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10 Lessons Learned

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By paulphilp
March 27, 2001

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When I suggested to Erick building a portfolio of companies that will lead us out of the current darkness, he asked, "How would we do that?" A very good question.

My first instinct was to turn to what I already knew - The Gorilla Game and Innovator's Dilemma - and reel off the same answers I would have given last year. However, those answers, if applied last year, would have destroyed most of my net worth.

Perhaps a little doubt and a little less certainty would be profitable. My next idea was to see if I could learn something from the incredible events of the last 3 - 4 years.

This is my attempt to capture some of the lessons I have learned. My intent is to spark a discussion of lessons learned so that we all profit from everybody's experience. Please add your own lesson and challenge any of my assertions.

Next - How to use those lessons to help select the New Leaders?

Paul


10 Lessons Learned from the Internet boom and bust.

1) Don't bet against innovation.
The bull market began in 1982. Why? In the early 1980s entrepreneurship and innovation began to be systematically accepted in the United States as valid business practices. Venture capital changed from being a cottage business into being a well-organized industry. New forms of credit became available to support entrepreneurs. Books and schools now teach the best practices of entrepreneurship. It is this wave of innovation, more than anything else, which has led to our recent productivity gains and increased standard of living.

Nothing has altered the trend toward entrepreneurship and innovation. Recent capital excess may have provided too much capital to too many 'get-rich-quick' schemers disguised as entrepreneurs. This has been corrected.

Recent comparisons of today's situation with America in the 1920s and Japan in the 1990s discount the economic power of entrepreneurship. Japan has many structural problems but the most severe is the lack of an entrepreneurial class. Much the same can be said for America in the 1920s. Innovation unleashed will heal almost all economic bottlenecks.

This is a primarily American phenomenon. Only Hong Kong, Singapore, Taiwan and to some degree Israel have learned the secret to America's economic prosperity. As a Canadian, I am amazed at the systematic disincentives to innovation we tolerate in the name of fairness.

Innovation is a powerful force and there is no upside in betting against it. All doom and gloom scenarios ignore innovation and are thus flawed at the core. We are in for stormy weather, no doubt. Some entrepreneur somewhere will figure out how to make a buck selling us umbrellas. This person will lead us out the current downtrend more than any analyst, author, editor, consultant or news anchor.

Follow the entrepreneur and don't panic until the US government implements policies that impede the dynamic force of innovation. Then, feel free to panic!

2) The market is always right.
Today, this is a hard lesson to learn. Still, the lesson is there to be learnt. Market participants have wildly divergent goals and strategies, different levels of risk tolerance, access to different information, different methods for sizing opportunity and measuring risk, and differing temperaments and personalities. Put them all together into a giant real time auction and their collective actions consistently produce better results than any one individual. If you love a company or its stock, you may dismiss or not understand a risk that somebody else sees and understands. If you understand a technology or an emerging market better than most, your investing actions teach the market. This is the network effect in action in real time, updated by the second and available on CNBC for the world to watch.

What about the tech bubble? History will write that the bubble in Internet and technology stocks in the late 1990s served to attract enough capital to overcome the serious technological and economic limitations of the Internet. Without high valuations and easy access to capital would the fiber-optic network have been built? Would wild-eyed Photonics scientists been funded and then forced to compete in the market place? Would the giant eCommerce experiment, which taught us what works and what does not work, have happened?

It is not pretty. It may not even be efficient. But, the market is effective. The moment we think we know better than the market is the moment we start to lose our capital.

3) Dogma stops thinking.
The bull and bear market sent everyone off to their corners to protect and defend their ideas and decisions. This is all too human. We all fight to protect our worldview and are quick to assume that somebody with a different worldview just 'doesn't get it.'

Where we get into trouble is that our worldviews discount information that doesn't fit. This is the source of the most famous saying of the 1990s - 'This time it's different.' Well, probably not all that different.

Eventually all bulls are proven wrong and all bears are proven wrong. Momentum trading works when momentum trading works. Charts don't lie until the assumptions for interpreting the charts prove false. Long-term holding isn't forever.

So much happened over the last four years that has never happened before that nobody's models withstood all the anomalies. The only way to profit was to challenge your own personal dogma, test your models, learn and adapt.

Ever notice how many people think everybody else acts like a herd? Think about it.

4) Over the long term CAP wins.
Great companies in growing markets with the strongest and best-protected competitive positions create wealth. The best technology does not always win. The best product does not always win. The best management does not always win. The best competitive position always wins. Over the medium to long term companies with inferior competitive positions destroy wealth.

This is the beginning, middle, and end of the valuation debate � wealth creation capacity. Keep wealth creators. Sell wealth destroyers. Learn how to measure wealth creation capacity.

The key to understanding wealth creation is to understand competitive strategy. Coca-Cola has created so much wealth because it consistently has the superior competitive strategy. Coke also has a long history of changing strategy when the current strategy stops working. Competitive strategy is not a fixed entity. It changes from industry to industry and from time to time. Following competitive strategy is like following the rainbow. It is elusive but that's where the gold is.

5) Understand your learning risk.
Recently, some friends were complaining about how much money they lost in Nortel shares. I gave them a simple test: given that electrons and photons both travel at the speed of light, why are photons better suited for high speed data communications and why don't we replace all electronic equipment with photonic equipment? They barely understood the question let alone the answer. I only knew because I had bought and read a couple of introductory quantum mechanics books.

This is truly the knowledge age and we all have a limited capacity to study and learn. How much of your learning capacity you are willing to invest is a critical part of your investing strategy. If you don't understand a technology, a market, or an industry, hire a fund manager who does or stick to industries you know.

Nobody has perfect knowledge and everybody has a learning risk. Understand what you know and what you don't know and what you are willing to learn. Inside that box you have an advantage. Outside that box you are at a disadvantage.

There is a saying in poker, "If you don't know who the mark is within 30 minutes � it's you.' The same principle applies to investing.

6) Industrial economics matter more than macroeconomics.
Macroeconomics is important but the economics of an industry have a much larger impact on the companies in that industry. Traditionally, technology was immune from recessions. Not understanding the overcapacities built up in technology lost many people a lot of money.

Even more important, particularly in technology, it is industry economics that drive end applications. Large companies attempting to rid themselves of bureaucracy and to provide the right information to the right people at the right time drove the PC age. This gave rise to various forms of productivity applications...from the spreadsheet to the fully integrated accounting system.

Unfortunately, macroeconomics makes better headlines. The width of Alan Greenspan's briefcase is news worthy. The balance sheet of the telecommunications industry cannot compete.

7) Master your discipline AND extend your toolkit.
Fundamental analysts make money. Better fundamental analysts make more money. Technical analysts make money. Better technical analysts make more money. Whatever your method the key is to success is to master the method. Experiment a little. Exchange ideas with people smarter than you. Read the source books again. I am constantly amazed how much I learn every time I reread The Gorilla Game or The Innovator's Dilemma. Be careful of the human pull to complacency when things go well and blame when things don't go well.

Mastery comes out of your mistakes not from your wins. Early celebration reinforces bad habits.

Other disciplines can offer everybody something. Even the most ardent Gorilla Gamer or Rule Maker would benefit from a little understanding of the impact of supply and demand on the price of a stock. There are ways to risk-reduce your buying and selling even if you are a LTBH investor. The same is true for technical analysts. Some fundamental tools can help risk-reduce your trading decisions.

This interdisciplinary approach will have gone too far when people starting seeing 'Peeling Banana' patterns on the chart of a Gorilla candidate.

8) Understand your investing strategy and financial goals.
Stick to your game plan. As Paul Simon says, "Breakdowns come, breakdowns go, it's watcha gonna do about it I want to know."

Avoid betting your child's education fund on the latest George Gilder photonic poster child unless following Gilder is your strategy and you are in the process of mastering that strategy. Don't invest on margin until you understand the risks involved and are convinced that those risks match your financial goals. The guy on the train who made a bundle last week writing covered calls might not have children and a mortgage to think through. He also may be complete idiot, you just never can tell.

Decide whom to trust and then trust them as long as their advice is consistent with your goals. I love taking care of other people's children. I get to wind 'em up and send them back to their parents. Lot's of people are willing to do that with your money.

Most of the people running for the hills today should never have been out in this weather without the proper protective clothing.

9) Disruptive technology is still the largest wealth creating force.
This is key. Nothing has changed about the economic impact of technology except our expectations. The Internet does not change everything but it sure does impact a lot of things and we have really just begun. The first car was invented in the 1880s but Ford was not mass-producing the Model T until the early 1920s and Alfred Sloan didn't figure out how to manage a large automotive company until 1930. The interstate highway system began in the 1950s and didn't finish until the early 1970s.

History will write that the time from the first IBM System 360 in 1964(?) to the deregulation of the Internet in 1993 as the 'horse and buggy' period in technology. We are just now seeing the business benefits promised by technology showing up in economic measures.

There are many excellent growth industries and growth companies. Biotech and Energy stand out to me but there are many others. However, none of these industries is impacting the economic infrastructure of the world in the way technology has and will continue to do.

A word of caution: I consider another technology bubble very likely. Eventually the current skepticism will fade and another new technology with massive economic promise will arrive and the same conditions that created the Internet bubble will exist. This will not happen next year or the year after but it will come.

The early warning sign will be the first person who says � "This time it's different."

10) The Web is an early Internet application but NOT the last Internet application.
Many people were introduced to the Internet via the World Wide Web and equate these two technologies. Avoiding an overly technical discussion, keep in mind that the Internet is not the same thing as the World Wide Web. The Web was the second killer application for the Internet (e-mail was the first).

Even the current web is only a partial implementation of what the inventor Tim Berners-Lee had in mind. To understand the difference, keep in mind that Napster did not use the Web but it is an Internet application. New technologies like Java and XML and Microsoft's .Net are already beginning to reshape the landscape. New materials and methods for designing and building semiconductors are just now reaching market. George Gilder's favorites continue to innovate. Tim Berners-Lee continues to labor to ensure that his complete vision is fulfilled.

And they are all driven by a passion to make the world a better place. So, don't forget: Never bet against innovation.