Irrationality in Public Markets
Having completed the business plan and a first round of financing, entrants into a new segment of the telecom market typically sought a public offering. At this point, the third reinforcement of irrational exuberance emerged: the equity markets. (See Exhibit 3.)
An interesting example of this behavior can be found in the U.S. CLEC industry. In the middle of the telecommunications bubble, the conventional wisdom of operators, reinforced by equity research analysts, was that a new carrier’s market capitalization was driven directly by the number of markets in which the service was launched. Similarly, stock value was related primarily to capital expenditures on plant, property, and equipment. This premise put pressure on companies to “land grab” across multiple markets, without regard to customer acquisition, revenues, and profits.
Another irrationally exuberant mechanism reinforced by the stock market is what we label the “consistency of strategy” story. During the telecom frenzy, operators tended to allocate resources beyond the optimal level in a new business in order to send a “signal” to the stock market regarding their consistency in executing a given strategy. If the market perceives the new investment as consistent with the original strategic intent, it will reward the operator with a higher market valuation, even if the investment does not necessarily yield a positive return to shareholders.
In this process, sell-side research acts as a primary reinforcement vehicle, since equity analysts in investment houses are generally those who interpret the signals sent by public companies in terms of their strategy and implementation. This effect also supports Professor Shiller’s notion that, in many cases, a narrative (also referred to as “the investment story”) trumps analysis.
We have observed these kinds of investments particularly in cross-border market expansions, in bidding for the acquisition of controlling interests in privatized telecommunications companies, and in spectrum auctions. For example, in 1991, now-defunct GTE purchased a controlling share of the privatized Venezuelan monopoly CANTV. GTE’s bidding price of $1.89 billion represented a 29 percent premium over the $1.47 billion Bell Atlantic/Bell Canada bid.
If information about the carrier’s performance is publicly available to all bidders, what explains the spread between the first and second bids? The privatization sale occurred at a time when GTE was aggressively trying to expand overseas. Having lost several privatization bids to competing foreign entrants, GTE management considered it necessary to send a signal to the markets that it had decided to invest overseas and that it was delivering against that strategy. This last factor was entirely external to any rigorous analysis of the return on investment and the rational bid that would result from it. The opportunity to signal to financial markets, which were rewarding consistency, appeared to be the primary driver.
The fact is that in the telecommunications industry, the markets tended, at least throughout the bubble period, to rely on stories spun on specific investments rather than information about demand, supply, and the returns on a specific investment. Although the basic information existed, the analytics that were needed to pull together the required conclusions were not carried out. In this context, the markets reacted positively to the investment story, feeding back a reinforcement of irrational behavior. Public markets also fed back irrational exuberance to private sources of funding. The astronomical market valuations drove the private equity funds and lenders to support untenable telecom business plans.
Is Exuberance Schumpeterian?
An exploration of the factors that drove irrational exuberance in telecom leads to an important question: Can the behavior of investors be avoided, or is it, in fact, intrinsic to the process of creative destruction identified by Joseph Schumpeter? In other words, should we look at irrational exuberance as a situation to be avoided — or might it be a fundamental component of economic development and growth?