Are we in a Web 2.0 Bubble? Yes!

Posted September 12th, 2011

Past bubbles

Historically, humans have been bad at recognizing bubbles as they form, with a herd mentality trumping rational analysis of an asset's true worth. Often cited as the first recorded asset bubble, the Dutch tulip bubble of the 1600’s highlights many of the exact same concepts we've seen in more recent examples. Put briefly, tulip flower bulbs had become a fashionable item and the prices of the bulbs began to increase. Buying activity suddenly surged as many sought the promise of future returns (that is, the tulip bulbs could be planted to yield additional bulbs), the desire to buy and quickly sell bulbs for a profit (more recently known as flipping), or just a simple desire to not feel left out of the action. This continued until prices reached astronomical levels. Then when prices began to taper off, selling volume increased. Before long panic set in and values collapsed to pre-mania levels as quickly as they had risen.

While the account of the Dutch tulip industry is sometimes contested, two more recent examples illustrate the herd mentality that prevails even today. During the late 1990’s many companies such as pets.com saw extreme increases in market value based on nothing more than the promise of a future revenue model. Believing the internet was the way of the future, firms rushed to establish an online presence without having any concrete idea of how to generate sustainable revenues. Once these promises of failed to materialize, valuations peaked, and as investors all tried to exit, valuations plummeted back to pre-bubble values (in some cases, that meant zero). Of course, the concept of the internet truly was the future and is as visible as ever today, but a sound business model was still required as is true in any industry. While some companies such as Yahoo! and Microsoft continued to operate viable businesses, many others vanished.

Most recently, we saw yet another example of this mentality in the housing industry. While not directly related to the technology industry, it illustrated the exact same principles as in earlier bubbles. As people saw home values increasing at faster and faster rates, they traded up to bigger and bigger homes, believing that the future equity to be gained could be tapped for retirement or to purchase cars, boats, and the like. Real estate agents goaded customers to push their budgets to the limit, urging them not to miss out, since even in the worst case scenarios their incomes would increase even if the home seemed too expensive now. Likewise, many market analysts assured the pubic that home prices could never fall, only that they would "plateau". In hindsight, this is eerily similar to the general notion in 1929 that the stock market had reached a "permanent plateau" which of course was false. In the end, many of these transactions turned out to involve "no-doc" or "liar" loans. When people started having trouble making mortgage payments and speculators could no longer flip houses for a quick profit, the market stalled and ultimately collapsed.

Today, we see similar language being used to describe newer web companies. Watch this video of an interview with Marc Andreessen, a prominent internet industry investor. Around the 1:30 mark, notice how he describes companies as “important” and "powerful" to justify companies' stratospheric valuations. While we respect that he is a successful investor and knows the industry well, experts have been wrong quite a few times before as we described above, which leads us to doubt his analysis.

Still addicted to MySpace?

Defenders of the newest web concepts reject the notion that their popularity might be a fad and believe that the company behind the idea will therefore always be around. Yet while the concepts of innovative companies do often become a part of mainstream culture, the actual companies behind them don't always fare as well. Here are some examples of companies that did not fare was well as the ideas they pioneered:

Netscape was the first mass-market browser and was at one point the most popular. Today the browser is as important as ever due to the general move from locally installed software to online and cloud-based programs. However, Netscape's popularity waned as Internet Explorer took over, which in turn has recently ceded much of its lead to Mozilla Firefox and Google Chrome.
Ask Jeeves was popular due to the fact that one could ask a question in English and obtain relevant results. While semantic search has indeed become prominent, Google and Bing now lead the way in search innovation.
People used to proudly announce the creation of their own home pages which were likely hosted at Geocities, Tripod, or Angelfire, among others. The everyday consumer is as present online as ever, but modern social networking sites have become the main venue for showcasing personal information.
Online communities have existed in many forms, such as BBS, AOL Instant Messenger, chat rooms, and online forums maintained by individual websites. Many active communities still exist, but their popularity has waned as much of the activity transitioned to social networking sites. Likewise, the concept of a “wall” to post on is not new; remember when nearly every site had a guestbook?
Facebook recently popularized the one-click “like” button as an easy way to show interest in an item. This idea is appearing elsewhere in the form of the Google +1 button as well as on other sites such as YouTube, where you can click to like or dislike videos. This type of interaction will continue to spread and dilute Facebook's share of it.

Social networks operate on the principle of the network effect, where the website becomes useful only when other people use it at the same time. Once a site achieves a critical mass of popularity and all one's friends and acquaintances are on it, many think there's no reason that would ever make them leave. The best example is MySpace, to which many people were addicted circa 2006 since so many of their friends used it as well. But as it slowly became infested with spam, glitches, and glaring profile designs, people began to migrate to the new exclusive Facebook website. As soon as just a few people transitioned, a few of their friends followed, as did a few of their friends, and so on. This created a snowball effect that gave Facebook the critical mass it needed to achieve the popularity it has. Google+ recently debuted, which has piqued the curiosity of many technology early adopters for its newness factor and clean interface. Will it be enough to topple Facebook? Probably not, but we wouldn't write off the possibility completely; we expect the social networking industry to fragment a bit at the very least. Many cite the fact that they have so many pictures, posts, and other items on Facebook and that they'll never leave. On the contrary, we believe as soon as people's friends begin to migrate, the herd mentality will once again take over as we've seen so many times before. Besides, we’re sure there will be an easy way for one to import or transfer all their items via some third-party ustility. We don't know if Google+ will be the one to set off this reaction, but we're sure it will happen at some point.

Here’s a graph illustrating MySpace’s rapid (in retrospect) rise and fall. News Corp purchased the property in 2005 for over half a billion dollars. At one point during an attempted buyout, its peak valuation was $12 billion; it was recently sold off for a tiny fraction of those amounts. AOL fared even worse with social networking site Bebo; it purchased the site in 2008 for $850 million but ultimately sold it for about $10 million when the site never caught on. During MySpace's peak popularity, would anyone, especially the site's core demographic of teens and young adults, have predicted the mass exodus? Almost certainly not, yet many are adamant that such an event will never take place again.

MySpace's purchase, peak, and sale price valuations, in $Billions

Page views, followers, and "likes" do not equal revenue, much less a profit

Remember website hit counters and AOL keywords? In the early 2000’s companies were sure to advertise their AOL keyword right alongside their website URL. This is very closely paralleled with today's occurrence of firms accumulating “likes” and “followers.” In many cases they pay good money to advertise their presence on Facebook and Twitter (among others) and attract visitors. Companies are thus quite involved in the hype associated with social media and it essentially amounts to free advertising for the social media companies. This free advertising thus makes the sites even more popular, which attracts even more vistors, and so forth, creating a cycle just like we've seen with the bubbles presented above. As with all such cycles of hype, eventually the enthusiasm will taper off as will the number of likes and followers companies attain. At that point, advertisers will begin to direct less money into their social media campaigns, which will cause the start of a decline in valuations in the market. This decline could be accelerated with the entrance of and migration to a new market player, perhaps Google+. Thus, today's corporate Facebook and Twitter profiles will be looked upon just as we do today at AOL keywords and MySpace pages.

There's nothing 2.0 about Web 2.0

Web 2.0 is supposedly separated from the "old" web via the concept of user-generated content and social interaction. That is, instead of a site owner or "webmaster" publishing content on their own schedule, much of a site's value is supposed to come from the community's participation. We disagree; the web has always been social, just to a lesser degree. From the first bulletin boards, to AOL chat rooms and games, to community message boards, we web has always social in nature. It's obviously more popular than ever, and there are more venues in which user interaction is utilized, but the concept of Web 2.0 is evolutionary rather than revolutionary. Once the novelty of the new "social web" wears off, the increase in valuations will halt.

On barriers to entry

The study of markets in economics involves the analysis of barriers of entry into that market. Part of Facebook’s story is that it was able to overtake MySpace while being started in a college bedroom; all it took was a web server, a domain name, and a group of eager participants. This illustrates that the barriers of entry into today's web market are also quite low relative to others since all one needs is a website and a scalable idea (which is still easier said than done, of course). In the case of Groupon, the simple idea of a group discount was relatively simple to implement and therefore spread very rapidly. While this translated into benefits such as growth, popularity, and revenue, profitability was not one of them, at least not yet.

To take on a company such as Google, one would require robust large-scale search and data algorithms which a person or small group cannot devise on their own. Likewise, an attempt to take on Apple would require a manufacturing base, design methodology, and popular following which take years to develop. One would say, then, that the barriers of entry into their markets are very high. Social networks, on the other hand, can grow huge due simply to a group of people looking for something new. As discussed, when Facebook offered a cleaner, more exclusive alternative to MySpace, people quickly forgot about MySpace and moved to what eventually became the next big thing. Once would therefore expect the valuations of companies in difficult markets to enter to be higher per unit of revenue or profit than those in easier markets to enter. Most will conclude that the higher valuations are due to projected growth patterns, but growth in this case may mean website visitors and "eyeballs;" the real revenues and profits are more difficult to come by.

Valuation metrics of selected technology companies (from Yahoo! Finance)

Our verdict

For all these reasons, we believe we are in the midst of a growing tech bubble, and the ensuing volatility could rival that of the original. As of September 2011, LinkedIn, Groupon, Pandora, and Zynga have all filed or plan to file for IPO's. Already the market is seeing some turmoil as Groupon's IPO might be in danger. This will intensify once the bigger names such as Twitter and Facebook file as anticipated, and we anticipate many individual investors will try to get a piece of the household names they know, paying grossly inflated prices to do so. In the end, there is no reason to disagree with the premise that the web has become ever more social, and it will continue to grow even more so. But we don't believe the hype and astronomical valuations are justified, and while the ideas and concepts introduced by the newest companies will live on, many of the companies themselves will not.