Capital market myopia

Abstract

The purpose in writing this article is to focus attention on a phenomenon we call capital market myopia, a situation in which participants in the capital markets ignore the logical implications of their individual investment decisions. Viewed in isolation, each decision seems to make sense. When taken together, however, they are a prescription for disaster. Capital market myopia leads to overfunding of industries and unsustainable levels of valuation in the stock market. We use the Winchester Disk Drive industry to elucidate the phenomenon. We argue that capital market participants should have seen the problem coming. They should have known that valuation levels were absurd, based in large part on the greater fool theory. The data necessary to anticipate the problem were readily available before the industry shakeout began and stock prices collapsed. There are several lessons which we believe can be learned by careful examination of the disk drive experience in the period under study. These include: Taking the Broad View of the Industry is the Key to Profitable Investment. The investment mania visited on the hard disk industry contained inherent assumptions about long-run industry size and profitability and about the future growth, profitability and access to capital for each individual company. These assumptions, had they been stated explicitly, would not have been acceptable to the rational investor. Certainly there are valuations which arise which cannot be justified under any circumstance. These are the times for the manager to raise money from the public capital markets. Those managers who took advantage of unsustainable valuation levels now have a chance to survive the shakeout. Growth Is Not Equivalent to Profitability. The high growth rate in the industry made it the focus of considerable managerial, investor and technological attention. The industry attracted so many resources that the growth had high probability of being unprofitable. Excesses in the capital market turned an opportunity into a disaster. Profits For Some Are Not Equivalent to a Good Business. Many players made high profits by investing in the hard disk drive business, including the investment bankers and certain of the venture capital groups which invested early enough to “catch the wave” of euphoria in the stock market and still sell under Rule 144. Many others rode the cycle up and down without liquidity. For many buyers of disk drive stocks in 1983, losses were massive. Short-term successes of some gave the illusion of long-term profitability for all. Investors should not be fooled by such invevitably ephemeral successes. Market Instability Can Be All Bad News. Very rapid change often creates entrepreneurial opportunity: it also creates risk. Analysis of the hard disk drive industry reveals the dark side of rapid technological evolution and of customer instability. Early players are often preempted by changes in technology and in customer needs. Early birds are not always winners in product markets, but late comers are almost always losers. Recognizing the Chain. One of the more important lessons to be learned from the tale of the disk drive industry is that all players—entreprenuers, venture capitalists, investment bankers, industry analysts and investors—must recognize the chains involved in such a process. First, there was a technological chain, a series of bets on technological advances in disk drive components, disk drive designs, and end-user designs. Then, there was a financial chain, a series of related bets on the internal financial health of each player in the technological chain and on the nature of access to capital in the private and public markets. The likelihood that any player in the disk drive industry would prosper without a serious setback due to a weak link was effectively zero. Indeed, weaknesses in the chain were created by exactly the same people whose financial success depended on an unbroken series of favorable outcomes. During this same period, the public capital markets were also a large supplier of funds to the disk drive industry. The total amount of money raised in public offerings of common stocks for participants in the industry was over $800 million. During the middle part of 1983, the capital markets assigned a value in excess of $5 billion to 12 publicly traded, venture capital backed hard disk drive manufacturers. The strong market valuation of these companies paralleled the boom in other high technology stocks and rising valuation levels in the stock market in general. Table 2 contains data on stock prices and valuation levels for some disk drive manufacturers, and Table 3 provides general data on the economy and capital markets.