Digital Matters - Issue 34

"A few years from now, we'll look back on dotcom mania as a model of investment sanity and prudence."

On February 2, Amazon.com announced that it had lost a record 323 million in the fourth quarter of 1999. That night in the aftermarkets and well into the next trading day, shares of Amazon.com traded up as much as 33%, once again prompting the Internet question of questions: What's up with that?

The sharp rise in Amazon's stock price following the release of ugly financial results reinforced many people's belief that the markets have lost touch with reality. Publications such as Barron's and Fortune have been arguing for years that the Internet bubble is bound to burst. And with each "dotcom mania" anecdote, they bang the drum louder. But all the while, the markets and the Internet-technology indexes have continued their heady ascent. If you believed what you read in Barron's, you would have left 8,000 points of upward Dow movement on the table and missed the extraordinary run-up of the NASDAQ.

For a vast new group of investors, today's financial markets offer the opportunity to achieve unprecedented wealth. And taking advantage of that opportunity boils down to correctly answering a fairly simple question: Do you think that Yahoo! is worth four times what the Gannett Co. is worth? Gannett, an old-economy media conglomerate that publishes a bunch of regional newspapers as well as USA Today, operates those properties at high margins, has strong revenues and a very positive cash flow, enjoys tidy profits -- and, in late February, had a market capitalization of nearly $20 billion.

Yahoo!, a new-economy Web company, has decent revenues, a positive cash flow, good profits -- and (also in February) a market capitalization of more than $80 billion. On paper, Gannett is "worth" more than Yahoo! But the stock market isn't about paper; it's about the future. People who buy stock aren't betting on what has happened. They're betting on what they think will happen.

The smart money on Wall Street is betting that the future will look radically different from the present. Investors look at Gannett and see all of those journalists and all of those delivery trucks and all of those "giveaway" marketing programs and all of those classified ads migrating to the Web. They're betting that five years down the line, the combination of those factors will cap Gannett's growth. In the words of one media analyst, "It's a dead-tree business -- 'dead' being the operative word here."

These same people can hardly contain themselves when it comes to Yahoo! It's a credit-card business, it's an auction business, it's a content business, it's a shopping-service business, it's a bill-paying business: It's a galaxy of services and opportunities. And every month, more than 120 million people click their way through Yahoo! to do whatever it is that they're doing. Using a standard multiplier ($1,000 per customer), the Wall Street wizards have come up with a figure of $120 billion. Employing the same multiplier that AT&T used when purchasing MediaOne (roughly $5,000 per customer), that figure rises to $600 billion -- more than seven times the February selling price of the stock. To borrow the immortal phrase of America's favorite British action hero: "Yeah, baby!"

As crazy as the stock market sometimes seems, we're on the doorstep of another wealth-creation technology that will make today's market valuations and fluctuations seem rustic. A few years from now, we'll look back on dotcom mania as a model of investment sanity and prudence.

The global economy is entering the dawn of the genomics revolution. It is possible that by the time you read this, the entire human genome will have been sequenced by a company called Celera Genomics (whose parent company is PE Corp.). Once the human genome is sequenced, scientists all over the world will go to work on pairs of genes whose instruction sets lead to such physical ailments as heart disease, high blood pressure, stroke, or cancer. Once the source code of, say, cancer is understood, pharmaceutical and agriculture products can then be created to delay the onset of the disease or to erase its code altogether. What's the value of that?

The value of that is the value of your life. Celera Genomics hit the New York Stock Exchange as a tracking stock in May 1999. It went out at about 20, spiked, and then languished at 15 for a couple of months. At the end of February, it sold at a split-adjusted 200 a share. There are people on Wall Street -- serious traders -- who believe that it will eventually be worth $10,000 a share. Among those companies heavily invested in Celera Genomics are Janus Capital Corp., Putnam Investments, the Vanguard Group, and a dozen more of the nation's leading investment firms.

Look at the genomics revolution in the context of agriculture. About half of the European Union's budget, for example, is set aside for agriculture. The EU opposes genetically modified foods, in part because it has some concerns about the biosystem and in part because of constituency politics.

Assume for the moment that Celera Genomics or the publicly funded Human Genome Project completes the sequencing of the human genome sometime in 2000. And assume, for the sake of argument, that the sequencing leads to breakthrough discoveries in health care and pharmacology. (Wall Street already makes both of those assumptions.) Now imagine that genetically modified foods can be produced that not only provide consumers with basic nutrients but that also contain genetic instruction sets that suppress the onset of arthritis or the possibility of stroke -- products known in the genomics world as "agriceuticals," products that many agricultural experts believe are, at most, five years away from existence.

Now go back to Europe. If agriceuticals are in fact made available in the next five years, the EU will be left with a choice: Either it can continue using about half of its budget for harvesting great-tasting carrots and corn that contain all of the basic nutrients, or it can buy genetically modified carrots and corn that are equally tasty and nutritious -- and that also reduce the likelihood of stroke by, say, two-thirds. Which way will it go?

EU bureaucrats probably won't buy the genetically modified vegetables. But everyone else in the world will. As a result, European-grown carrots and corn will quickly become noncompetitive in the global marketplace. And, in turn, the EU will have to devote even more of its budget to agricultural subsidies, and its citizens will be forced to eat food products that have no added value.

As it happens, three big companies -- DuPont, Monsanto, and Novartis -- own roughly 66% of the world's genomic seed technology. It's likely that in seven years, the value of agriculture in its entirety will be housed inside those corporations. And the EU will be spending perhaps more than half of its budget on agricultural products that will no longer be competitive. If you manage $10 billion or $20 billion or $300 billion on Wall Street, you can't not bet on genomics-based agriculture, no matter what you think of DuPont or Monsanto or Novartis -- or how you feel about the welfare of EU citizens. And so it should be no surprise that all of the major investment firms are heavily loaded up on those very companies.

It is said, over and over again, that we live in a time of unprecedented change. That's an understatement. There are two great divides in modern life: the Internet divide and the genomics divide. If Wall Street believes that a company is on the "right" side of those divides, it awards that company a value at unprecedented multiples. Companies that Wall Street perceives as being on the "wrong" side of those divides can't catch a break.

Does betting on the "right" side of those divides constitute a speculative frenzy? Or does it reflect a reasonably sensible estimate of where future value will be found? The question is the answer. It isn't a mirage if you can touch it. Which is not to say that the financial markets are safe. There's still a certain level of danger involved -- but overvaluations and eventual company failures aren't what you have to worry about. In fact, those two prospects are, to some extent, inevitable -- and have been since the Industrial Revolution. The real danger in the financial markets today can be summed up in one word: leverage. The democratization of corporate finance has brought with it two unintended consequences: a huge derivatives market that hedges and covers bets, and an unprecedented lending and buying of financial instruments on margin.

In simple terms, here's what happens: Someone buys 1,000 shares of Microsoft stock, borrows $50,000 against that investment, buys 500 more shares of Microsoft stock, borrows $25,000 against that investment, buys another 250 shares of Microsoft stock, and borrows against that investment. All is well if the face value of Microsoft stock continues to rise. Our investor gets richer, borrows more to buy more stock, and gets richer still. But if the price of Microsoft stock starts to fall, and continues to fall, our investor is leveraged into disaster.

Leverage is the genuinely scary thing about the new economy on the new Wall Street. Practically every bet on the future value of financial instruments is doubled and tripled and quadrupled by derivative bets and margin buying. The slightest unanticipated development can send shock waves through the whole system.

Remember Long-Term Capital Management, the hedge fund that all but collapsed in 1998? A bunch of rich guys in Greenwich, Connecticut ended up losing their shirts. And because of the derivative fallout from those guys' losing their shirts, several of the world's largest investment firms -- including Bear Stearns, Goldman Sachs, and Merrill Lynch -- came within a button of losing their shirts. Only the intervention of Alan Greenspan and the Federal Reserve Board kept the United States from experiencing the financial equivalent of a grand mal seizure -- and taking the whole world down with it.

That's why Wall Street is so jittery about the new economy and why the fluctuations in the marketplace have become so dramatic. People who work on Wall Street understand that Internet technology will transform the global economy. They understand that genomics will fundamentally change entire categories of business. And they understand that the entire financial system is perched precariously on the tip of an iceberg of debt.

It's not the fundamentals that are problematic. Yahoo! is probably worth about 10 times as much as Gannett. And PE Corp.'s value is probably 50 times that of American Home Products Corp. The problem is leverage, which is why it seems likely that the Federal Reserve will continue to raise interest rates, one-quarter point at a time. Because that's the surest way to drive down margin debt without causing panic.

John Ellis (jellis@fastcompany.com) is a writer and consultant based in New York City.

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