Why predicting the next Tech Revolution won’t generate returns
Exciting new technologies and the companies that create them seem like obvious investment opportunities. Why wouldn’t you want to invest in the companies leading a new world-changing technological paradigm?
Each past technological revolution has changed the world in profound and distinct ways but their relationship with financial capital has been remarkably consistent. We can’t predict how emergent technologies will change the world we can draw insight from how financial markets have behaved through past technological revolutions.
A technological revolution is a big deal it modernizes all existing industries increasing the full spectrum of economic productivity. It is easy to get caught believing that today’s most successful industries and companies are unlike anything that we’ve seen in the past. But within the social and technological paradigms of their time past technological revolutions have resulted in unprecedented surges in productivity and growth. The relationship between these technological revolutions and financial capital has followed a consistent pattern.
- There is an eruption of the revolution resulting from incremental advances and innovations that culminate in a technology with the capacity to increase the economy’s productivity and the financial capital to support it.
- This is followed by two or three decades of the new technology being installed in the economy. The installation phase can be turbulent as the new technology divides the economy into old and new creating social and economic divisions regulatory turmoil and wealth inequality.
- The installation period has historically been accompanied by a major technology bubble centered on the new breakthrough technologies and spurred by the extraordinary profits produced by them.
- The major technology bubble is as with any bubble followed by a collapse.
- The collapse leads to a recomposition of the regulatory framework that sets the conditions for the final deployment period of this new technology.
- The final phase consists of more organic growth in financial assets that lasts until the limits to productivity and growth from the technology are reached setting the stage for the eruption and financing of the next technological revolution.
The major technology bubble tends to happen midway in the process of assimilation of each technological revolution affecting primarily the companies engaged in those technologies. This bubble-like behavior of technological revolutions ultimately results in low returns for investors. These bubbles are an empirical fact in the historical data that cannot be ignored when we’re talking about investing in technological revolutions.
The surge of development in canal mania was followed by a canal bust, railway mania was followed by a railway bust. The infrastructure boom of the late 1880s was followed by several busts. The roaring 20s ended in the great depression and the surge of ipos in the internet bubble ended in the tech crash. The lesser-known British bicycle mania followed a similar path.
Investors get into an irrational frenzy about the potential for high profits from the new technology: irrational exuberance as Robert Schiller describes it. This results in prices that exceed a notion of fair value. While there is likely a contribution from irrationality to these bubble-like patterns I don’t think that it would be intellectually honest to assume that investors have been consistently irrational through all past technological revolutions. I’m not saying that investors are perfectly rational but perfect irrationality is arguably a bigger assumption. When an exciting new technology company is being tested there is a huge range of potential outcomes: maybe it’s the next Microsoft but maybe not. The concept that uncertainty about average profitability leads to higher prices is counter-intuitive but it’s important.
Uncertainty increases the price without requiring the assumption of irrational behavior uncertainty increases the fundamental value of a company. As the market learns about the profitability of businesses in a new technological paradigm the uncertainty about their growth rate decreases causing their prices to fall all else equal. The high prices of the internet boom were not necessarily detached from fundamental values when the high levels of uncertainty are accounted for.
We always have to remember what a stock represents. A stock is a claim on a company’s future profits. Investment returns do not come from a company’s growth. They come from the relationship between a company’s future profits and how much you the investor paid for those profits. Paying a higher price should lead to lower realized returns all else equal. This is exactly what the historical record shows.
Since the inception of the S&P 500 index, its industry composition has changed materially. In the 1950s steel, chemical, auto, and oil companies dominated the index whereas today health care and technology dominate. Despite the decline of the originally dominant industries, had an investor bought and held the original firms in the s&p 500 at its inception, they would have beaten the actual index by more than one percent per year for the next 50 years. This is due to investors overpaying for expected growth. From 1900 through 2019 rail companies declined from a 63 share of the u.s stock market to a less than one percent share. It is the ultimate example of a declining industry. Over that time period, rail stocks beat the u.s market, road transportation stocks, and air transportation stocks. Since the approximate start of the age of information in 1971, the software industry has grown more than any other from basically non-existent in 1971 to the largest industry by market capitalization at the end of 2019 at nearly 15 percent of the u.s. stock market. The oil industry on the other hand has seen a massive decline in market capitalization from nearly 15 percent of us market in 1971 to about 3 percent at the end of 2019. Over this period a dollar invested in the oil index grew to 134 dollars while a dollar invested in the software index grew to only 76.
Another common assumption is that by betting on the winning companies the companies that end up dominating a technological paradigm make good investments. This has simply not been the case historically every technological paradigm has had winner take all companies. These huge companies make up a large portion of the stock market and drive the economy. Their stock returns though have left much to be desired. For each decade starting 1930 40 50 and so on through 2010, the 10 largest companies at the start of the decade have trailed the market as a whole by an annualized 1.51 percent on average for the decade that followed.
Bets on new industries or against declining ones have historically failed to pay off. What about the next technological revolution? Does it make sense to look for the next apple, amazon, or google before their prices rise? This notion is more akin to playing the lottery than many people realize. Evidence from ipos and venture capital tells us why. Stock returns in general exhibit positive skewness. Most stocks perform poorly and a relatively small number of stocks perform exceptionally well. The positive skewness in ipos which tend to behave like small-cap growth stocks and venture capital is even more pronounced.
The vast majority of small-cap growth stocks produce poor returns while a few produce large positive returns. Almost two-thirds of venture capital financings lose money while a tiny number of them produce huge returns. The chances of picking winners before the fact are not in your favor.
Investing in technological revolutions is one of the least successful strategies in investing. But every time that a new technology or industry creates new opportunities for financial capital investors flock to it with seeming disregard for the historical record predicting similar outcomes in the future.