Was I Wrong About Bubble 2.0?

I think I was wrong. I can't be sure yet, but it looks like I messed up. I'm very sorry it happened. But believe me, dear reader, I had no idea that this was coming.

I'm talking about an article I wrote at the end of last year titled "There Won't Be a Bubble 2.0." I argued that we wouldn't again see the same out-of-control tech IPO market that engulfed America in the late 1990s. I thought changes made since the dot-com bust would keep investors (relatively) safe from the same sort of financial shenanigans that gave dinky companies with no assets or business model billion-dollar valuations because they tied a ".com" on the end of their names. And I was wrong about that, thanks to a bill Congress passed and President Obama recently signed into law.

I don't want to be wrong without learning a lesson from it. I'd like to share what I've learned with you, so that we can both come away a bit wiser and a bit more cautious from my mistake.

From the pens of politicians
Say hello to the JOBS Act, dear reader. My colleague Ilan Moscovitz wrote an excellent take before it was signed into law earlier this April. To sum up:

  • Most companies get a break on financial-reporting rules for the first five years after going public, making it more likely that new companies will be able to lie about their numbers.
  • Companies and investment-bank analysts can advertise their stock, as long as it's done to pump up an offering meant for high-net-worth individuals.
  • Companies can get up to $10,000 each from small investors, for a total of $1 million a year, while offering them only limited meaningful information.
  • Companies in these positions won't need independent auditors.
  • Fake numbers, real jobs! At least that's the theory.

I wrote about the crowdfunding chunk of this new law (the third bullet point) in December, on the very day the first "whole" version of the JOBS Act emerged in the House. I had reservations then, expecting the very sort of boiler-room pump-and-dump schemes now predicted by a number of Street watchers. Now it seems that such schemes will virtually be openly sanctioned.

It's what you don't know that can hurt you
For all the widespread small-f foolishness of the dot-com years, investors could (generally) still access hard numbers underneath the relentless pumping of the major investment banks. For example, I can still find an original Pets.com quarterly filing in all its gory glory, with sales costs valued at twice total sales and everything. If you had really been serious about investing in that short-lived company, you could have reviewed its finances beforehand, and at least known that those numbers had been run by an independent auditor.

But there's still no guarantee of accuracy today, even with outside controls. We've already seen plenty of accounting shenanigans from Groupon (Nasdaq: GRPN  ) , running the gamut from made-up metrics like ACSOI to multiple earnings restatements in the span of a year, and that company's already too large to make use of the JOBS Act's cloak of confusion. At least we can be thankful that every time this sort of mealy-mouthed math crops up, there are more than enough analysts to take it apart. This happens because we still have independent auditors poring through Groupon's books, but even those auditors are at times a step behind the company's fiscal creativity.

Now let's wash away even that thin veneer of corporate accountability. Let's say you have a website that offers free marmosets for looking at ads. Let's call it "Marmosetly." You don't necessarily have to tell the public that you're losing a ton of money sending people free marmosets. Just tell them your Dedicated Eyeballs Relative to Potential Simians is through the roof. What's that, you say? DERPS just doubled this quarter? Give me a million shares!

Sound familiar? It almost makes me want to party like it's 1999.

Tortured intrerpretation
The IPO Task Force was one major driving force behind the act's passage. Here are a few key conclusions from their report, which helped inform some of the act's changes:

  • Of all jobs in companies earning less than $1 billion in revenue ("emerging growth companies"), 92% were created post-IPO.
  • IPOs are way down from the '90s, especially small IPOs.
  • Venture-capital-backed companies were worth 21% of U.S. GDP post-crash and employed 11% of the total private-sector workforce.

I'll start my rebuttal with this chart:

Source: Prof. Jay R. Ritter, University of Florida.
Excludes REITs, closed-end funds, partnerships, and banks and S&Ls. Three-year return does not include ADRs. Returns tallied for all but class of 2010.

Ninety-two percent of all jobs in "smaller" companies were created post-IPO? When 20% of the companies going public in 1999 were off the market two years later, I think we can credit many with ultimately creating the same number of jobs: zero.

IPOs are way down? That's a good thing for investors. Look at how terribly stocks performed post-IPO when a massive number of low-quality companies launched at once.

VC-backed companies, under the Task Force's analysis, include Apple (Nasdaq: AAPL  ) , which was in 1980 already making more than $100 million in revenue, and profitably, when it had what was at the time one of the largest and most successful IPOs of all time to that point. Yet this event is dubbed a "small-cap offering" in the report. This is the kind of analysis that helped birth the JOBS Act.

And did I mention that the IPO Task Force is led by a venture-capital executive? Just a little context.

Don't drink the water
As Ilan noted, "when investors lose faith in accounting standards, they're less willing to buy stocks." Faith in the rule of law and the fairness of the rules has been, for much of America's modern history, one of the greatest defining characteristics of its economic success. Many in the current investing generation have already lived through both dot-com bust and financial crisis, two huge erosions of shareholder faith for different -- but fundamentally similar -- reasons. Many have lost faith and abandoned the market entirely.

When a broad swath of investors loses faith or otherwise cashes out, it doesn't just hamper the values of speculative garbage stocks. It also drags down even the best businesses with the best-known resources. You may be well informed, but many of your fellow investors aren't. If they wake up one morning to find that their free-marmoset stock crashed through the floor, they may not blame themselves for failing to do enough research. They might just decide that the market is rigged against them and pull out altogether -- and thanks to this law, it truly is. Multiply this by millions, and you might have a sense of the scope of this problem.

I hope I'm wrong about being wrong. But the law isn't on my side any more. The best defense against this offensive act is to focus on companies with stable business models, consistent (and consistently improving) earnings, proven track records, and solid dividends, if at all possible. That's what I continue to look for, and it's what should be your backstop against any bubble. If you're looking for a great go-to list of stocks that more than meet these criteria, take a look at The Motley Fool's free report on how you can "Secure Your Future With 9 Rock-Solid Dividend Stocks." We know how important it is to have a firm foundation, which is why we're offering all the information you need to make your next buy. Find out more -- claim your free copy now.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter, where he goes by @TMFBiggles, for more news and insights. The Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of and creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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