Dot-Com Bubble: Causes, Effect, and Lessons Learnt

Abstract

This paper looks at the causes, effects, and lessons learnt from the 2001 dot-com bubble financial crisis. To support my statements I investigate a variety of sources, including recently published academic journals, newspaper articles, books, and market reports. I find that the so-called “Get Big Fast” business model that many dot-com companies employed was fundamentally flawed, and after the bubble burst many companies have found it more beneficial to move to a more prudent model.

Introduction

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The dot-com bubble was a historic speculative bubble in the stock market which occurred in the years on 1995 to 2000. As an indicator of the bubble, the NASDAQ composite index is often quoted. The NASDAQ composite index rose from 751.49 to 5,132.52, a 682% increase, from January 1995 to March 2000 (Appendix A, B).

In this work, I look at factors that may have caused the 2001 dot-com bubble to grow and then subsequently burst. I look into the role of the media, interest rates, venture capital, and finally the “Get Big Fast” business model. Next, I look at the effect the 2001 dot-com bubble had on companies, considering measures of survival, levels of mergers and acquisitions, and changes in image to remove the association with those times, but also on investor confidence. Finally, I look at what lessons may have been learnt from the dot-com era.

Cause

American publications such as Forbes and the Wall Street Journal encouraged the public to invest in risky companies despite many of the companies’ disregard for basic financial and even legal principles (Lowenstein, 2004). Buffett (2000) says “Equity investors currently seem wildly optimistic in their expectations about future returns.” However, not only can the media be argued to have caused the huge growth of investment, but it can, according to Niederhoffer and Kenner (2003), also be attributed to its demise. They speak in particular about Alan Green’s “irrational exuberance” speech in December 1996 setting off a chain of events that leads to an eventual “reaction against technology, optimism, and growth”.

In reality, of course, no financial crisis can be sensibly attributed to just one cause. It is more likely instead to be a combination of many. For example, the low-interest rate in 1998-99 has been said to have helped increase the start-up capital amounts and lead to increased venture capital being offered (Metrik, 2007).

The coining of the “Get Big Fast” belief started during the dot-com era. The initial start-ups operated with a short-term loss business plan, insisting that by grabbing the market share and dominating their specific sectors they could then charge what they wanted at a later date. Recent research (Goldfarb, Kirsch and Miller, 2006) suggests that many companies would have had better success targeting smaller niche markets. In addition, they say that the “Get Big Fast” belief drove investor behaviour during the period leading to more stocks bought and companies became overpriced.

So, as a combination of a number of factors, the bubble burst and the effects were widespread.

Effect

The effects of the bubble bursting were that several companies went bankrupt. An example is WorldCom who admitted to billions of dollars of accounting errors (Tran, M., 2002), and as a consequence, the stock price fell so drastically they had to file for bankruptcy.

Many other struggling companies became acquired or merged with other companies. Aharon et al. (2010) found that there was an increase in mergers and acquisitions during the dot-com bubble. Interestingly, they also found that the pricing of mergers and acquisitions did not change.

Mintel (2010) states: “The investment bond market was badly hit by the bursting of the dot com bubble in the early noughties and has been in perpetual decline ever since – in 2002”.

Many companies changed their names to remove any association as a dotcom company. Cooper et al. (2005) mention how during the bear market of the early 2000s “investors react positively to name changes for firms that remove dot.com from their name”.

Lessons Learnt

Within the technology sector, Parsons (2012) argues that greater prudence is ensuring the “sector is financially solid and is currently the only one to have more cash on its balance sheet than debt”. There also seems to be an awareness of the damage to Initial Public Offerings by companies. Recent research (Pilbeam and Nagle, 2009) suggest that “the high-tech IPO market was dramatically affected by the Dot-Com Crash and that after the crash, the number of high-tech IPOs dropped considerably”.

Many companies moved away from the “Get Big Fast” belief that epitomised the dotcom era, seeing that it was not sustainable as a business model. Eventually, these companies would have to start to get the fundamentals right and turn in a profit. So many were being started too quickly, all with the business plan of monopolising their particular market place, which inevitably not everyone could succeed and many as a consequence folded. Berlin (2008) says “Many of the companies that survived the dot-com bust did so by ignoring the prevailing “Get Big Fast” business model”. He talks about research by David Kirsch and the Dot Com Archive that found that they referred “micro-niches” which were markets that did not offer huge profits quickly but instead presented viable internet-based business opportunities. Companies that had learnt from the dot-com bubble were not believing that life-altering changes would happen over-night.

Many believe that lessons have not been learnt from the 2001 dot-com bubble financial crisis. Many think that we are in another social media bubble currently which has very analogous characteristics to the 2001 dot-com bubble (Vass, 2012; Foley, 2012).

Conclusion

In this essay, I have looked at the cause, effect, and lessons learnt from the 2001 dot-com bubble financial crisis. The cause unsurprisingly does not seem to come down to one single factor. The media clearly played a large part in making investors overconfident during the growth and then overly pessimistic leading to its eventual demise. However, I also found that an unsound business model of the time, “Get Big Fast”, played a major role too. I found evidence that a more prudent business model based on modest profits had to lead to the technology sector recovering. As always, history has a habit of repeating itself, and I also looked into the belief of some that lessons have not been learnt by Social Media companies and that we may be in another Social Media bubble right now with characteristics very similar to that of the dot-com crisis.

Appendix: Line Graph Illustrating the 2001 Dot-Com Bubble

Figure 1: The close price of the NASDAQ Composite (Yahoo! ticker symbol ^IXIC) from 2nd January 1990 until the beginning of 2012. The graph clearly illustrates the 2001 dot-com bubble, where the value of the NASDAQ composite rises steeply up until its peak in February. Data is taken from Yahoo! Finance Historical Prices available at http://uk.finance.yahoo.com/q/hp?s=^IXIC.

Appendix: Table Showing the Extreme of the Nasdaq Composite Price

Table 1: Historical prices of the NASDAQ Composite (Yahoo! ticker symbol ^IXIC) at the start of its growth in 1995, to its peak in 2000, to its huge fall in 2002. Data is taken from Yahoo! Finance Historical Prices available at http://uk.finance.yahoo.com/q/hp?s=^IXIC.

References:

1. Aharon, D.Y., Gavious, I., Yosef, R., 2010. Stock market bubble effects on mergers and acquisitions. The Quarterly Review of Economics and Finance, 50(4), pp.456-470.
2. Buffett, W., 2000. Warren Buffet’s Letters to Berkshire Shareholders. Berkshire Hathaway Inc., 1 March
3. Berlin, L., 2008. Lessons of Survival, From the Dot-Com Attic. The New York Times, 21 November.
4. Cooper, M. J., Khorana, A., Osobov, I., Patel, A. and Rau, P.R., 2005. Managerial Actions in Response to a Market Downturn: Valuation Effects of Name Changes in the Dot.com Decline. Journal of Corporate Finance, 11(1-2), pp. 319-335.
5. Foley, S., 2012. Is the dot com bubble about to burst. The Independent, 4 August.
6. Goldfarb, B.D., Kirsch, D., Miller, D., 2006. Was There Too Little Entry During the Dot Com EraRobert H. Smith School Research Paper No. RHS 06-029, 24 April.
7. Lowenstein, R., 2004. Origins of the Crash: The Great Bubble and Its Undoing. New York: Penguin Press.
8. Metrick, A., 2007. Venture Capital and the Finance of Innovation. New Jersey: John Wiley & Sons, Inc.
9. Mintel, 2010. Investment Bonds: Mintel marketing report. February 2010. London: Mintel International.
10. Niederhoffer, V. And Kenner, L. 2003. Practical Speculation. New Jersey: John Wiley & Sons, Inc.
11. Parsons, A., 2012. Tech firms learn lessons of the dotcom bubble. The Share Centre, 10 June.
12. Pilbeam, K. and Nagle, F., 2009. High-Tech IPOs in the US, UK and Europe after the Dot-Com Bubble. International Journal of Financial Services Management, 4(1), pp.64-75.
13. Tran, M., 2002. WorldCom accounting scandal. Guardian, 9 August.
14. Vass, S., 2012. The new dotcom bubble Sunday Herald, 13 May.

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