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TIP777: The 1999 Dot-Com Bubble w/ Clay Finck
01:10:23
Clay explores the dot-com boom and bust through Roger Lowenstein’s book, Origins of the Crash.
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Host
You're listening to tip.
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Narrator
On today's episode, we're exploring one of the most dramatic chapters in financial history, the dot com boom and the unraveling that followed, as told through Roger Lowenstein's book Origins of the Crash. For those who didn't live through it, like myself, the late 1990s can feel almost mythical. A time when new technologies seem destined to rewrite every rule of business and investing stocks soared, IPOs doubled in a day, and Wall street, corporate insiders and everyday investors all got swept up in the belief that a new era had arrived. But behind the headlines and the hype were deeper structural problems such as hugely misaligned incentives, questionable accounting practices and an obsession with short term stock price movements. Loanstein traces how all this came to a head, from the manic rise of Internet companies to the stunning collapse of Enron, reminding us just how fragile markets can become when speculation overtakes discipline. In this episode, we're going to walk through the causes, the characters and the cascading consequences of the crash, and more importantly, the timeless lessons individual investors can take from it. These events reshaped corporate governance, transformed regulation, and exposed the system's vulnerabilities when greed, leverage and new technology collide. So with that, I hope you enjoy today's episode on the Origins of the Crash by Roger Lowenstein.
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Host
Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host playthink.
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Narrator
On today's episode, we'll be reviewing Roger Lowenstein's book Origins of the Crash, which outlines the speculative mania that was at play during the 1999.com bubble. Lowenstein has written several great books including Buffett, the Making of an American Capitalist and When Genius Failed, which is a book I covered back on episode 707. Investors that are my age or younger did not live through the dot com bubble, but we're all familiar with it since it's referenced so often before the fireworks of the late 90s, we need to understand the slow burning fuse that started decades earlier. If we rewind back to the 1970s, it was a brutal time to be a stock market investor and for the most part, stock investing was just not on people's radar. For example, in 1979, 90% of the money invested in pension funds was in bonds, T bills and cash as stocks were viewed as too risky and didn't have good prospects of high returns. Since the previous Decade had high inflation and did not treat stock investors all that well. Many executives became complacent in the 70s. They held little regard for looking out for shareholders. But once corporate raiders stepped into the market, the term shareholder value started to get thrown around much more once executives realized that they could be out of a job if Carl Icahn or another corporate raider were interested in buying out their deeply undervalued stock. In other words, executives not only showed up to work and did their job, but they also took more of an interest of what the market thought their shares were worth. A frenzy of leveraged buyouts in the 1980s helped executives appreciate that shareholder value could be created by utilizing some level of debt in their business, buying back shares, cutting costs, or selling off divisions unrelated to their core business. But what was needed more than anything was that in order for CEOs to truly behave like owner managers, they needed to actually be owners, which led to an increased use of stock options in their compensation packages. In 1990, Michael Jensen, a Harvard professor who had championed leveraged buyouts as an antidote to corporate America's ills, He published a call to arms in the Harvard Business Review for boards to revamp the way in which CEOs were compensated. Although their recommendations would probably have led to higher absolute levels of pay, their recommendations really revolved around how CEOs were paid instead of just how much they were paid. Their main issue with the current compensation structures was that the managers themselves did not have enough skin in the game. Since most CEOs were not independently wealthy, they recommended that they be granted options in their compensation packages. It was Silicon Valley that made stock options fashionable among Wall Street. Robert Noyce, who was the co inventor of the computer chip, he left his job at Fairchild Semiconductor because they refused to give him options. So he went on to start intel, which made options a central tenet of its culture. In the 1980s. Companies like Oracle and Microsoft followed Intel's lead, and Silicon Valley would eventually become known as a place where nerdy programmers worked for modest wages and would eventually get rich off stock options. By the end of the 1980s, the percentage of corporate shares reserved for options had doubled to 5% of the total outstanding. In his paper, Jensen stated what really matters was the percentage of the company's outstanding shares the CEO owns, end quote. And he pointed to Warren Buffett as an excellent example. Because Buffett owned roughly 45% of Berkshire Hathaway at the time, he thought like an owner. However, the key lesson that Jensen missed was that Buffett acquired those shares with his own money, Whereas stock options tend to be handed out in a compensation package. To use an analogy, buffet poker players tend to play more aggressively when they're playing with house money. That's sort of what it's like when you own $10 million worth of stock that were basically handed to you, but when the chips in front of them were earned through their own blood, sweat, and tears, they tend to watch that money more closely. Or let me frame it another way. Let's say that you saved up over the course of your career. You're 40 years old, you have some good savings, and you have these good investing habits, and you managed to build up a $2 million portfolio. You would really appreciate what you built up to that point. Now, let's say your friend, who's the same age and didn't build up those same savings and investing habits, he won the lottery and won $2 million. Your friend is much more likely to immediately go out and buy a new house or a new sports car, a new boat, because in his mind, he didn't really have to work for that money. So it's much easier to spend and let go of. The same idea applies to having skin in the game. Shares that were handed to you tend to not be as valuable psychologically as shares that you paid for with your own money. So a manager like Buffett is more likely to treat shareholders well relative to a manager that never bought a share with his own money. By the early 1990s, stocks were really starting to enter the mainstream consciousness. As the economy picked up. And after the 1987 flash crash buck, the market just started to take off because the market seemed to just keep going up. People enjoy just jumping into the market and joining the party without really understanding fundamental analysis or how to value a business. When the market seems to only go up, every drop of 10% or 20% is an opportunity to buy the dip before the tide turns yet again. Public interest in the stock market can partially be measured by the increased popularity of 401k retirement plans. In 1990, close to $400 billion was invested in 401 s. By 1995, that figure had doubled. And 401ks, of course, helped give people exposure to the stock market more broadly, since it was an account that was tied to work. So for many people who ended up getting jobs, they were offered this 401k as a benefit. So they naturally would get exposure to what it really looks like to be invested in the stock market. And it was oftentimes the employees themselves that were doing the selection of the funds they would be investing in, rather than the money just being sent off to some distant pension fund manager. Tying to the point earlier about managers paying more attention to stock prices, starting in 1994, the SEC required companies to publish a chart of their stock price performance in the annual proxy statement, which is where the CEO's compensation was disclosed. Though the chart was useful for shareholders, the CEO now saw his pay linked explicitly and also quite publicly to this one barometer. As the adage goes, you manage what you measure. Executives intent on managing their stocks became hypersensitive to a single the quarterly earnings per share. As Lowenstein puts it, from an economic perspective, quarterly numbers are virtually irrelevant in because it typically takes years, not months, for business strategies to bear fruit. End quote. As a result, throughout the 90s, publicly traded companies performed more and more financial engineering. Profit was now not only obtained by selling goods above cost, but also from trading, restructuring, and financial engineering anything that Wall street could find to bring into that quarterly EPS figure. The game was to keep earnings rising, but never buy too much so you can save more for next quarter. The rise of corporate finance also sparked a parallel rise to prominence of the chief financial officer, once a mere administrator or number cruncher, now the person responsible for quote making the quarterly earnings number. The book also gets into the questionable actions that executives would make in the 90s. For example, we talked about stock options earlier. Stock options can be problematic because even subpar performance for shareholders can still lead to big payouts for managers, even if the stock compounds at, say, just 5% per year. And boardrooms would often be filled with conflicts of interest and become fraternal places. Buffett once wrote that to stand up and criticize the CEO felt like belching at the table. Disney's CEO, for example, he stacked the deck by putting on the board his personal lawyer, the principal of the elementary school previously attended by his children, and the president of Georgetown University, who the CEO had donated more than $1 million to. But don't worry, any options that were paid out to executives and financed through share dilution would end up being bought back on the open market, no matter the value. So it's not a real cost. At least that's what some managers would claim. In 1993, FASB recommended a rule that would require companies to deduct the cost of options from their reported earnings. But corporate America strongly discouraged such a change, as it would potentially keep Americans from getting their slice of the American dream. But FASB argued that they weren't asking companies not to pay out stock based comp but to acknowledge that it was a real cost incurred by the business. As they say, there are no free lunches. And the reality was that 75% of options were handed out to the people who ranked in the top five in the company. So Wall street was simply trying to protect those at the top. But then when it came to filing taxes with the irs, they would routinely deduct options as a cost, saving billions of dollars in taxes. Stock based compensation presents several issues in terms of shareholder alignment. Perhaps the most concerning was that success was rewarded but failure was not punished. As Lowenstein puts it, under such conditions, a gambler would bet on every horse he could. If CEOs have nothing to lose, then they are prone to making increasingly riskier bets with shareholders capital. And even if the investment ultimately failed, it could bear fruit if they could keep the market enthusiastic about their prospects. For example, the CEO of Warnico, the apparel company, they harvested $16 million in pay in addition to cashing an options package worth $76 million in 1998 while the company was on its path to bankruptcy and a zero dollar stock price. In questioning and criticizing the exorbitant comp packages in the 90s, Loanstein writes, it is hard to think of any other society in which failure paid so well. End quote. Chapter four of the book is titled Numbers Games, which gets into the tricks that Wall street would pull in order to help fuel a rising stock price. Loanstein outlines a case study in General Electric, Jack Welch set the standard for shareholder value creation. If a business wasn't first or second in its industry, Welch wanted to unload it. Few executives in the 90s would make more on incentives than those at Georgia. In a 10 year stretch, Welch earned $400 million in salary, bonuses and options, which was just an extraordinary fortune for a hired hand. And most of it was derived from GE's rising stock price. Over Welch's two decades as CEO, shares of GE rose from a buck 20 to $50, a 42x increase. He encouraged divesting from unattractive businesses, investing in more attractive businesses, and he demanded relentless improvement in quality and productivity. This focus led to GE's earnings increasing a phenomenal 100 quarters in a row, Loanstein writes here. Investors gladly paid for that consistency. It saved them from sleepless nights from having to analyze the companies themselves. They could simply rely on Jack. When you looked underneath the surface, though, Welch was just a master at managing his earnings growth. GE wasn't a unicorn business that didn't face surprises. So it's not Reasonable to assume that a good business is going to just have these steady, predictable growth in earnings per share year after year. Every business has its fair share of surprises. GE was set to enter every quarter with a specific profit goal in mind and to do everything in its power to just make and report that number, regardless of whether the actual performance turned out to be better or worse. One way GE would cook the books was to adjust reserves that GE Capital maintained against problem loans, adding to their reserves in strong quarters to quote, save income for a rainy day and reducing them in weak quarters when the income was quote needed. GE Capital was so complex, it was considered a black box to outsiders, even those who were financial experts. Another example is what they did with their pension plan. Pension plans can be a bit of a black hole, and by law, once money goes into a plan, it can never be used for the benefit of stockholders. Nonetheless, the plans can be used to create an appearance that is favorable to the stock. When pensions earn a surplus, the parent company can book a credit to its earnings, the size of which is highly dependent on management's assumptions. So during a period of time, about 10% of the profit reported to Wall street was actually money safely locked in the pension plan that neither Wall street nor shareholders could ever touch. Unlike managers like Warren Buffett, executives who played numbers games became less candid with investors as their moral basis was undermined. When IBM was questioned of their practice of making expenses look lower than they were, the computer giant responded by saying that their accounting was within the letter of accepted industry practice. Companies like GE, IBM and many others in the 1990s ultimately forgot who their shareholders were. Shareholders were the ones who actually owned the company, and they deserved management's complete candor. Now it's easy to point fingers at the managers who would massage the numbers and say that investors were the victims here. But the relationship was actually symbiotic. Lowenstein uses the term game here. Both sides were playing the game. Professional investors wanted the numbers that were disclosed to them to be managed. In other words, in some sense they wanted to be misled. But of course, none of it would be phrased that way. It's also interesting to consider the impact of the regulatory authorities on the investment industry. Loanstein dedicates a chapter to the regulatory environment during this time and how things evolved leading up to the dot com bubble. The SEC was interested in protecting individual investors. With millions of new investors having entered the market during that time, they wanted investors to understand the risks that were inherent in investing. When you get into the market and you only see the market going up. It's human nature to just overlook the risks involved. In 1994, the Republican Party won control of Congress and enacted a law that discouraged shareholder lawsuits and added a new layer of protection to executives and accountants, even those who had signed misleading reports. Further fueling the permissive climate, the Justice Department showed little interest in prosecuting cases of accounting fraud, which was not considered a major problem. These developments gave executives, accountants and corporate lawyers a general sense that that the risks to themselves had been diminished. By the summer of 1995, Congress was awash in proposals to reduce the scope of regulators, freeze the budget of the SEC for five years, eliminate some of its commissions, and reduce disclosure requirements. But Arthur Levitt Jr. Who was the former chair of the SEC, he understood that the system was designed for cronyism. Analysts who in theory were paid to research stocks, had oftentimes become promoters of the assets the firm held on behalf of clients, Lowenstein writes. The analysts could be seen at plush investment conferences tooting client stocks like Carnival Bankers, CNBC and Wall Street Week were forever asking analysts to reveal their top picks to viewers, few of whom were aware of the inherent conflicts. Shareholder value, supposedly the analyst's prime concern, had become tainted by cronyism and greed. Analysts were not rewarded for being right, so few tried to be. There is little payback for doing research, as one analyst said, end quote. With that as a backdrop, let's jump ahead now to September of 1998. That month, the Internet auction king ebay went public. The stock opened for trading at $18 a share, and it closed the day at 47. And at the end of the year, less than four months later, the stock traded for 241. A 13 bagger. Since day one of going public, ebay was one of the few hot Internet stocks that actually had earnings. But the Stock traded for 1800 times trailing earnings. One company that had no earnings was theglobe.com, which was started by two 20 somethings who operated a website where people could build homepages. With less than $3 million in revenue in its nine months of existence, the stock more than 10x after going public and was valued by the market at $1 billion. Let's take a quick break and hear from today's sponsors.
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And better yet, every enterprise can apply the same innovation playbook that Amazon perfected in house. See the Amazon ad story@aws.com AI R story. That's aws.com AI R story. All right, back to the show. One of the poster childs of the dot com bubble was Amazon, which of course, as we know, is one of the few Internet companies from that time that actually proved to be a viable business long term. Jonathan Cohen, a securities analyst at Merrill lynch, issued a sell rating on Amazon.com, the Internet Bookseller. At the time. It was extremely rare for analysts at Merrill lynch to ever issue a sale rating, which was sort of telling of the market valuations at the time. While Amazon's revenues were exploding, Cohen observed that book selling, even on the Internet was inherently competitive and low margin. Furthermore, Amazon was being valued at $4 billion, which was twice the value of Barnes and Noble, which was actually generating profits and had vastly higher revenue. But the sell rating didn't stop the stock from tripling over the ensuing three months. In December of 1998, Amazon was valued at $12 billion. Yahoo might have been the most popular Internet stock at the time. It was viewed as the portal or the doorway to the Web. And it was a proxy for one of the bubble's most alluring fantasies. Portals such as Yahoo or AOL were supposedly New age networks with theoretically unlimited appeal to advertisers. And Yahoo attracted more viewers and eyeballs than anyone at the time. To Wall street, eyeballs were as good as gold. When Yahoo was added to the S&P 500, a change that did nothing to their fundamentals, the Stock surged by 64% in the week and eventually reached a market value of $100 billion. It reminds me a lot of the messages that I got from friends in 2021 during the crypto NFT GameStop craze where everyone around you was sort of bragging about the easy money they were making. And you know, when you get those sort of texts and you see those signposts, you know you're in dangerous territory. And I'm sure the dot com bubble was very similar to that feeling I experienced in 2021. By 1999, the Internet bubble reached peak craziness. Priceline, which resold airline tickets but owned neither gates nor planes. They were worth as almost as much as the entire tangible airline industry. EToys, a tiny but well publicized retailer, they went public with a value three times that of Toys R Us. But eToys had revenues of 25 million and Toys R Us had revenues of 11 billion. Lowenstein writes, the bizarre yet inescapable conclusion was that according to the market at the turn of the millennium, a.com stock was worth more than an actual cash generating business. To Wall street, the 1400 stores of toys R Us were not an asset, but an albatross, an anchor on its steadily sinking stock price. Anything touched by new technology soared. All else was tainted. End quote. Now, when I read this line, I also just couldn't help but think of what's happening this year here in 2025. It's really, you know, the past few years, 23 through 25 after the release of ChatGPT, it's really been all about AI. Any stock that is directly in the AI ecosystem has done exceptionally well while the rest of the market has really floundered. And as AI stocks have soared, anything that is perceived to have disruption coming from AI is really getting beaten down. As many of the listeners know, I own Constellation Software and their two spinoffs, and these stocks have just gotten absolutely hammered in 2025 over AI fears. I personally believe these fears are overblown and I haven't sold a single share in any of these. And AI may even be a tailwind for them, at least in the near term. And Sean o' Malley and I recently chatted about Adobe on the show, which is down more than 25% this year while the business really continues to grow. Adobe has integrated AI into many of their offerings, but the market is still pricing this stock as if it will never grow again. So I do see similarities to the tech bubble on how investors are clearly pricing in these potential risks of new technologies. But I also believe that in many cases these fears are really overblown. Constellation Software, for example, is down 25% this year, and yet their business prospects largely remain the same as they were at the start of the year. So all that has really changed is the market's opinion of those prospects. I'm also reminded of one of our members of our mastermind community. He worked at Microsoft for 25 years starting in 1998. So he really had a front seat view to the dot com mania. And for much of the 90s, he had a majority of his net worth invested in Microsoft, which was compounding at 40% per year during that time period. And he did a member spotlight with us to share his takeaways from actually living through the dot com bubble and the crash that followed. And a few of his main takeaways were, first, very few companies that are participating in the mania end up being long term winners. Second, there's an institutional pressure to participate in market bubbles because the indexes will become overvalued and if you don't participate in the run up of the new technology stocks then you're likely going to trail the market and face redemptions from your investors. And then third, history teaches us that all financial bubbles eventually end in tears. One of the hottest stocks from the dot com bubble was Cisco. And I just checked the stock price chart. Many people thought that Cisco during the bubble would be a sure winner. But 25 years later Cisco still trades below its all time high from the dot com bubble. Anyways, I wanted to jump back to the book here. Loenstein explains that this bubble didn't simply happen overnight. Seeds were sown throughout the 90s that enabled this to happen. From 1990 to 1998 the NASDAQ and Dow Jones average had tripled. And it wasn't just Internet stocks that were richly valued. There were blue chip staples like GE and Coca Cola too. If General Electric were valued at 40 times earnings, who's to say what the limit was for Amazon? What was even better in many investors minds is that since Amazon did not have profits, it allowed them to just let their imaginations wander without burden of being anchored to a PE multiple to introduce at least some level of rationality. As Lowenstein writes, it allowed their naive optimism to ripen into something larger and dreamier. As the world imagined what the Internet would bring, the Nasdaq would go on to rise by 86% in 1999. This points to a common theme we see throughout history. Sometimes these new technologies lead people to get rid of the investment principles that are timeless, such as knowing the value of something before you buy it, or truly understanding the business model and its prospects. If one were to assume that a new technology were to change everything and simply buy based on that basis, then you may be getting carried away with the hype related to that technology. One of the assumptions that people make is that new technology is equivalent to an investment opportunity. Revolutionary technologies do not always equate to fruitful returns for shareholders. In fact, new technologies and increases in productivity can even dampen profitability. Many new technologies level the playing field and smooth out the imperfections in the marketplace. One of the main benefits of the potential of the Internet was that it was the ultimate information dispenser. It empowered individuals and leveled the disparity in knowledge, allowing consumers to be better informed on the options available to them and the prices that different companies charged back on episode 693, I put together an episode discussing the power law in venture capital, which was a really interesting episode to me. And the venture capital industry was all over the Internet craze. From 1990 to 1999, venture capital funding went from $3 billion to 60 billion in venture firms. Really helped fuel this bubble. Some venture capitalists would push these startups to IPO because they saw an opportunity to just 10x their money rather quickly. So they encouraged these firms to just spend, hire and build, which allowed them to go public once some sort of business model was in place and the public was willing to pay significantly higher prices for these firms at the time. So venture capitalists for a relatively short period of time were able to invest in Internet startups, almost irrespective of their prospects for success, with the hope of selling the shares to Wall street at a much higher price. And Wall street was of course, fueling this fire as well as standards for companies to go public declined. And it was common for a banker at Goldman Sachs or Credit Suisse to personally invest in a venture firm and then turn around and take one of the firm's young companies public. So when these bankers are invested in the venture firms, there's just this blatant conflict of interest between Wall street and their customers or the general public. They ignored the Internet company's lack of profits, and they ignored the history of numerous other inventions, such as the railroad, that had these speculative booms and busts. But we shouldn't put all of the blame on the venture capitalists and Wall Street. As Main street got Internet fever earlier than many on Wall street, some people had started using the Internet in their private lives, which led to increased interest in the stock market. People everywhere got exposure to, you know, market news, rumors, opinions, and anyone investing in stocks likely heard about somebody making a killing. And on Internet stocks, prior to the Internet, if an everyday person purchased a common stock, I'd imagine that it was typically a company that they knew about in their local area, or maybe it was a well known blue chip like Coca Cola. Information on these companies would have traveled very slowly, and you likely wouldn't have known many other people that also own that company. And you know, the share prices just weren't as volatile as many of these Internet stocks. Now with the Internet coming about, people were able to sort of form their own bubbles. The more other people got excited about Amazon stock, the more likely you were going to join that party and fall prey to groupthink and fomo. So the Internet forever changed how people would interact with the stock market itself. The Nasdaq would eventually hit its peak around $4,700 in March of 2000. In the 12 months leading up to the peak, the dot com market went into a fever. Priceline went public at $16 a share and ended the day at 69. IVillage, a women's site without a remote possibility of profit, opened at 24 and soared to 80 bucks. Fortunes were made by investors seemingly overnight, investing in the next hot Internet IPO. The top performing IPO of 1999 was Internet Capital, an incubator of business websites. The stock went public in August at 6 bucks a share and closed the year at 1 70, a 28x increase in just four months. The company was valued at $46 billion. And after netting out the cash, the market was assuming that the 47 startup ventures they had investments in were worth on average 120 times invested capital. From 1999 to 2000, investment banks earned $3.9 billion in fees for technology deals, and Credit suisse alone earned $780 million. Much of this money was made for brokering deals on companies that weren't remotely close to earning a profit. And Main street investors largely paid the price for it. Instead of them giving the public actual investment opportunities, they were the casino spinning the roulette wheel. In this case, brokers or the house would always win at somebody else's expense. There are many examples in the book, but another example I needed to share was a company called All Advantage. This company recruited and paid millions of people to surf the net, and this was initially funded by venture capitalists who were counting on eventually selling their shares to the public. So AllAdvantage was recruiting all of these members with the hope of being able to leverage those eyeballs and convert them to advertising dollars. The company was started by three recent Stanford graduates and an older entrepreneur. The company even got the attention of President Clinton, who paid a tribute for their inventiveness in the new economy. However, advertisers felt a bit suspicious, as their ad dollars weren't going near as far as they expected. After doing some due diligence on this, they discovered that the majority of clicks on All Advantage's website actually came from bots that were programmed to to look like web surfers. And All Advantage was unwittingly paying for these so called eyeballs. Credit Suisse was apparently unaware that its clients was in large measure a fraud, although they knew that they were generating ad revenue of just $9 million a quarter, which was tiny considering that they were shooting for a billion dollar IPO. As I mentioned, NASDAQ peaked around March of 2000. There was no outward signal or obvious trigger that we hit the peak and the market was simply exhausted by the unceasing parade of IPOs. AOL about perfectly timed the peak. In January of 2000, the preeminent Internet company struck a merger with Time Warner, perhaps the preeminent old media company in America. Few people were able to recognize that they were at the top of the bubble, which would serve as a lesson for all of us. Timing the market consistently is next to impossible, so one shouldn't think that they'll be able to time when a market bubble is going to end. As John Maynard Keynes said, the market can remain irrational longer than you can remain solvent. For a bubble to continue to inflate, it requires an ever increasing level of greed and capital to help fuel it. If fundamental investors are involved, then fewer and fewer of them will be invested as the bubble inflates, which requires more and more speculators to pile in. And you can't assume that more speculators will continue to join the party as eventually rationality will take hold. My advice to those that are fairly certain that they're in a highly inflated bubble is to not be overexposed to it as the potential for capital destruction is just significant. I'm reminded of when I was a child, the Wile E. Coyote character that runs off a cliff while chasing the roadrunner and then for a few seconds he doesn't fall, his legs just kept spinning and he appears to be suspended in midair. Only when he looks down and realizes there's nothing supporting him does gravity suddenly kick in and he plummets. This is analogous to the dot com bubble because there was nothing to sustain the high stock prices. If you think about all the speculators that would need to pile into profitless.com company when they eventually realize that the party is over, they are just going to dump their shares. You know, they don't care about the potential long term fundamentals of the business. And there are no greater fools who are willing to buy the shares that they bought a month ago. In just one month, Yahoo stock was cut in half. And in mid April 2000 the NASDAQ plunged by 10% in a single day. By early 2001, the NASDAQ plunged from nearly $5,000 to under 2,000. Amazon went from a $37 billion valuation to 5 billion. The dot com bubble was rooted in the insanity of speculation, but when we look at Enron, it was rooted in Deception. But both stories illustrate the issue of distorted incentives in a market culture obsessed with appearances rather than profits. Wall street, in much of corporate America was really never the same after Enron was uncovered as a fraud and filed for bankruptcy in December of 2001, less than a year after they've reported revenues of over $100 billion. So since this impacted financial markets so significantly, I really wanted to cover the story of Enron as well. Loenstein writes, if a single corporation could represent the corruption of shareholder value, it would be one in which the executives were riveted minute by minute on the stock price. The desire for a higher stock would dictate every facet of the company. Its disclosures would be scripted, its accounting would be rigged, its strategies and even its lines of business would be chosen with buy or sell orders in mind. The executives would be consumed with their company's appearance and they would enlist a network of well paid professionals, you know, the accountants, analysts and even lawyers. To buttress the corporate image. It would endeavor to shift assets and related liabilities off the balance sheet and away from prying eyes. Enron's history began in the 1980s merger wave where Omaha based Pipeline Enernorth and Houston Natural Gas merged to form Enron. The new entity was led by Kenneth Lay, who would quickly become the fifth highest paid CEO. Although Lay was very well paid, he was fairly indifferent to the gritty details that came with being a CEO and an executive. In 1987, he was informed of some dishonest bookkeeping in their lucrative oil trading division and he decided not to get rid of the culprits in order to try and keep the big profits rolling in. Enron ultimately lost $150 million at that time and two traders were convicted of fraud. What's more alarming was that Enron never explained the episode to shareholders in subsequent annual reports. This was an attempt to protect the stock price and their image, which would ultimately be a short term win, but a long term loss. One of Kenneth Lay's favorite McKinsey consultants was Jeffrey Skilling, who wasn't too fond of Enron's traditional pipeline business, or really any traditional business due to their capital intensity. With the gas industry deregulating, Skilling was drawn towards trading. And in 1989 he suggested that Enron established a gas bank. Ley was drawn into Skilling's ideas to reinvent the company. So he hired him to take charge of their trading division. Trading requires capital, and as Enron continued to grow, they needed access to more and more capital which they would get through the credit markets. To remedy this issue of continuous capital needs, in 1991 they concocted a series of special purpose vehicles that were mostly financed with credit. But to legitimize them to outsiders, they did put up a measly 3% equity stake. Their gas assets were removed from the balance sheet and placed under these SPVs, and this allowed them to borrow more, since the gas assets were no longer under its control. In an attempt to further boost reported earnings per share, Skilling managed to convince regulators to let Enron adopt a mark to market method of accounting, which allowed them to record the value of securities at the close of market every day. But some of the assets they owned had values that were entirely subjective, such as the pipelines they owned, and this allowed them to book earnings that were nothing more than projected profits many years into the future. Practically every year, Skilling launched a new plan or new business simply to appeal to Wall street and appeal to the stock price. One year it might be gas distribution in Brazil, the next year Canadian paper mills. Such diverse ventures reflected his view that expertise was less critical than talent. Which is to say that Skilling believed that Enron could fearlessly enter terrain in which it had little or no experience. With its legions of consultants and freshly minted MBAs, it's as though the company wasn't an energy company, but a vast army of consultants. Let's take a quick break and hear from today's sponsors. Imagine scaling your business with technology that understands your customers. Literally. That's the story behind Alexa and AWS AI. 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Supervision at Enron was exceptionally loose, and Skilling paid no attention to the expense line, arguing that what really mattered was the entrepreneurial spirit. But of course, real entrepreneurs, like the Sam Waltons of the world, are obsessed with costs. Loanstein explains. What Skilling embraced was not the spirit of entrepreneurship, but the spirit of the stock market. And Skilling was affected by a haughty arrogance. He would embark on these daring adventures, like skydiving, you know, as if he were guided by some sort of leadership manual. He urged his employees to join him. His bravado was imitated by many on Eneron staff, and judging from the parking lot, Ferraris and Porsches were practically the company car. This level of arrogance led him not tolerating thoughtful disagreement. He gave latitude to those in his favor and was dismissive to those who doubted him, his black and white pattern of responding reflected his lack of comfort with attention to detail. But Skilling's personality internally apparently wasn't showcased to the public. As in an annual Fortune survey, Enron was voted the most Innovative company award six years in a row. The Journal of Applied Corporate Finance applauded its genius for transforming energy markets. With Enron growing swiftly, Lei declared that his goal was nothing less than to become the world's greatest energy company. In 1996, Enron's revenues were just 1/9 that of ExxonMobil. Meanwhile, they had made many acquisitions that were ill timed and unprofitable. These acquisitions left them starved for cash and its credit rating of BBB had them close to junk bond level. At the end of 1996, Skilling was promoted to the president of Enron and he worked alongside Andrew Fasto, a 34 year old vice president of finance, to pull more sophisticated financial hat tricks. They increasingly used special purpose vehicles to finance projects and borrow more money. But Faso found it pretty inconvenient that these outside entities had to control the assets in order for Enron to report them as separate and off the balance sheet. So his new solution bordered on diabolical. He decided to create a new vehicle that was separate and independent of Enron, but would be controlled by Fastau personally. This new entity would be known as Chuco, named after a character from Star Wars. Enron's law firm suggested that this was just an obvious conflict of interest that would require public disclosure, which Skilling wanted to avoid. Conflicts of interest were really a common theme in Enron's story. So they decided to structure the partnership with a protege of Fastile who was a lower ranking employee, which meant that a disclosure requirement wasn't triggered. This new entity in 1997 was created and it immediately bought an interest in a portfolio of Enron's investments, thereby keeping hundreds of millions of dollars off of Enron's books. Fastau then went on to tell the board that this new entity was an unaffiliated vehicle with outside and unrelated investors. Failing to mention his protege's role. Vincent and Elkins, Enron's law firm. They took care of the paperwork at a mere 48 hours and they wanted to get the deal closed given that Enron was their biggest client and they wanted to continue to, you know, get more business from them in the future. But to the lawyers, shareholders were just a mere abstraction. Yet it was a group that the lawyers were ultimately responsible for because it's actually the shareholders money that paid their bills. Had they seriously acknowledged the need to look out for shareholders, they may not have been so quick to sign off. And perhaps they would have discovered the troubling facts regarding Chuco. First of all, the outside equity actually didn't exist, since Fastao wasn't able to find investors for even the 3% equity required for Chuco to be considered independent. The entire purchase price of nearly $400 million was borrowed from the banks, and Enron guaranteed both the loans and the portion of the capital that was supposedly equity. So Enron was able to sell a half interest in an energy portfolio to a paper shell managed by its own employee. And in violation of every accounting standard, they kept hundreds of millions of dollars of unprofitable assets off of its balance sheet. In 1997, Enron reported a net income figure of 105 million, and Chuco accounted for around one fourth of that figure. By 1998, it was clear that the dot com rage was on. And Skilling, he came across a stock chart that showed how the dot com names all traded at these elevated PE multiples, while the rest of the market tended to trade at lower multiples. Of course, to no surprise, Skilling came to the conclusion that he wanted to be included with the rest of the dot com names. Enron decided that their Enron online division would trade broadband, which were the networks that carried Internet traffic across the country. And they'd also invest in a fiber network itself and acquire and build a system that would stretch 18,000 miles. Scaling figured that online trading or really online anything would get Enron stock really moving. After a good run for the stock in the early 90s, it had modest growth until 1997. So he really needed to create this good story to help kick the stock back into gear. And Enron's managers had a good reason to try and pump the stock price. In 1998, executives and other employees received 15 million stock options and in 1999, more than double that amount, an amount equivalent to 5% of the outstanding shares. In decades past, this would have been an unthinkable level of dilution. Enron itself also participated in the dot com mania. They had an investment in Rhythm's NetConnections, a startup that went public in April of 1999. It had minuscule revenues and of course, no earnings. But it was yet another blockbuster IPO leading to Enron's investment soaring. They weren't legally able to sell their position until the end of the year, so they were looking for some ways to hedge their clearly speculative position that could fall just as quickly as it rose. Management's next trick up their sleeve was putting together a partnership with what was referred to LJM and LJM2. I had to look up what this even was. It turns out that LJM stands for Andrew Fastow's family members. And this new entity would buy and sell assets from Enron to ensure that Enron's reported results continue to appear favorable on the surface. In one case, Enron was desperately trying to sell three barges that were generating power off the coast of Nigeria in order to boost their earnings for Q4 1999. But no one wanted them, so they contacted Merrill Lynch. They also refused. But Enron verbally promised that if Merrill did the deal, Enron would later unwind it at a profit to Merrill. So in the final days of December, with no due diligence, Merrell suddenly acquired the barges, with Enron providing the financing. And six months later, LSM2 reacquired Merrill's stake at a price that netted Merrill and the promised 15% return. Enron had to pay LJM2 a hefty fee. But as far as the public was concerned, Enron got to record a profit. And the people who were following Enron's reported numbers, they would not have had the slightest idea of the deception that was yet to be uncovered. With Enron getting into the broadband business, Skilling characteristically decided that fiber optic capacity could be traded. And Kenneth Rice, the head of Enron's broadband unit, he declared publicly that the broadband trading platform would in a few years be worth $22 billion. Wall street loved the idea of Enron trading, a commodity linked to the foundation of the Internet. So after a sharp rise in 1999, the stock rose by another 50% in the first three weeks of 2000. Enron would host a conference at the Four Seasons Hotel on January 20, 2000, to talk about their stock to the public. And as Enron executives gave their presentations, the stock was rising by the hour. Lowenstein writes. Stock analysts who didn't know broadband from baseball kept breaking from the meeting to phone their clients, urging them to buy more Enron, end quote. That day, Enron Stock rose to $67, a 25% increase in a single day. The press certainly played their part in fueling the bubble. Fortune declared that Enron had dispelled any doubt about its telecom venture even though the business was not even off the ground. The stock, of course, continued to rise. When you're in a bubble, investors need some sort of story or narrative to latch on hope to keep the game going and keep that stock price increasing. Shares of Enron then vaulted to $90 and the company was now valued at 70 billion. Now people love to talk about the dot com bubble, but I think what's also important to understand and study is the telecom bubble. And this was also taking place during the same time period back in the 90s, as the Internet was getting off the ground and gaining more and more traction. Internet traffic was doubling roughly every hundred days. And that's a 10x increase per year. Now you can only grow at that pace for so many years before the growth starts to stall out a little bit because eventually you just run out of people. So that level of growth started to slow in 1997. However, the notion of tenfold growth per year, it just refused to die. In September of 2000, WorldCom's Internet unit told the Washington Post that Internet traffic has been doubling every three months over the past five years because all these companies were throwing out these insane estimates of Internet usage. This led to the telecoms hugely overinvesting in their fiber buildout. Companies like WorldCom and Enron, they dove to the ocean floor, laying millions of miles of fiber that for the most part would remain dark. The cumulative investment marked the greatest binge in the history of private finance. In the half decade after deregulation, telecom companies borrowed $1.6 trillion from banks and enlisted Wall street to sell 600 billion in bonds. There was a huge misalignment of interest as managers of these high growth sectors were eager to increase investment and make the most of their option grants. Managers got to capture much of the upside using shareholder capital on highly risky investments. And the bankers egged them on as they got to collect fees on the capital raised. One of the companies that got caught in the spending binge was Global Crossing, who had invested in a network of 100,000 miles of fiber and and accumulated $8 billion in liabilities. In June of 2000, the CEO of Global Crossing sent a desperate memo to their chairman. I quote, like the colored salmon going upriver to spawn at the end of our journey, our niche is going to die rather than live and prosper. The stock market can be fooled, but not forever. End quote. Instead of alerting shareholders, Global's executives chose to maintain the false appearance of prosperity for as long as possible, which was a pattern that was just pervasive in the industry. To masquerade the problem, telecom companies utilized a vehicle known as a capacity swap. Carriers began to swap broadband leases for large identical sums of cash. And the money was simply round tripped Checks were being sent in both directions with no net effect, but each carrier booked its side of the swap as revenue. Around 20 public companies resorted to swaps, including AOL, Time Warner and Enron. In aggregate, they padded their revenues by an estimated $15 billion. For global, these swaps accounted for more than 20% of their revenue and virtually all of their cash flow in 2001. Worse yet, auditors of these telecoms not only were fine with the use of these swaps, but they also helped promote the use of them. Despite the concerns internally at Global, their forecasts looked more promising than ever. They promised cash flow growth of 40% in 2001, while executives sold hundreds of millions of dollars worth of shares. In aggregate, insiders within the telecom industry sold over $8 billion worth of stock in 2000 and 2001, around the peak of euphoria. Analysts were also bullish on enron. Going into 2001, the stock was near an all time high and Fortune had recently listed it as one of 10 stocks to own for the decade, as if success was a sure thing. But the more one actually dug into what was happening at Enron, the more red flags one would uncover. For example, the company reported revenues of 100 billion. But much of this revenue was from its broker business where dollars were simply passed from the buyer to the seller. Which is of course extremely generous to consider that revenue. Enron suffered from the same problem that many of the dot com players did. They had a lot of traffic, but they had little to no actual real cash profits. And as the stock was peaking, Enron executives continued to paint a rosy future, claiming that the stock was undervalued while in aggregate selling over a billion dollars worth of stock from 1999 to 2001 and collecting bonuses that were based on the high stock price they had orchestrated. A number of executives even borrowed from the companies they worked for, essentially using shareholders capital as an ATM machine. Kenneth Lay at Enron, for example, pledged his own shares to borrow over $70 million. The last red flag I would highlight is the involvement of auditor Arthur Anderson in helping keep the facade going. Arthur Andersen was central to Enron's climactic undoing. They not only audited Enron's books, but they also served as a consultant to help Enron massage their reported figures. They had around 100 employees working at the Enron headquarters full time. This represented a disastrous conflict of interest because if the auditors didn't like the direction that Enron was heading, then they risked losing the fees they earned from the consulting side of the business in the short term, of course, it was in Arthur Anderson's best interest to keep the party going. In 2000 alone, Arthur Andersen collected $52 million in fees for having Enron as a client. But finally, In March of 2001, the skeletons in the closet started to be uncovered. Bethany McLean, a young journalist at Fortune, wrote a probing piece that asked a question that was overlooked by a lot of investors. How exactly did Enron make money? Enron replied that the details were proprietary. For a company with public shareholders, it's not exactly a comforting response. During an earnings call, Enron's executives received questions on their reported results. And Jeffrey Skilling didn't help investors uneasiness. Richard Grubman, who had been short Enron, he was curious about a line on the balance sheet listed as accumulated other comprehensive income that was showed on the balance sheet. It was a negative $1 billion line item and he thought that Enron might be using the balance sheet to hide losses. Grubman thought it was suspicious that Enron was the only major financial institution that couldn't produce a balance sheet. By the end of the quarter. It was available closer to their deadline. Skilling didn't have a great answer for the investors questions during their earnings call in the spring of 2001. And this had further exposed the facade that Wall street had fallen for. Skaling was defensive and inarticulate and didn't really have answers to the difficult but important questions. In the months that followed, the stock had dropped month after month and Scaling believed that Enron's image was beyond repair. So he just resigned in August. Enron attributed the resignation as a personal decision. And Kenneth Lay reassured the public that Enron did not have any accounting issues and that they were in the strongest shape they've ever been. Kenneth Lay then received an anonymous letter from an Enron employee sharing their concerns about the future of their employment and that a wave of accounting scandals were potentially about to unfold in light of the 911 terrorist attacks that year. In 2001 the stock continued to fall and in mid October Enron disclosed a $710 million pre tax charge resulting from the termination of one of their special purpose vehicles. The market just lost faith in Enron and they didn't have any reason to believe that more write offs weren't just around the corner. Kenneth Lay was obviously disappointed in the situation he found himself in. But his colleagues were simply following the playbook that he implicitly gave them from the start. Build the stock price and massage the reported earnings. But as I mentioned, earlier, the CEO of the global telecom company Global Crossing stated, the stock market can be fooled, but not forever. The SEC launched an investigation into the special purpose vehicles. And the final domino to crack Enron was the credit agencies downgrading them to one level above junk bonds. In early 2001, the stock traded for 126 bucks and by now had already fallen by 90%. At this point, credit from the banks was what propped up Enron. And in less than a year, trust in their ability to make good on their promises had evaporated. Shortly after, they got downgraded again to junk bond level, which required them to start repaying billions of dollars of debt, which of course, they couldn't do. The stock traded down to just 70 cents and was continuing to fall. In early December, Enron filed for bankruptcy. From the moment Enron admitted to having misstated its books, Wall street and much of corporate America were never the same. The Enron scandal exposed the unvarnished greed by managers, the conspiratorial neglect by gatekeepers and the hysterical attention to share prices. And it would be foolish to think that Enron was the only one guilty. Shockingly, Enron paid $55 million in retention bonuses in the month before bankruptcy and Arthur Andersen had undertaken a concerted effort to hide the truth by shredding loads of papers. The fall of Enron showcased to many average investors that Wall street can't be trusted and that success in the stock market was based on false promises and rosy forecasts. Many small investors returned to older, cynical views of the stock market that the fat cats would always ultimately trump the little guy. The fact that Enron's executives had pocketed millions while its workers had lost more than a billion dollars in savings was agonizing. So for the first time in a decade, average investors pulled money out of equity mutual funds and rediscovered a love for bonds. By Christmas of 2001, the economy entered a recession for the first time in 11 years. And it was then clear that the reckless optimism from the 90s had been extinguished by the terrorist attacks of 911 and the downfall of Enron. A few months later, not too long after, Global Crossing followed in Enron's footsteps and also filed for bankruptcy. It was then the SEC's time to make changes to prevent similar catastrophes from occurring in the future. One of the first proposals was to separate auditing from consulting and require that audit partners must rotate every five years to prevent cozy auditor relationships. At the end of July, the Sarbanes Oxley act was signed into law, which was the fullest and the most significant tightening of securities laws since the Great depression. It required CEOs and CFOs to personally certify the accuracy of financial statements in the effectiveness of internal controls, making them legally accountable for fraud. Sarbanes Oxley zeroed in on issues related to accounting. The adult committee of the board, not the management, had responsibility for appointing the outside auditor and for overseeing the audit. And the SEC also required to create a new board that would oversee public accountants, adding more standards related to auditing, quality control, ethics, etc. Other provisions were drafted with bad actors exactly like Enron in mind. These new laws did not prevent the stock market from continuing to fall as Lowenstein described 2000 as the year of the locusts. 60 telecom companies had failed, new IPOs had come to a standstill, investment in American businesses had plunged, and consumer confidence fell to a 10 year low from peak to trough. The S&P 500 fell by around 50% from the spring of 2000 to the fall of 2002, the Dow fell by 40% and the NASDAQ fell by an astounding 78%. This was the largest slide by a major index since the Great Depression. Around $7 trillion of the public savings had evaporated, Loenstein explains People demand an explanation for crashes, but their origins are invariably to be found in the boom years that precede them. The collapse of communism at the end of the 1980s and the daunting advances made Silicon Valley throughout the 90s gave a public a heated appetite to invest in shares and ultimately to speculate. End quote. Greed got the best of investors, managers and Wall street insiders. With the booms and busts that come with markets, it's inevitable that it will bring a wave of speculators. But what's more disappointing about the dot com bubble was the abuse to the average investor by corporate and Wall street insiders, which brought about a widespread distrust of the stock market overall. Events like these highlight the importance of becoming truly knowledgeable about investing rather than blindly following hype or headlines. As a host here at the Investors Podcast Network, I'm very passionate about helping increase financial literacy for our listeners and help educate people to build a strong foundation of knowledge so they can really better protect themselves from the market manias and fraud and make investments that are rooted in real value rather than speculation, which is something that is just so prevalent in today's financial landscape. I think it's important to highlight one of the important differences between stocks and a number of other assets. You know a stock is intangible meaning that we can't touch it, we can't eat it, we can't live in it. And the price of a stock depends on what the future holds for the underlying business or what the future is perceived to hold. But for a house, people generally purchase a house to live in it. People might purchase a stock believing that they hold share in what will become the greatest company in the world, but no one purchases a house believing that it will someday become a castle. And since stocks can be traded about every single day, this leads to people speculating on where the price of a particular stock is heading, which brings about more bubbles and crashes than what you tend to see in other assets. This would inevitably lead to bad actors taking advantage of the inherent nature of stock prices and their dependency on the perception of the future, such as what happened at Enron. Thankfully, the SEC took action to hold managers more accountable to the information they were sharing with the public and requiring officers to personally sign on the information, which would hopefully lead them to give pause in error on the side of caution. But how we're wired as humans hasn't fundamentally changed since then, so we can use these events from the past as opportunities to hopefully avoid such catastrophes in the future. In light of these disastrous events from the dot com bubble and crash, I wanted to leave our listeners with a few lessons and reminders. The first lesson is that it's most often new technologies that lead people to drop the timeless investing principles like understanding the value of what you're buying, not falling prey to fomo, and understanding what you own. The hot technology as of today is of course AI, but really this could apply to any new technology. Second relates to the downfall of Enron. A company's downfall can seemingly happen overnight, so you have to do the work early. If the business feels like a black box or management continues to pump the stock whilst personally selling their shares, then that should give you reason to either dig deeper or just avoid it altogether. Third, be wary of managers using their position in the company solely to enrich themselves. Now, I'm all for managers who actually add value to the firm and you know, are well compensated as a result. But if they're doing what they do just for the money, then they may not be the right person for the job. There's a saying that you're never going to beat somebody who's just obsessed with what they do. And when executives are motivated by genuine dedication rather than personal gain, shareholders typically get far better outcomes than when a company is led by someone you know just trying to get their slice of the piece of fourth. Eventually the market will recognize the true underlying value of an asset. When the value of stocks that are in the next new technology are just quickly rising, it can be tempting to hop along for the ride, even though you know in your gut that these stocks are overvalued. I personally felt this way back in 2021 buying stocks like Shopify, which taught me this lesson the hard way. In order to be successful as an investor, you need to stay disciplined with your process and not get too carried away with the craziness happening around you. Even great ideas can be terrible investments when you pay the wrong price for them. The Internet was transformative. Amazon, ebay, and Yahoo, they were onto something big. But extraordinary technologies don't justify infinite valuations. A great company can be a disastrous investment if you overpay Lastly, I just wanted to share that we should likely be a bit wary of stock options. While they're often framed as aligning managers with shareholders, they can just as easily encourage reckless risk taking when executives have little to lose but a lot to gain. Options also dilute existing shareholders, and they can create incentives to prioritize short term increases in the stock price over long term value creation. In many cases, managers who buy shares with their own money behave far more responsibly than those who simply receive options as a part of their compensation package. So that wraps up today's episode on the Origins of the Crash by Roger Lowenstein. If you'd like to pick up the book, I'll be sure to get that linked in the show notes. It's a great reminder that while the market environment is always changing, human behavior rarely changes, and understanding these past cycles can make us far better investors going forward. So with that, thanks a lot for tuning in and I hope to see you again next time.
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Host
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