"Engines That Move Markets"

A book review

Not new a book (it was originally released in 2001, this is the second edition updated in 2018), but definitely worth a read: a comprehensive history of market-shaping, revolutionary industries and how their development impacted investors.

“This book has much wisdom, and much that could be learned by investors or companies planning to back new technologies.” (Financial Times)

The author (Alasdair “Sandy” Nairn) was at the time of the first edition the Director of Global Equity Research at Templeton Investment Management and would then become CIO of Scottish Widows investment Partnership before founding Edinburgh Partners, an independent fund management company acquired by Franklin Templeton in 2018 (to close the circle of his career).

The book originated indeed within Templeton as an in-depth study of the impact that the great technological inventions of the past 200 years – from the railways to Internet – have had on financial markets and investors fortunes. It started just as the great stock market bubble of 1999-2000 was coming to a head, and tried to answer a simple (but not easy!) question: “How and why can new technologies create such apparently irrational stock market bubbles?”

With hindsight, we can see clearly how the TMT bubble of the late 1990s developed into one of the greatest of all stock market manias, just as many expected at the time. However, as it is usually the case, living through a bubble simply defies all notions of common sense or professional expertise.

The ten historical episodes covered in the book are:

1. The railway boom in Britain from the 1840s onwards

2. The early railroad industry in the US

3. The development of the automobile industry

4. The story of the discovery of electric light and its commercial exploitation

5. The discovery and early development of crude oil

6. The emergence of the telegraph business

7. The early history of wireless, radio and TV

8. Semiconductors and the growth of the computer business

9. The PC battles of the 1980s and 1990s

10. The internet and the dot.com bubble

Most of these episodes tended to be associated with just one or two successful companies: Western Union in the telegraph business; GE in lighting; Ford and GM in the automobile industry; IBM in computers; Microsoft in the software business. Yet the eventual success of these companies was far from a foregone conclusion: for every company that built an enduring market position, there were hundreds of others who tried to do the same thing, and failed.

A must-read for anyone investing in the tech sector (AI first and foremost, but also cleantech, …).

“You have to know the past to understand the present” (Carl Sagan)

Jumping right to the end, these are the main guidelines and lessons that the author takes from the analysis of past historical examples.

1. Many big breakthroughs in new technology are derided when they first appear

Without needing to resort to Nobel-prize winning economist Paul Krugman’s prognostication (“By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s”, he asserted in 1998), far from being seen as potential transformers of economic or social life, many of the biggest breakthroughs in technology have been initially greeted with hostility or condescension, even by experts who should have known better. The reason for this is that new technology by its nature threatens the existing order of things and in doing so creates a conservative reaction from incumbents.

The telephone

“Well-informed people know it is impossible to transmit the voice over wires and were that it were possible to do so, the thing would be of no practical value.” (Editorial in the Boston Post, 1865)

The automobile

“The ordinary horseless carriage is at present a luxury for the wealthy; and although its price will probably fall in the future, it will never, of course, come into as common use as the bicycle” (The Literary Digest, 14 October 1899)

2. As a result, many pioneers of new technologies have to struggle in order to win initial acceptance

Thomas Edison spent years battling to convince a sceptical world of the merits of his incandescent lamp. Guglielmo Marconi had to do the same with his early work on wireless technology. In these and other cases, without favourable economic conditions, the pioneers of new technology have often needed to display huge amounts of fortitude and stubbornness in order to prevail. This phenomenon has not entirely changed, despite the ready availability of venture capital and other funding sources. It is only in exceptional conditions that shortage of capital and scepticism suddenly cease to be an issue for technology pioneers. These periods are the exception rather than the norm.

3. The inventors and pioneers of new technology are not always the best guide to what is going to happen

Despite their persistence and stubbornness, many inventors and pioneers of new technologies fail to grasp the true significance of what they have found; and even when they do grasp it, are not always able to cash in on it, usually because of financial pressures. When radio first appeared, it was widely assumed that its main use would be for interpersonal communication, competing with the telephone, whereas in fact its real growth was to come through the development of broadcasting. Many Internet companies made a similar mistake, believing that the principal market was in B2C applications of physical products.

History records many examples of those who have been forced to sell the rights to their inventions at what subsequently proves to have been giveaway prices.

4. New technology and overpromotion have always gone hand in hand

Scepticism and shortage of funds demand industry pioneers sound confident at all times if they are to have any chance of finding the risk capital that they require. Overegging the potential of new breakthroughs is part and parcel of the territory of developing new technology. When an overpromoted concept reaches the stock market, this can easily translate into a bubble if market and liquidity conditions are receptive. This is what happened with Internet stocks, just as it happened earlier with railway companies (the 1840s), radio shares (the 1920s) and electronics companies (the 1960s).

5. Winning the technology battle is no guarantee of commercial success. Nor does the best technology always win

In many cases, once a new technology has been demonstrated to work, it is followed by fierce competition from scores of rival producers to bring it into commercial production and viability. This inevitably lessens the possibility that investors can pick the eventual winners; and lessens also the scale of the returns that they stand to make even if they do successfully pick out the best technology. The winners of these competitive struggles are not always those who have the best technology, but those who can most clearly see the way that an industry or market is likely to develop. It is not clear whether Amazon necessarily had the best technology, but it is hard to argue that it did not have the vision.

A company that has the capability to implement the right market strategy can overcome the disadvantage of having technology which is not necessarily superior. Microsoft is perhaps the best-known modern example, but there are others. Microsoft has consistently been managed against a vision of the future that has proven largely accurate, but it has also been swift to react when its original thinking was proved wrong.

6. Insiders usually make the best returns from new technologies

Many new technologies in the past have made plenty of money for insiders, but outside investors have fared less well. In part this may just be an issue of timing and the investment cycle. Sometimes it has been the result of false and misleading accounting, sometimes the result of a lack of equity in the treatment of different classes of investor, and sometimes simply the outcome of outright fraud of one kind or another. This phenomenon recurs time and again in past periods, though fraud and misleading accounting were inevitably more common in the early years, before legislation and effective regulators emerged to provide greater protection to investors.

During any period when investors are willing to suspend rational valuation measures in order to chase short-term speculative gains, there will always be manipulation. Investors willing to suspend reality have always been simply too attractive a proposition for unscrupulous operators. The early railway companies, for example, all competed for investors’ capital by promising and paying high rates of dividend. As these dividends could not be covered by internally generated cash flow, the companies could only pay them by taking on large amounts of debt or by paying them out of capital. When this game was exposed, share prices in railway companies collapsed, never to recover.

7. Bubbles in financial markets require more than just a new technology

Other necessary factors for a bubble include easy monetary conditions (typically low interest rates), a previous period of relative prosperity and calm, the emergence of an extensive and uncritical trade press, and a general climate of optimism and overconfidence. The timing of the bubble has more to do with external conditions than the current state of development of the technology that is ostensibly the subject of the bubble. Ironically, one of the clearest lessons to emerge from history is that in almost every case the quality press warned about the dangers of the market bubble emerging at the time. These warnings were usually ignored.

8. The only surefire way to make money from new technologies over any extended period of time is through monopoly protection

Even with the most successful inventions, commercial success may be short-lived. Unless the companies involved have patent protection for their products, or are shielded from competition by powerful barriers to entry of another kind (such as a sustainably superior cost curve), the degree of effective competition is probably the single most critical factor in determining how profitable investment in new technologies is going to be. Above-average returns are often simply competed away.

9. All new technologies veer from capital starvation to capital surplus and back again

In virtually every industry that has experienced rapid or far-reaching technological change, periods of boom and abundant capital have invariably been followed by phases of retrenchment, industry consolidation and recapitalisation. These are usually much better times for investors to buy into a new technology than at the time when it is most in demand, as prices are invariably much lower and it is possible to invest on more favourable terms. By the same token, periods of capital surplus are the ones when the worst excesses tend to occur. The high prices that can be commanded for risky businesses, and the presence of widespread media attention, are magnets that eventually lead to an oversupply of the commodity for which investors are clamouring. Eventually the pendulum will swing in the opposite direction and access to capital will again become more difficult.

10. Understanding technology is a vital component of generating superior returns – but investing in early-stage technology companies is a losers’ game

It is worth emphasising that most new technology companies are fated to be losers. It is a high-risk game, in which many are called but few are chosen. New company formation in the technology area is characterised by a high mortality rate and fluctuating market leadership. Successful companies do eventually emerge, but they are rarely the ones that appeared successful in the first flush. Often they are companies that failed in earlier incarnations and have been recapitalised to try again. Recessions act as very powerful filters in this process. Investors need to own the companies that successfully deploy new technology and avoid those that do not.

11. Investing in new technologies is a high-risk business

What all these factors underline is that there is – and should be – a substantial risk premium attached to long-term equity investments in most new technology companies. The irony, of course, is that these risk premiums tend to fall, and are frequently eliminated completely, at times of fervent market speculation. In such cases, many companies reach the stock market that would not normally be able to do so.

There are many groups and individuals who make money out of technology booms both before and after companies reach the stock market. Those on the supply side, including the issuers and traders of shares, generally generate the more immediate and more certain returns. There is nothing wrong with seeking speculative gains, provided investors are comfortable with the real risks they are taking. The mistake is to believe that such gains can be anything but transitory for most participants.

Those without specialist knowledge of what they are buying need to display particular caution at such times. Investing in new technology demands a thorough understanding of the impact it will have, and also the patience to watch events unfold and pick the correct time to invest. This will be when the risk/reward profile is at its most attractive, not when everyone else is clamouring to buy the same things.

In aggregate, the evidence clearly shows that it is the application of technology – what you do with it, not how wonderful it may or may not be – that is vital. This typically takes time to emerge. History suggests that leadership rarely remains with so-called ‘first movers’, and even where it does, the investor who ignores reasonable valuation parameters does so at his peril. The typical result of ignoring the price of what you are buying is that even if you pick a subsequent technology winner, it may be at the cost of never actually making any money.

12. Spotting the losers is easier than spotting the winners

In reality the losers from technological change are much easier to spot than the winners. Losing technologies often face insurmountable obstacles in reacting to their new competitors. Canals, for example, simply could not achieve the speed of throughput that railways could. The telephone allowed voice transmission, whereas the telegraph did not. Cars made horses redundant as a means of transport. The digital computer provided greater accuracy and speed than any analogue equivalent could achieve. Online retailing of branded products and the advent of price-comparison sites redefined the ability of retailers and service providers to segment their markets and benefit from differential pricing. As a consequence customers both flocked to online provision and offline suppliers saw dramatic price deflation.

Everything that is new is old: Spotify in the 1900s

Music on the telephone

“In the case of the telephone music service, it was first set up in Delaware in 1909 by a company called the Tel-musici Company. The service involved the subscriber calling in and requesting the music to be played. The operator then placed the music on the phonograph and the subscriber switched on the loudspeaking equipment attached to the phone. The service cost three cents a piece and seven cents for grand opera! It was received with much initial enthusiasm before the technology of music reproduction and the radio made it redundant.”

Lessons learned, unlearned and relearned

I personally think that the most important lesson of the book is that it doesn’t matter how life-changing a new technology is, it still can’t defy the basic laws of economics.

In the heyday of canals, more than 60 new companies were created in Britain between the late 18th century and 1824, raising more that £12 million of new capital (equivalent to around US$12 billion in today’s money): demand for their shares was so great that capital was easy to obtain and many of the issues were substantially oversubscribed.

While at first this enthusiasm appeared relatively well founded, historians have noted that over the full life of the canal system, many British canals provided substandard returns for investors, despite the fact that before the railways emerged to take away their market, canals did provide strong absolute and relative share price performance.

“As with many infrastructure projects, the problem for canal investors was the continuing need for large capital outlays. To recoup such heavy upfront investment required an extended period of profitable operation. The arrival of the railways denied canal investors this necessary period of capital recovery and provides a timeless lesson for investors attracted by the lure of a new technology.

Any technology that necessitates heavy capital expenditure and requires returns to be earned over an extended period is always going to be a high-risk undertaking – unless, that is, there is some form of protection against competition. This protection may take the form of patent, copyright, legal prohibition or simply fundamental competitive advantage (such as a superior cost curve). There is an obvious parallel between what happened with the canals and the debate about the prospects for third-generation (3G) telecommunication licences at the time of the first edition of this book in 2001. In both cases, massive amounts of capital expenditure were committed but without any guarantee that the new technology would enjoy a sufficiently long period of dominance in which to earn back, let alone exceed, the capital cost.”

In 1824–1825 alone, canal companies attracted a further £55 million in new capital (US$45 billion in today’s money), the single largest category of investment other than collective investment schemes. This was the high-water mark for the canals: since the early 1830s, when the railways began to undercut and displace them, the share prices of the canal companies began to be badly affected. The new railways could ship goods at prices at least one third lower than the canals, which were forced to drop their prices significantly in order to remain competitive.

And, surprise surprise!, the exact same thing happened to railways few years later:

“Such was the success of the railways that more and more new lines were proposed. In order to maintain some semblance of order, the Board of Trade set a deadline of 30 November 1845 for all new plans to be submitted. Riots broke out as more than 800 groups of promoters sought to reach London on time. Roads were blocked as coaches vied with each other, and existing railways refused passage to their new potential rivals. As with many dotcom companies 150 or so years later, few of these proposals for later lines rested on rigorous analysis of their revenue-generating potential. Few investors attempted to calculate whether revenue would exceed costs by a sufficient margin to provide an adequate return on invested capital. Such was the environment that the scrip shares issued on companies immediately went to a premium, providing instantaneous paper returns. The parallel with the IPO boom of 1999–2000 could not be clearer.”

The lure of quick and easy gains was irresistible, not only to the investing public, but also to promoters of new issues, at least those willing, able and fast enough to obtain approval in Parliament to launch a new joint stock company. Existing railways understood the dangers associated with the massive increase in new track and hence competition. They lobbied hard in Parliament against the creation of new companies, but with limited success.

“The rate of interest had been gradually decreasing since 1839. From six per cent in August of that year, to five per cent in January 1840; from five to four, and from four to two-and-a-half per cent had the value of money fallen by September, 1844.

“[…] There followed in the next few years a fever of railway speculation. Attracted by a bull market and the irresistible appeals of the financial press, groups of middle-class folk, who hitherto had never known the Stock Exchange, hurried to place their small accumulations in securities. The public funds and foreign government bonds were now eclipsed as the chief objects of speculation, and their brokers and jobbers were crowded out by the specialists in railway securities.”

I guess the lesson we will learn, over and over again, is that if you want to understand the future you need to study the past.

Engines That Move Markets: Technology Investing from Railroads to the Internet and Beyond