I wanted to write this article for a long time, but the dogfight between Dan Gillmor and Chris Dixon triggered it.
I spent my first years as a grad student wondering how bubbles were even possible: there were rumours about it in 2000, but agents were considered rationals — and there certainly were, after listening to so many classes on economics (financial maths, really) like I did. That summer, I worked as an intern for one of the most advanced portfolio managers at the time on ‘cushion-guaranteed funds’ and the reality stroke me: those funds had the most dangerous mix I coudl thing of: they worked based on an idea that was fairly technical, very simple to explain, and wrong. Alas, wrong for the reasons that seemed obvious to me but needed to think in many dimensions.
Two years later, I would finally have a proper class on economics (courtesy of Pr. Boyer & Orléan, notorious non-neoclassical figures, a crime at the time). Their course featured bubbles preeminently: their definition was simple, there can and will be bubbles if
- some economic agents know the value of something, and
- others don’t (know) but still buy it.
The later ones aren’t necessarily stupid; it could be because figuring out the value is expensive, and they make the bet that the first ones were honest. Note that there is no disparity in valuation yet: it’s simply at this stage, about ownership and knowledge. However, it rarely lasts long; either mischievous behaviour from people who look like they know, or cargo cult from those who don’t, either could lead to absurd valuations of stocks that aren’t worth it.
Let me repeat that: bubbles go through three distinctive steps
- new economic model (agile or scrum, SoLoMo, what have you) that isn’t trivial;
- public acceptance of the (often legitimate) high valuations associated with those;
- excessive extension of those valuations to other assets.
Note that in 2001 the most egregious of valuations, Google, was a fraction of what it proved to be worth: most ratios that investors would look at remained within what VCs deemed acceptable for certain companies. However, the management at Pets.com was not the same as Google’s and… Well, you get my point: a bubble starts when non-specialised investors get in the picture, ie. step 2. but it only does damages when step 3 is revealed.
So, back to the Gillmor vs. Dixon — and more generally to Is there a tech bubble? and Should we trust well-known investors about it?
Are investors who know little about tech considering to pour large amounts on, say, Facebook? Well, it’s hard to call Yuri Milner or Goldman-Sachs uninformed, but the IPO should offer a resounding Yes. It doesn’t mean that Facebook valuation is above what it should be: the company will grow and have a major economic impact (that may or may not translate into profits and longevity). Therefore, there isn’t an over-estimation yet; I would actually advise anyone who can spare the cash to buy a share in Facebook, if only to make history. However everything is in place for a bubble: weird valuation formulas and a public hungry to put their first savings from the recovery somewhere shiny.
Well, there isn’t an over-estimation, if you conveniently exclude Groupon. And maybe Zynga. But no one mentions those. And Christ Dixon says there isn’t a bubble… So what gives? Because Chris doesn’t know anyone who ignores proper valuation rules: if he knows them, they know him and therefore, they can get proper investment advice from the horse’s mouth — and knowing Chris, he doesn’t save his enthusiasm and effort to preach for the right companies to invest in. Therefore, no, neither him nor most pundits have seen any significant over-estimations, the last stage of a bubble: not in private because they talked those away long before they happened, and not in public either, because we are not there yet, and we won’t be for a while: many valuable and deserving companies will need money before the made-up ones appear and raise the roof. And those fakesters won’t have access to the inner circle. Once again: look at Groupon’s current investors’ list.
Is Chris, or any well-known Angel, sincere when they deny the bubble? Yes, more than you would know, therefore calling him biased and suggesting that this is because he is financially invested is probably in poor taste: among many reasons, including that
- if he sold out (which he won’t) he would have more money than he can spend, so why try to have more?; and
- he won’t sell because his money is to invest; suggesting he did so unwisely is actually fairly insulting to his identity as an entrepreneur and an Angel. It’s his life and legacy, and that bias is much stronger. And he should be praised for it, not called on it.
He is smart, deeply invested in the Valley business so he won’t see anything wrong until it’s too late. Don’t ask him about bubble, but do ask him about good companies to invest in, and spread that word, preferably with detailed explanations, and financial targets to avoid excessive spin.
Who should you ask, if you are a journalist covering a possible bubble?
Anyone with a little money on the side, who doesn’t know much about tech. Ask if they are considering to buy some Facebook stock, or Groupon, or maybe if they’d be interested in Twitter if it ever opens its stock — and ask about share structure, possible strategic options to increase revenue or profit, the evolution of the cost structure, value creation and retention, competitive advantages, response to threats. Compare that to answers from people who consider investing in more common stocks, like car manufacturers, insurance, distribution or real estate. You may have reassuring responses: Facebook and twitter are extensively covered; you may have scary one: those business are very unusual and presumably obey natural contestable monopolies that make them worthwhile but riskier investments than most would think.
The best coverage might actually not be the usual interview summary, but a multiple-choice questionnaire: test a reader’s knowledge of the industry, and, to someone who failed, explain that those were only a few among the many questions that they need to figure out before putting their money anywhere. Make sure more non-specialised financial analysts would fail those, because surprisingly enough after fifteen years since Netscape’s first floated, tech is still an odd sector with spectacular value discrepancies.
I’ve heard of this a new way to assess possible new hires: don’t ask for recommendations, but write to wonder if their are exceptionnal. Unless you get a “He’s looking for a job?!” don’t bother. Maybe suggest to potential investors to extend to buying stock using the same filter: ask if the company is exceptional, and don’t bother if you don’t get an over-enthusiastic response. You might get punked (just like you might hire a complete tool away from someone who lied) but knowing the hacker’s ethic ruling in the Silicon Valley, I doubt it.