Investment in new technologies has always been risky. Older innovations, like railways, canals, telephones, cars and aeroplanes, resulted in substantial losses for many investors. The uncertainty surrounding the projects, lack of understanding of the technology and unrealistic return expectations were all contributors. Recent technology investment cycles are similar, though there are additional risks.
First, the financing model has changed. Patient capital has been replaced by a focus on quicker returns.
Historically, government funding for research was important. Public money funnelled through the Pentagon helped develop the internet. A National Science Foundation grant seeded development of Google’s algorithmic search engine. Publicly funded venture capital provided great societal benefits as well as large profits for private businesses. In recent years, research funding has declined in real terms in many nations due to increasing public finance pressures.
Large-scale, long-term corporate investment in pure research and development in basic science, has declined. Researchers working at Bell Labs, an American research and development company, helped develop radio astronomy, the transistor, the laser, the charge-coupled device (CCD), information theory, the UNIX operating system, the C programming language and the C++ programming language. Palo Alto Research Centre (“PARC”) contributed innovations such as the personal computer, the laser printer and the graphical interface. This type of investment funded by often monopolistic, highly profitable businesses is less likely to be made in an environment of short-term shareholder value maximisation.
Today, entrepreneurs, backed by venture capital or angel investors, favour disruptive technologies, with limited long-term growth and productivity potential. They hope to extract short term monetary value by selling out to an incumbent or the public through an initial public offering of shares.
Second, the few successful businesses that emerge then engage in a further destructive process, investing profits from their high-margin primary products into risky, speculative projects, sometimes with very large investment needs. It is like using a large, lucky lottery win to purchase tickets in new lotteries, ignoring the statistically infinitesimal chance of a subsequent success.
Alphabet has used the profits from its Google search business in this way, looking for a second profitable product – its self-titled “moonshots”. These projects include related activities like high-speed internet provisions and smart household devices. It also encompasses more ambitious projects like high-altitude balloons to provide internet access around the world (Project Loon), self-driving cars and space explorations. There is no certainty that any of these investments will prove successful or over what time frame. In 2015, the projects lost around $3.6bn.
These two factors affect technology investments in several ways.
Safer proposals are likely to receive funding rather than uncertain but potentially ground-breaking areas. Increasing reliance on corporate investment or sponsorship accentuates applied research rather than basic, pure research. Crucial fundamental knowledge is now neglected.
Returns may be below expectations as the new technologies are rarely the sought-after game changers. Quantum physics makes silicon chips possible. Einstein’s theory of relativity underlies satellite navigation systems. Abstract mathematics allows computers and telecommunications. In contrast, Uber and Airbnb are ultimately a car and accommodation booking service.
It also promotes over investment. Competing groups simultaneously finance competing ventures, resulting in unprofitable projects or games of technology leap-frog. This leads to low returns or losses on some or all investments. The related instability makes it difficult to recover invested capital or earn economic returns.
Changes in financing arrangements have fostered a close relationship between the financial and technology sectors. Investment banks now collude with venture capitalists to create products allowing insiders to cash out and transfer the true risk onto external investors keen to participate in the new digital frontier. The naïve political belief, amplified by a sycophantic media, that technology is pivotal to economic revival and ample liquidity, resulting from loose central banking policies, have facilitated the process.
The approach entails high valuations, obscure pricing metrics, and complex private funding arrangements (often with guaranteed returns for some). The emphasis is not on new lasting business but the creation of "unicorns"; businesses with a valuation of in excess of US$1bn (£798m) which have become a status symbol. At their peak, there were around 150 such firms with a combined valuation of over US$500bn. It thrives in a frenzied atmosphere dominated by FOMO (the fear of missing out). It may not be compatible with the duller requirements of building new and successful industries over decades.
Third, new technologies frequently have unstable earnings models.
Google, Facebook, Twitter and their successors rely heavily on cannibalising existing advertising revenues. Earnings are vulnerable to declining advertising rates driven by the lack of space on smaller mobile devices, resistance to ads and the advent of blocking software.
Much of the new Internet-based economy is predicated on free services. Where they are not dependent on advertising, new businesses emphasise free platforms or services. The aim is to create a sufficiently large user community from which stealth revenues can be extracted either directly or by selling user data to allow targeted marketing or worse. Attempts to move to subscription models or charging for access generally meet with resistance. Users, habituated to not paying for the service, switch to new free competitors. This lack of pricing power restricts profitability.
Many innovations may require a “winner-takes-all” near market dominance model. Intel, Microsoft or Google are examples of this phenomenon. Many new businesses now do not displace competitors through efficiency or create new markets but seek to engender the belief that investors accept that they will dominate their industry, inevitably. But fierce competition in each segment increases spending through higher expansion and customer acquisition costs extending the period before investment is recovered. It may also generate poor long-term returns. Businesses like Amazon highlight the difficulty of building a profitable, sustainable business.
Fifth, new technology investment is motivated, in part, by an increasingly difficult economic environment characterised by low growth and diminishing returns. Investors desperately seek higher-than-market-average growth in revenues and earnings to meet return targets and attract investment. It drives excessive investment in many new ventures. The technologies and business models are unproven. Investors rarely understand the underlying technology, its potential evolution or risks. Given that the outcomes are frequently highly uncertain and unpredictable, a level of intrinsic volatility may be inevitable.
These factors perpetuate cycles of technology booms and busts. While it may benefit a few individuals and create short-term trading opportunities, it is unclear whether it creates the significant long-term and economy-wide impact on growth and productivity of previous industrial revolutions.
Satyajit Das is a former banker. His latest book is 'A Banquet of Consequences' (published in North America as The Age of Stagnation to avoid confusion as a cookbook). He is also the author of 'Extreme Money and Traders, Guns & Money'
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