Twitter frenzy could generate another tech bubble

The start of something beautiful? Garrett Heath

During the past few years, a strange evening ritual has begun to spring up around the City of London. Instead of heading to the local pub with their colleagues, city workers are flocking to cocktail parties to rub shoulders with tech types.

Walking into one of these soirées, one is struck by the two distinctly different types of people hobnobbing in the same room. On one side are bearded dudes wearing jeans and trainers, maybe a crumpled shirt and a suit jacket they found in the back of their closet. They are drinking beer and talk about code, or maybe fixed-wheel bikes.

On the other side of the room are a group of more distinguished looking gentlemen in fine dark suits and ties. They discuss their portfolios over a middling glass of sancerre. They wait for the obligatory speech which makes fun of this two tribes being brought together.

During this speech they are told about a glittering future, powered by web 2.0, social media and all sorts of other digital innovations. It’s a future that offers opportunities for money making.

This widespread enthusiasm for technology is not just talk. Established firms are regularly willing to pay a massive premium to acquire emerging tech companies which have no clear plans about how they will generate a profit. But are we setting ourselves up for another crash when we believe the hype?

The most recent example of the endless enthusiasm for all things tech is Twitter’s initial public offering. Plans to list were at first based on a price of US$17-US$20. However, following weeks of media hype, the company settled on US$26.

Some saw this as a relatively conservative price that might help Twitter avoid the big hit suffered by Facebook following its own IPO last May. For others, the valuation is based on some rather shaky assumptions.

When the markets opened, the price rocketed beyond the US$50 mark at one point. By the end of the day, the price of Twitter shares was up 73% from the listing price at US$44.90. This rapid rise was largely driven by frenzied demand from retail investors and led many commentators to note that collective hype had led investors to overlook the fundamentals of the company.

Typically when shares are initially floated on the stock exchange they are underpriced but over-valued. The price they are initially offered at is lower than what the market is willing to pay. This means the price normally goes up during the first day of trading. However, in subsequent trading, the price usually falls because investors begin taking a long hard look at the fundamentals of the business and find them wanting. On average the medium term fall is somewhere between 20% and 50%. This indicates the price of shares was overvalued at the time of the IPO.

Why so cheap?

This strange pattern opens up two big questions. The first is why do firms like Twitter initially sell their shares so cheaply? To answer this question we need to look at the broader context in which IPOs occur.

Typically, investment banks help to make the deal happen by acting as an underwriter. These banks are working on many IPOs a year –- and their objective is to keep their clients happy. But they have two sets of very different clients: on the one side is the company whose shares they are offering, on the other are the institutional investors, like pension funds, to whom they are selling shares.

They can afford to annoy the company because they only work with it only once or twice to sell its shares. But they cannot afford to upset the institutional investors because they continue to do business with them on a routine basis during other IPOs. This means they probably need to sell the shares of an IPO a little cheaper than the open market might like in order to keep their precious institutional investors happy.

Guessing value

The second big question is why are investors willing to pay over the odds? This is often because there is a lot of uncertainty about how much a firm is worth. Investors just don’t know the companies and what kinds of benchmarks they should use to assess them.

In the absence of this important information, symbolism becomes everything. Investors tend to look for indicators a company might be a good bet, such as whether it has prestigious partners or investors, whether it is able to tell a good story about itself, if it has [hired respected or well-known staff](]( or even if it is based in a particular location.

Another important way investors try to quell their anxiety is by keeping an eye on what others are or doing or saying about the firm, such as if there is a big media buzz.

All these pieces of information are used as rough indicators about whether the firm is a good investment or not. But, crucially, they can often stop investors from asking tricky questions about the fundamentals of the firm in which they are investing. Twitter may prove to be a good long-term bet. But the only thing we can be certain of is that we don’t know.

This tendency to be carried along by the story rather than asking tough questions about the assumptions, the endgame and the reasoning behind such a valuation could mean actors are making themselves artificially stupid.

If we want to avoid a repeat of the disastrous tech-stock bubble of 1999-2000 then it is important that we begin to ask tough questions about the assumptions on which valuations are made, the quality of reasoning these valuations are based on, and precisely what the end game of these stocks might be. To do this, it is necessary to put aside the frothy feel-good stories and think in a hard headed way about a much more mundane, and probably less profitable future.