Scott Maxwell: Where Will You Be When the Next Bubble Pops?

In 1998, I received a request from the CEO of Putnam Investments to lead an Internet strategy project. had gone public in 1997, and there was a concern within most companies that the Internet would disintermediate their distribution channels similar to what was happening in the book retail industry.

From a financial services perspective, E-Trade appeared to be outflanking the industry by offering trading over the Internet, and many of the senior investors at Putnam thought that we should be doing the same thing (Putnam historically sold its investment products through financial advisors).

The broader issue at the time was how Putnam could capitalize on the Internet.

As a former McKinsey & Company consultant, I was well trained on fact-based analysis, so I led a team to sort out what was going on with the Internet and how it could be used strategically. We did deep analysis on each of the major Internet companies and created and evaluated several scenarios for how Putnam could incorporate the Internet into its strategies.

Our conclusions were that the Internet was a powerful new interactive communications channel, but the fundamental economics of the Internet were being dramatically outpaced by the valuations that were being paid for the “dotcom” companies. We even did some analysis that showed what the future would need to look like in order to support those valuations.

In essence, most companies were chasing “eyeballs,” but the eyeballs weren’t paying the bills.

Our strategy work led some Putnam initiatives to better use the Internet to automate workflow and communicate with Putnam’s financial advisors and end-customers. But dramatic strategy changes like copying E-Trade quickly died on the vine: they made no sense for Putnam.

A few months later, in early 1999, the head of Equity Investments at Putnam asked me to speak to the Growth Investment team at their annual offsite. I thought that this would be a pretty interesting conversation given my strong point of view.

The basic points I made at the meeting were:

– Some of the economic models of the “dotcom” companies were attractive, but many were not economically viable.
– The valuations for the companies could not be supported by the fundamental economics and there were no reasonable projections that we could come up with that would support the valuations.
– The potential for increased valuations would probably rest on the “greater fool” theory of investing (in essence, the price would go up if there was a fool that would purchase the stock at a greater price).

The growth investors at Putnam clearly did not agree with me. We had a raging debate for an hour that I had great fun with, as I knew all the facts and had a really strong conviction that I was right. They had similar facts and were equally convinced that the world was different — that the Internet revolution was fundamentally going to change things. It was one of the best raging debates I have ever had, and it was 25 really smart and successful investors versus me.

For the next year, I pretty much looked wrong. The valuations continued to go up, the growth investors continued to go long beta (some had returns of over 100% for the next year), and I started to wonder if I was missing something. I actually ended up leaving Putnam in early 2000, right around the time of the market peak, to find out.

Of course, everything ended badly, with the peak valuations taking place in early 2000 and then the bubble deflating over the next couple of years.

The growth investment group at Putnam (and everywhere else) lost their investors a lot of money. The Putnam team is no longer there, the assets under management of Putnam have fallen dramatically, and their reputation in the market suffered for many years.

E-Trade had a stock adjusted valuation of $577 in April 1999 and is now trading in the low double digits. had a stock adjusted valuation of $105 in April 1999 and, post crash, did not get back to that level for over 10 years.

Is it different this time?

In the private equity markets, there are many signs that a new bubble is developing. One of the biggest signs is that more and more market participants think things are different this time around.

And things are different this time. There are more people using the Internet, more transactions online, and more sophisticated products and teams that continue to innovate at an increasing pace. Things are very clearly different, but are they different enough to support the increasing valuations?

My sense is that the more people that think so and believe the increased valuations are fair, the more the bubble will grow. There simply won’t be anyone left throwing buckets of cold water on the over-exuberant investors.

My thoughts this time are similar to last time, although it is still too early to tell. The data is not easily available since the valuation bubble seems to be forming in more private companies than public ones. That said, I suspect the following points could turn out to be true (note the similarity to last time):

– Some of the economic models of the Web 2.0 companies are attractive (particularly Facebook, Zynga and Groupon from what I understand), but many are not economically viable as they have limited or no sources of revenue.
– The valuations for the companies are not supportable by the fundamental economics and there may not be reasonable projections that would support the valuations.
– The potential for increased valuations could rest on the “greater fool” theory of investing.

If valuations continue to grow at a greater pace than the underlying economic fundamentals, it will clearly lead to a bubble. It could change, but my sense is that we are moving in this direction and that the bubble will grow and then pop. The last bubble kept growing for a year after my meeting with the Putnam growth investors, and this one could go on for a year or longer as well.

The question is, where will you be when the bubble pops?

EDITOR’S NOTE: We reached out to Putnam Investments for this piece, and this is what they had to say: “Given the references are well over a decade old, we are not in a position to corroborate accuracy, validity or context.”

Scott Maxwell founded OpenView Venture Partners in 2006 and has worked in venture capital for over 11 years. For more insight from Scott, you can visit his blog and follow him on Twitter @scottsnews. Opinions expressed here are entirely his own.