CASE STUDY

THE DOTCOM BUBBLE

Prepared By:
Vansh Khanuja
Vanshkhanuja78@[Link]
June 27, 2021
PREFACE
The Dot-com bubble was a result of excessive
speculation. With the advent of the Internet and various
other technological advancements, people forgot the
basic investment principle that the price you pay today
will decide how much you can earn. People often forget
such simple things when greed takes over.
Philip Fisher, the legendary investor once said
“The stock market is filled with individual who know the
price of everything but the value of nothing.”
This quote aptly represents the mindset of people during
the dotcom mania. In this case study, I will explain what
caused the dotcom mania and what lessons an investor
can learn from it.
TABLE OF CONTENTS
1. The Dot-com Bubble
• Introduction
• Causes
• Valuations during the bubble
• The Burst and the Aftermath
2. Lessons for the investor
• Fear and Greed
• Price vs Value
3. Appendix
A. How technology affected investing
B. How can financial experts lose money in bubbles
like this?
4. References
 (1) THE DOT-COM BUBBLE
INTRODUCTION
“The internet bubble circa 2000 is the most extreme in
modern capitalism. In the 1930s, we had the worst
depression in 600 years. Today is almost as extreme in
the opposite way.”
- Charlie Munger
The dot-com bubble was caused by excessive speculation
during the late 90s, the advent of the internet caused
people to speculate in technology stocks which fueled
the prices of every company related to tech. The
valuations were really high and triple digit price-earnings
ratio were common. These high valuations were justified
by the concept of a world where internet will change
everything. People believed that the companies are
losing money in the short run and would be profitable in
the years to come. The fear of missing out on the
opportunity made people who do not even understand
the stock market, invest in it. This kind of behavior is a
typical bubble situation. Suddenly, everyone was smarter
than Warren Buffett.
CAUSES
“Stock market bubbles don’t grow out of thin air. They
have a solid basis in reality, but reality as distorted by a
misconception”
-George Soros
If I had to sum up the cause of the dotcom bubble (or any
bubble), I will describe it in just 4 words:
“Fear Of Missing Out”
A bubble is a self-reinforcing cycle, someone looks at an
investment and believes the payoff is huge. This investor
earns a lot of money due to which, several investors join
the party (Until now the price are low making potential
returns high).
When a lot of people start making money by following a
particular kind of investment, everyone wants to join in.
If you look at your neighbor driving his/her new high-end
car he/she earned by investing in a particular kind of
investment, you will be excited too. This creates an
environment where the original rationale behind the
investment if forgotten. Some people originally invest
because of the prospects of the investment, this is called
investing. But in the later stages of the bubble, people
start buying because the prices are going up.
If you buy a stock trading at 100$ because you think it
can go to 150$, you will never make money, this is called
speculating. But this is what exactly happens in a bubble.
You will earn some profits in the short run but here the
greater fool’s theory is in play.

“The greater fool theory argues that prices go up

because people are able to sell overpriced securities to a
"greater fool," whether or not they are overvalued. That
is, of course, until there are no greater fools left.”
Source: Investopedia
Microsoft was very huge (not only in terms of market
capitalization but also in revenues and profits) just
before the dotcom bubble. Many investors who
purchased the stock earned great profits. This instilled a
fear in people of missing out the next ‘Microsoft’.
Everyone wanted to be a part of the next technology
startup. People forget the basic investment principles at
times like these.
The Mosaic web browser was released in 1993 and
subsequent web browsers during the following years
gave computer users access to the World Wide Web,
which popularized the Internet. Between 1990 and 1997,
the percentage of households in the United States
owning computers increased from 15% to 35% as
computer ownership progressed from a luxury to a
necessity (Source: Wikipedia). This marked the shift to
the Information Age, an economy based on information
technology, and many new companies were founded.
At the same time, a decline in interest rates increased
the availability of capital. The Taxpayer Relief Act of
1997, which lowered the top marginal capital gains tax in
the United States, also made people more willing to
make more speculative investments. Alan Greenspan,
then-Chair of the Federal Reserve, allegedly fueled
investments in the stock market by putting a positive
spin on stock valuations. The Telecommunications Act of
1996 was expected to result in many new technologies
from which many people wanted to profit.
 VALUATIONS DURING THE BUBBLE
"High Valuations entail high risks”
-Benjamin Graham
The valuations during the dotcom bubble were sky-high.
Between 1995 and its peak in March 2000, the Nasdaq
Composite stock market index rose 400%.

SOURCE: Wikipedia

The new normal way of investing was to not look at

earnings but to rather focus on the story. Any company
having dotcom in its name jumped up in price. The
venture capitalists were eager to invest because they
were essentially betting that they can earn huge sums in
the long run. IPOs of many technology companies
fetched billions. Companies were going up in prices (in
multiples) the first of their listing.
For instance, a company called Priceline was founded by
Jay Walker. Thousands of airline seats were going unsold
every day. Priceline offered these seats to online
customers who could name the price they were willing to
pay. Consumers got cheaper flights and airlines sold
excess inventory and Priceline took a cut for facilitating
the process.
Launching in April 1998, Priceline was a dot-com
“overnight success,” growing from 50 employees to more
than 300 and selling more than 100,000 airline tickets in
its first seven months of business. By the end of 1999, it
was selling more than 1,000 tickets a day. It attempted to
expand into hotel bookings, car rentals, home
mortgages, and Walker’s intention was to take the
Priceline idea to every applicable market.
In March 1999, Priceline went public at $16 a share. On
its first day of trading went up to $88, before settling at
$69. This gave Priceline a market capitalization of $9.8
billion, the largest first-day valuation of an internet
company to that date. Few investors were concerned
that in its first few quarters in business Priceline racked
up losses of $142.5 million. Or that it had to buy tickets
on the open market — at cost — to fulfill customers
lowball bids, losing, on average, $30 on every ticket it
sold. Or that Priceline customers often ended up paying
more at auction than they could have paid through a
traditional travel agent. Investors were more interested
in grabbing a piece of a company that was going to
change the future of business.
Source: [Link]
Venture capitalists were focusing on the IPO of the
company. Here is an explanation of how everything
worked:
The year is 1999, you have an excellent idea about a
tech startup. You want money to fund your idea and
make it a reality so you approach a Venture capitalist.
Suppose you say that you need 10 million USD, the
venture capitalist would be very happy because your
company can be sold for billions in the public market.
When you go public, you the venture capitalist sells his
stock for a huge profit. The public then observe the rise
of your company and is willing to purchase the stock at
any price. The company has a lot of money (raised by
several venture capitalists and money raised in the IPO)
but the reality of your company is that it’s a cash
burning machine. You report losses quarter to quarter
but people still invest because the stock price is going
up. People who have shorted your stock loses their
investment even though they were fundamentally right
because the party is not yet over. You are worth at least
a few million dollars because of your share in the
company. This goes on and on for a long time until you
ultimately file for bankruptcy or the public sentiments
about the stock market changes (You cannot raise more
stock easily during a bear market).

This explanation explains most of the companies during

the dotcom era, there were many great companies that
were genuinely capable of something great and many are
still active today like Microsoft, Apple, Amazon, etc. The
point is that you cannot differentiate between a good
and a bad company when the overall market is too
optimistic. High valuation persists for a long time and you
might judge your analysis based on prices.
THE BURST AND THE AFTERMATH
“A pin lies in wait for every bubble. And when the two
eventually meet, a new wave of investors learns some
very old lessons: First, many in Wall Street (a community
in which quality of control is not prized) will sell investors
anything they will buy. Second, speculation is most
dangerous when it looks easiest”
- Warren Buffett
On Friday March 10, 2000, the NASDAQ Composite stock
market index peaked at 5,048.62. But on March 13, 2000,
news that Japan had once again entered a recession
triggered a global sell off that disproportionately affected
technology stocks. Barron’s featured an article on March
20,2000 titled ’Burning Up’, warning investors that
Internet companies are quickly running out of cash,
which predicted the imminent bankruptcy of many
Internet companies. This led many people to rethink
their investments.
That same day, MicroStrategy announced a revenue
restatement due to aggressive accounting practices. Its
stock price, which had risen from $7 per share to as high
as $333 per share in a year, fell $140 per share, or 62%,
in a day. The next day, the Federal Reserve raised
interest rates, leading to an inverted yield curve (a yield
curve in which short term bonds have higher yield than
the long-term ones).
On April 3, 2000, judge Thomas Penfield Jackson issued
his conclusions of law in the case of United States v.
Microsoft Corp. (2001) and ruled that Microsoft was
guilty of monopolization and tying in violation of the
Sherman Antitrust Act. This led to a one-day 15% decline
in the value of shares in Microsoft and a 350-point, or
8%, drop in the value of the Nasdaq. Many people saw
the legal actions as bad for technology in general.
On November 9, 2000, [Link], a much-hyped
company that had backing from [Link], went out
of business only nine months after completing its IPO. By
that time, most Internet stocks had declined in value by
75% from their highs, wiping out $1.755 trillion in value.
The September 11 attacks accelerated the stock-market
drop later that year. Investor confidence was further
eroded by several accounting scandals and the resulting
bankruptcies, including the Enron scandal in October
2001, the WorldCom scandal in June 2002.
By the end of the stock market downturn of 2002, stocks
had lost $5 trillion in market capitalization since the
peak. At its trough on October 9, 2002, the NASDAQ-100
had dropped to 1,114, down 78% from its peak.
After venture capital was no longer available, many dot-
com companies ran out of capital and went through
liquidation. Supporting industries, such as advertising
and shipping, scaled back their operations as demand for
services fell. However, many companies were able to
endure the crash; 48% of dot-com companies survived
through 2004.
Several companies and their executives, including
Bernard Ebbers, Jeffrey Skilling, and Kenneth Lay, were
accused or convicted of fraud for misusing shareholders'
money, and the U.S. Securities and Exchange Commission
levied large fines against investment firms including
Citigroup and Merrill Lynch for misleading investors.

[The information above has been taken from Wikipedia,

although I've provided it in the references, but I'm
mentioning it here too because some paragraphs are
copied exactly as they appear in Wikipedia’s website]
 (2) Lessons for the investor
FEAR AND GREED
“Be fearful when others are greedy and be greedy when
others are fearful”
-Warren Buffett
Unjustified optimism caused greedy investors to pay high
prices for cash burning companies. If you were afraid
about the tech stocks and only focused on undervalued
opportunities available in the neglected industries during
that time, you would have performed very well in the
long run. If you were greedy like the others, you would
have to time the market to perform well. This means
relying on luck rather than analysis.
Although there is an element of luck in any investment
decision, a well performed analysis can greatly place the
odds in your favor. Legendary investor Charlie Munger
once said: “You’re looking for a mispriced gamble. That’s
what investing is. And you have to know enough to know
whether the gamble is misprices. That’s value investing”.

What Mr. Munger is trying to say here is that investing is

a job of getting odds in your favor through analysis. The
people who didn’t do their due diligence before buying
into tech dreams of late 90s were punished later when
the prices tumbled. This was not surprising because
stocks cannot go up forever. A classic mistake an investor
make is to not look at numbers.
A stock selling at 50$ might get to 100$, that does not
sound like a big jump (relatively), but consider the same
stock having a market cap of USD 1 trillion. For this stock
to jump from 50 to 100 means an additional 1 trillion of
value being created. When you go through the numbers,
you can understand the prospects more realistically.

Example) If a company selling for 700 billion is promising

to be the leading automotive company in the coming
years, is it worth buying? NO! If the company successfully
becomes the global leader in automotive segment, then
still the growth is already discounted in the price.
This explains the greed of investors, they will buy just on
the prospects of growth that might have been already
discounted in the price. But they a few of them actually
come out as winner (in the short run) because some
greater fool is still buying.
PRICE VS VALUE
"Long ago, Ben Graham taught me that price is what you
pay; value is what you get. Whether we’re talking about
stocks or socks, I like buying quality merchandise when it
is marked down.”
-Warren Buffett
The best time to buy the tech stocks was after the
market crashed. Some people do not understand the
simple fact that falling prices aren't necessarily a bad
thing because they are too inclined on short term results.
Price of the stock does not indicate it’s value. Every
investor should try to calculate the value of a stock and
compare it with the prevailing price. This is important
and not that complicated in practice. At least, finding
overvalued securities should not be that difficult. You
know a company losing cash every year but still priced at
billions is definitely overvalued.
Price and value are the basic elements of investing, you
should be able to differentiate between the two. Take
advantage of falling prices as well as rising ones. An
investor buys from the pessimists and sells to the
optimists.
 (3) Appendix
A. HOW TECHNOLOGY AFFECTED INVESTING
“If your business is not on the internet, then your business
will be out of business”
- Bill Gates
The technological advancements made during the
dotcom era changed a lot of things. For instance, the
newspaper industry faced rapid changes.
The competition was fierce because now there was a
platform to do business online. The capital expenditure
required to set up a business was greatly reduced. Now
anyone could have created an online shop and sell his
products directly to the consumers. Mark Zuckerberg
created Facebook and introduced a new concept of
connecting with people. This would not have been
possible in a world without the internet.
Thus, the internet created a lot of opportunities for
people. Overall effect of the internet has been positive in
my opinion. But when it comes to investing, a few things
have changed.
People now have access to data a lot easily than in
Graham’s time, this makes undervalued securities rarer.
People are now able to assess the data of any company
within seconds.
But these changes won’t affect human behavior, there
are still undervalued opportunities available to the
investor willing to search. The major change has occurred
in businesses. In order to scale up your business,
connecting with the internet is essential. Those who
didn’t adapt to the change perished. Competition has
also increased a lot.
Microsoft could not beat Google (google at the time was
not so big) in the mobile operating systems. This meant
that investor needed to be extra cautious. Many changes
like these makes it harder for investors to successfully
predict what the next 20 years are going to look like.
These reduces the number of companies where we can
easily place our money knowing that technology won’t
adversely impact the company.
Warren Buffett invested heavily in Coca-Cola because he
knows that internet will not change soft drink industry.
So far, he’s investing decision proves to be extremely
rewarding, if you’re an investor, you should be on a
lookout for companies whose economies you can predict
with some precision.
 B. HOW CAN FINANCIAL EXPERTS LOSE MONEY IN
BUBBLES LIKE THIS?
“Wall Street people learn nothing and forget everything”
-Benjamin Graham
The financial experts are expected to never lose money
in situation like this. After all, they are the experts. But as
it turns out, they lose as well. Reason?
The short-term thinking forces the financial experts to
get involved in stocks like these as well. The Fear of
Missing Out affects everyone equally.
The short-term mentality is due to the public as well.
For example)
Consider two mutual funds A and B.
A invests in value stocks that can return 15% but in the
long term. But temporarily, it remains down for the first
year by 20%. Meanwhile, B invests in junk-bonds (high
coupon bonds with low credit ratings) with coupon rates
of 15%. The bonds B invest in pays off the interest for 5
years but then due to bankruptcy, sells for only 5 cents
on a dollar.
In the example above, A’s first year return would be a
negative 20%, while B would earn 15%. An investor
looking merely at numbers would prefer fund B over A.
After 5 years, A’s return would be 100% cumulative (15%
compounded over 5 years) while investors in B would
lose 20% cumulative (5 years interest = 5*15 = 75, and
net realizable value of the bonds at 5. This adds up to 80,
making the total loss 20%).
This example was a bit detailed, but it accurately reflects
why mutual funds have a short-term strategy. People
would never invest in funds that outperform the market
by a wide margin. The fear that investors would divest
their money will inadvertently make mutual fund
managers (and other financial managers) to adopt a
short-term strategy.
This forces financial managers to invest in the same
securities like others. I am not saying that it’s the
investor’s fault, it’s a system which just works the way it
works. Everything works in cycles. To protect yourself,
trust your analysis and be invested for the long term.
Don’t get swayed away by the euphoric perception of the
market by the general public.
 (4) References

• Wikipedia: Dotcom Bubble. [Online] 2021. Available

from [Link]
• Investopedia: Dotcom Bubble [Online] 2021.
Available from
[Link]
[Link]
• [Link]: Dotcom Bubble [Online] 2021. Available
from [Link]
the-dot-com-bubble-of-2000-and-how-it-shapes-
our-lives-today/
• GRIN: Dotcom Bubble [Online] 2021. Available from
[Link]

(Accessed 28th June, 2021)