Investing in Technological Revolutions
A technological revolution is a big deal. It modernizes all existing industries, increasing the full spectrum of economic productivity. It can be easy to get caught believing that today’s most successful industries and companies are unlike anything we’ve ever seen before. . However, 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.
This repeated pattern was summarized in a model proposed by Carlotta Perez in her book, Technological Revolutions, and Financial Capital. The model states that first, there is an eruption of the revolution resulting from incremental advances and innovations that culminate in technology with the capacity to increase the economy’s productivity and the financial capital to support it. The eruption is then followed by two or three decades of the new technology being installed in the economy.
The installation phase of the new technology can be very turbulent, due to the fact that the newly emerged technology divides the economy into the old and the new, creating social and economic divisions, regulatory turmoil, and wealth inequality. The installation period has historically been accompanied by what Perez calls 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 through 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 lower returns for investors. These bubbles are empirical facts in the historical data that cannot be ignored when talking about investing in new technological revolutions. Examples of these major technology bubble trends include; The surge of development and canal mania which was followed by a canal bust. Railway mania which was followed by a railway bust. The infrastructure boom of the late 80’s followed by several busts, the roaring ’20s and in the Great Depression, and lastly, the surge of IPO’s in the Internet bubble ended in the tech crash.
The concept of a bubble used by Perez is convenient and easy to understand. Investors tend to get a frenzy about the potential of high profits from the new technology.
In the 2004 paper, Was there a Nasdaq bubble in late 1990? Lubos Pastor and Pietro Veronesi prove mathematically that higher uncertainty regarding t the average profitability of the companies creating new technologies leads to higher prices, all else equal. When an exciting new technology company is being tested, there is a huge range of potential outcomes. Could the company be the next Microsoft? Perhaps or perhaps not.
We should always keep in mind 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 historical records show in the fifth edition of Jeremy Siegel’s book, Stocks for the Long Run, Siegel offers the example of the S&P 500 Index.
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 IPO’s and venture capital explains 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 I IPO’s, 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. Whether we interpret the empirical reality through the lens of frenzied, irrational investors paying too much for expected growth or rational investors assessing highly uncertain future payoffs, the historical record remains the same. Counterintuitively, investing in declining industries or more generally, companies with low prices have produced reliably better outcomes. But every time a new technology or industry creates new opportunities for financial capital, investors flock to it with seeming disregard for the historical record and the theory predicting similar outcomes in the future.
