BUSINESS: The Ultimate Resource January 2003 Upgrade #4

KEYNOTE INTRODUCTION
On Booms, Busts, and the Value of Good Judgment
Robert Hormats

In the first part of the 1890s, the United States financed and built 70,000 miles of rail track. In the second part of the 1890s, companies that had built 40,000 miles of that track went bankrupt. Competition to build rail track got way ahead of demand; there wasnt enough stuff to put over those rails, so companies went bankrupt. The similarity between rail track then and fiber optics now (and other components of the telecom and information infrastructure as well) are striking. But there is also a hopeful side to the analogy. Despite the bankruptcies, the rails are still there. Someone bought them and consolidated themthe Harrimans and others. They knew how to manage a continental rail system, so they bought cheap properties from bankrupt companies and put them together to make money. Now we have a well-developed telecommunications and IT infrastructure, plus a lot of very talented engineers, scientists, and programmers who can be mobilizedat prices a lot lower than a few years ago. They will sustain the technology boombut on a more realistic basis, with less hype, less debt, and less irrational exuberance in the stock market. The rail industry did not end with the bankruptcies of the 1890s; it got stronger with consolidations and good management. The telecommunications/Internet industry will not end with the crash of the last couple of years; it will thrive with new configurations, new management, and new business opportunities. One of the key points of a transformative technology is not that the individual people who develop the technology make the money. Some do, many dont. The key point is that transformative technology enables other people in other sectors to become more productive and to make money. In other words, it is a technology that has broad productive uses for a large portion of the economy. Often its not the first mover who profits most; its those who use the technology most effectively to improve their own existing business models or to develop new ones. For instance, AOL was not the first of the online companies. We dont even remember what the first companies were; theyre mostly forgotten. One of the big mistakes people make is to think of financial markets as highly efficient. While they can be efficient over the long term, they can be very inefficient for sustained periods of time. They experience big booms and big bustsand are rarely at equilibrium. Money is often allocated for very inefficient uses or to finance excess. But markets are generally good at enabling people to allocate risk. If you are starting a company, you can then take that company public or to venture capitalists and spread the risk around instead of taking all or most of the risk yourself. This is part of the entrepreneurial process. Is it an efficient way of allocating capital? No, not always. But it is a critical part of the way capitalism works and technology evolves. If you could not spread the risk, you probably wouldnt have made the initial investment to begin with or developed the company as rapidly. If you are Bill Gates,

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you couldnt finance the rapid rise of Microsoft all on your own. You have to have others participate in the equity. In the 1990s the public equity market became, in effect, a venture capital market. In the history of American capital markets, most companies dont come to the public market until they are making money or are about to make money. They get money from banks before that. Generally speaking, very few companies come to the public market without some sort of track record. After Amazon and Netscape, though, many high-tech companies came to the public market with no profits and only the vaguest expectation or hope that they had short-term or medium-term or even long-term prospects for making profits. So the high-tech, overly exuberant investors, in effect, became venture capitalists, buying companies at a much earlier stage than they would have 10 to 15 years ago. A lot of people regarded this as a get-rich-quick approach, and really didnt have sufficient appreciation of the high risks involved. They were becoming venture capitalists without the sophisticationor very deep pockets. Most people have learned their lesson and wont go back to buying those kinds of stocks very soon. Average investors will steer clear of start ups for a long time to come. In the future investors will be more cautious and theyll have much more diversification in their portfolios among categories of stocks, and between stocks and bonds. It will slow the whole capital-raising process down. I think it will make equity capital raising for many companies much more difficult in the next 10 years. The Economy Will Likely Grow Again, but at a Slower Pace If you go back to the railroad and electricity booms, the economy did build on these technologies quite successfully. We are in, and will continue to experience, a period of very substantial technological progress. But for a while it will be harder to raise equity capital, except for extremely good technology companies with good business plans and good management. There will be a continued dynamism in many sectors of the economy. The new economy wasnt just about technology; it was about better management practices, better business models, more efficiency, globalization, more immigration. It was about combining many factors to achieve high productivity. That progress will continue. And the U.S. economy will grow thanks to the remarkable resilience of its people and an attitude that accepts that risk is part of economicsand that in the long run taking risks may produce some dislocations and failures but over time it also produces dynamic growth. The knowledge we have gained from financing these new technologies, as well as from the technologies themselves, has been dramatic. Someone said to Thomas Edison: Mr. Edison, you have done 50 experiments and havent developed a light bulb. Are you concerned about these failures? Edison replied: What failures? We have learned 50 different ways not to make a light bulb. This is a great part of the American entrepreneurial spirit. Try, fail, learn from mistakes, and then do it better. A New Level of Transparency Is Evolving between Companies and Their Customers The corporate sector will become much more responsive to the concerns of its stakeholders and will, in its own right and through governmental lobbying pressure,
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make changes. If you are a corporation, youre operating in an environment today where you have to be more environmentally minded because more and more consumers are environmentally minded. The Internet exposes any indiscretions, any violations, and any polluting that is being done around the world. It also exposes the way you treat your workers, or conduct your human-rights policies. The bright light of exposure on corporate policies and the growing numbers of peopleparticularly younger peoplewho are socially minded and obtain information in real time off the Internet will make a difference to the way corporations act. It will place them under continuous pressure to adhere to high standards of social responsibility. You dont have to wait until the government tells you to do it. Look at BP. They have been a very progressive company on environmental practices. Toyota developed the Prias, a hybrid car that is very gas-efficient and very cool. And it is working on fuel cells for the next generation of cars with high environmental standards. I think you will see a lot of companies doing this. Companies are also under pressure to improve workplace standards. The notion put about by the antiglobalization forces that foreign investment brings down workplace, environmental, or other standards is a myth. Generally these companies introduce higher standards than are commonly found in local companies. Moreover, if workers are treated badly in, say, a factory run by an American company in Guatemala, kids all over the United States know about it in minutes, because it is on the Internet. They talk about it in school, and they wont buy the companys products. I think transparency is here to stay. The Internet is just a sliver on the information timeline. The church and the king dominated books until Gutenberg, and then books were developed for large numbers of people. More and more people learned to read because there were more books. And more and more writers came forth to write books that interested large portions of the population. Magazines and pamphlets were instrumental in getting support for the American Revolution. Television and radio exponentially increased the number of people exposed to informationand helped win the Cold War by penetrating the Iron Curtain. King and church controlled information for the first half of the last millennium. Once moveable type was developed, they couldnt do that anymore. I think the Internet is the latest stage in that process of democratizing informationand it has had its effect quickly and globally. It provides individuals with access to others around the worldand no one, no country, no group can control it. Maintaining a Sense of Perspective I think what happens is that when things start looking good, too many people downplay and disregard risk. It always happens when you get a boom. That is why there are bustspeople borrow too much and invest too much in high-risk enterprises with the expectation that the boom will continue indefinitely. Some argued that more information would prevent this from happening, because it would enable investors to assess the prospects of companies better or shift out of bad investments more quickly thus cutting their losses. But information is not a substitute for good judgment. Tom Friedman has made the point that there should be a warning

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label attached to information technology that says, Judgment not included. He is right. There is a lot of information availableand the key now is to exercise good judgment in evaluating it and deciding how to act on the basis of it. So far we havent found the substitute for human judgment. Investors and companies made a lot of mistakes. They got greedy and carelessand a lot of people lost perspective about risk. For many it was a financial tragedy. If you had $1 million and put $100,000 into the dot-coms or other technology companies and lost much of it, that was unfortunate but probably not catastrophic. That was risk money. The real problem is that people who had $100,000 put $90,000 into these kinds of stocks, which is really where the human tragedies occurred. Thats where you get the heartrending stories of this period. Things were going so well they thought they could afford to take that kind of risk. And they not only lost their money, but also in many casesin light of the Enron and WorldCom abusesconcluded that the deck was stacked against them. One casualty of this period has been investor faith that markets are fair; to many, the C.E.O.s of the companies in which they invested treated them with contempt, and so did many of the so-called gatekeepers. Restoring confidence will not be done by legislation or pronouncements by committees; it must be done one C.E.O. at a time, one company at a time, one audit at a time, one analyst at a time. The lesson is that the potential for loss is often forgotten when everything is going well. You need to be very diversified. Dont invest more than you can afford to lose, and recognize that there are real risks. And demand that corporations, accountants, bankers, and government regulators adhere to high standards of ethics, transparency, and corporate conduct. The problem is that most companies did adhere to these standardsbut the few that did not tarnished the overall image of corporations and corporate governance. For the small investor especially, that image will take some time to recover. And for everybody there is a risk that overregulation could stifle risk taking and entrepreneurialism.

About the Author

Robert Hormats is vice chair of Goldman Sachs (International). Before joining Goldman Sachs, he was a presidential advisor, an assistant secretary for economic and business affairs in the U.S. State Department, and a staff member of the National Security Council. He has been a member of the Trilateral Commission and is on the board of directors of the U.S.-Russian Enterprise Fund, the Human Genome Sciences Corporation, Englehard Hanovia, and the Council on Foreign Relations.

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