share over the next few weeks. In the previous two parts, I discussed the economy, the Magnificent 7 and the skew they are causing in the stock market. In this part, I will discuss lessons from past technological booms and busts.
In the remaining two parts, I will cover our investments in EV and AI, as well as the impact AI will have on the economy.
In these client letters, I am not selling anything; they are written to IMA clients, who have already bought into what we are doing. I don't like sanitizing my letters (rewriting them into articles), as I don't learn anything from doing it, so I am leaving them as I wrote them.
Lessons from History's Technology Booms
You can also listen to a professional narration of this article on iTunes & online.
AI has a feel of "this time is different." Optimism rarely erupts about the same technology twice; this is why history doesn't repeat but rhymes. The technology at the core of the mania is different every time. What doesn't change over time is human emotion – the fear of missing out and then the fear of loss, in that order.
Humans are an optimistic bunch. We need it; it's essential to our survival and progress; but eventually, we take our optimism too far. The graveyard of financial ruins is full of these stories.
I have beat the dotcoms and Nifty Fifties to death, so let’s go to back another century. My friend the brilliant Edward Chancellor wrote about the railroad boom and bust in England in the 1800s. Here he is, edited for brevity:
The first railway to use steam locomotives opened in 1825 and was designed to carry coal, not passengers. Railway promoters simply did not appreciate the potential demand for high-speed travel. The successful launch of the Liverpool and Manchester Railway in 1830, however, demonstrated the commercial viability of passenger travel. By the early 1840s, Britain’s railway network stretched to more than 2,000 miles. Railway companies were delivering acceptable, if not spectacular, returns for investors.
Then railway fever suddenly gripped the nation. Enthusiasts touted rail transport not just for its economic benefits, but for its benign effects on human civilization. One journal envisaged a day when the “whole world will have become one great family speaking one language, governed in unity by like laws, and adoring one God.” In the two years after 1843, the index of rail stocks doubled.
Investment peaked at around 7% of Britain’s national income. Railway enthusiasts predicted that rail would soon replace all the country’s roads and that “horse and foot transit shall be nearly extinct.”
In 1845, Britain’s railways carried nearly 34 million passengers. If the 8,000 miles of newly authorized railways were to deliver their expected 10% return, then the industry’s total revenue and passenger traffic would have to climb fivefold or more – all within the space of just five years. “This should have alarmed observers by itself… But they were deluded by the collective psychology of the Mania”, writes Odlyzko.
In 1847 a severe financial crisis broke out, induced in part by the diversion of large amounts of capital into unprofitable railway schemes. It turned out that the revenue projections provided by so-called “traffic takers” were wildly overoptimistic. Railway engineers underestimated costs. The vogue for constructing direct lines between large urban centers proved mistaken, as most traffic turned out to be local. As a result, Britain’s rail network was plagued with overcapacity. By the end of the decade, the index of railway stocks was down 65% from its 1845 peak.
The railroad bubble in England is just one example; there are hundreds of similar stories across market history. They all share this theme:
A new technology appears on the horizon. In the early stages, investment is rational, but then at some point excitement, imagination, and optimism take over, leading to overinvestment (usually creating a financial bubble). Investors make a lot of money until most lose it all. When the dust settles, only a few companies survive.
This AI boom reminds me of the telecom sector in the 1990s. The internet was going to change the world, and it did, but first we had tremendous overcapacity in global fiber and telecom equipment.
One could say that telecommunications companies overestimated demand for broadband and underestimated changes in technology, and that would be true. But there was a more nuanced dynamic at play, what economists call the fallacy of composition: What's true for one participant isn't necessarily true for the group.
Here's a quick example: If you're at a football game and you stand up, you'll see better. But if everyone stands up, nobody sees any better. In the telecom industry, optimism led to collective action by hundreds of participants who poured hundreds of billions of dollars into fiber and infrastructure investment, ultimately killing the economics of the business.
What made this situation even more complex was the institutional imperative. It would have been difficult for the CEOs of these companies to opt out of making these investments and still keep their jobs. Shareholders would have likely revolted and fired them.
New technological advancements are built on the backs of optimistic equity investors (your neighbor) and piles of debt. Billions of dollars of malinvestment, hundreds of billions in market value wipeout, a few large bankruptcies, and we ended up with an incredible global telecommunications network. These companies are mostly forgotten and not there to remind us of their short-lived glory. Most investors today don't remember magnificent companies in the telecommunications space that were going to change the world and had to be owned at any price: Nortel, JDS Uniphase, Ciena, Level 3 Communications, Qwest Communications – the list is long.
Something similar is happening in AI investments today. Look at the spending and the scale at which each company is investing in AI – they believe they cannot not make these investments. The total bill will be in the hundreds of billions.
Unlike telecom companies of the 1990s, the Magnificent 7 have highly cash-flow-generative businesses, so I'm not predicting they'll go bankrupt. But it's very likely that they have collectively overinvested in AI, and the returns on this investment will be very disappointing.
Also, though it's hard to imagine today, it's very likely that five to ten years from now, their magnificence will have faded. Ego, new competition, almost unavoidable malinvestment, and poor stock performance and thus diminished employee morale are usually responsible for that. There will be new, no less magnificent companies, and new bubbles. And hopefully this marathon runner will still be writing about why he doesn't run sprints.
In the meantime, we're going to play games we think we understand and can win in the long term (though we can't make any promises). Our goal isn't to bring "excitement" to your portfolio, and what we own is going to make for a boring conversation with your neighbor who has a hot hand right now.
Hopefully, this boredom will pay off. Your neighbor, after losing a good chunk of his net worth, will hire someone like us to manage his shrunken and less magnificent nest egg and will probably be embarrassed to talk to you about his portfolio and instead switch to sports and politics.
I have a very selfish interest in being rational and process-driven – my family's entire liquid net worth is invested right alongside yours. I don't have any other outside investments. I'm in the same boat as you, eating the same soup I'm serving you.
Being thoughtful, rational, and process-driven is just another day at IMA – it's in our DNA. We don't play the games that are exciting and even rewarding in the short term but are destined to fail when the dust settles.
On a personal note, I have to thank Michael Conn, IMA's cofounder, for building a foundational layer of IMA DNA and the impact he had on me. Mike is definitely a visionary. He hired me on August 31, 1997, when I had been in the US for only six years. This was years before I received a graduate degree in finance and my CFA, before I taught investments at university, before I wrote books. My English was horrible, and I was in my last semester completing my undergraduate degree in finance at CU Denver. He saw more in me than I saw in myself.
The US stock market was in the very early stages of the dotcom bubble, and the next three years were treacherous. I remember countless meetings with clients who were upset with Mike for not playing the game of dotcoms and tech stocks that everyone "had to own". The IMA portfolio was doing fine, but it lacked the excitement and high-octane returns that the new world had offered. Mike patiently explained that we owned a lot of high-quality, undervalued companies. Though he didn't know when this mania would end, he knew that it would, bringing a lot of tears to those who had been uncorking champagne.
Some clients appreciated his insights, some did not and cancelled their accounts and found managers who would "perform." Mike was unfazed by cancellations and stuck to what made sense. He was willing to lose clients but not their money; he had soul in the game.
There's a quote often attributed to Albert Einstein: "Insanity is doing the same thing over and over again and expecting different results." As an investor, especially if you manage someone else's capital, you have to be slightly insane. During market manias, time slows down to dog years. You have to keep doing the same (rational) thing but expect a different outcome, knowing that at some point it will come.
Watching Mike being unafraid of being rational – contrarian, if you like – when the world was going bananas over the latest craze, instilled this contrarian gene in me.
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I'd love to hear your thoughts, so please leave your comment and feedback here. Also, if you missed my previous article "The Magnificent 7 And The Dangers Of Market Hype", you can view it and leave a comment here.
Below is my latest Youtube video:
Bruch – Violin Concerto No. 1
Today I wanted to share with you “Violin Concerto No. 1” by the German composer Max Bruch. It is one of my favorite violin concertos. It starts out a bit slowly, but in a few short minutes it turns into a brilliant masterpiece. Here is the who’s who of the violin world performing this concerto..
Vitaliy Katsenelson is the CEO at IMA, a value investing firm in Denver. He has written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Soul in the Game: The Art of a Meaningful Life (Harriman House, 2022) is his first non-investing book. You can get unpublished bonus chapters by forwarding your purchase receipt to bonus@soulinthegame.net.
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A well-written discussion of how we can overestimate technology in the short-term but underestimate it in the long term. It is always nice to hear your classical music pick 🙏🏻