How to Make Money by Understanding 'Hype Cycles' in Technology: Part I

During the "Peak of Inflated Expectations," companies that positioned themselves ahead of the pack boast about prestigious customers and exciting performance, and a bandwagon effect kicks in. "The stories in the press capture the excitement around the innovation and reinforce the need to become part of it or be left behind." Exuberance becomes irrational as risks are discounted or ignored, market timelines are compressed and likely demand is over-estimated.

During the "Trough of Disillusionment," "impatience for results begins to replace the original excitement about potential value. ... Problems with performance, or slower-than-expected adoption, or a failure to deliver financial returns in the time anticipated all lead to missed expectations. A number of less-favorable stories start to emerge as most companies realize things aren't as easy as they first seemed. The media, always needing a new angle to keep readers interested, switches to featuring the challenges rather than the opportunities of the innovation."

After the Trough of Disillusionment has passed "some early adopters overcome the initial hurdles, begin to experience benefits, see the light at the end of the tunnel, and recommit efforts to move forward" into "The Slope of Enlightenment," where the innovation matures, companies improve their products and real-world benefits begin to materialize. Innovations that successfully make the transition eventually reach a "Plateau of Productivity," where "a sharp uptick ("hockey stick") in adoption begins, and penetration accelerates rapidly as a result of productive and useful value."

A third and more easily overlooked hype cycle arises when there's a fundamental change in the market for products manufactured by companies that are well out on the Plateau of Productivity. While hype cycles in established industries are less volatile than either R&D or new technology hype cycles, they can provide outstanding opportunities to buy the security of reliable earnings with market-beating upside potential.

I started drawing the hype-cycle curve for clients long before Gartner described the fundamental reasons for each stage in the evolution of a technology or resource deposit. Using the hype cycle as an analytical tool and rigorously adhering to its discipline has never failed me. Every time I've ignored the hype cycle, or convinced myself "it's different this time," the outcome has been very unpleasant. While hype-cycle investing requires substantial time and a lot of patience because the timing of transition points is uncertain, experience has shown that the best entry points for long investors are before the Innovation Trigger and near the bottom of the Trough of Disillusionment, and the best entry point for short investors is at or near the Peak of Inflated Expectations. If you can accurately identify where a particular company is situated on its own hype cycle, successful investing is like fishing in a trout farm.

Two examples of predictions I've made based on hype cycle analysis follow.

Lithium-ion batteries. I started criticizing lithium-ion battery manufacturers in the summer of 2008 because their market valuations were out of line with their underlying business realities. The fundamental reason for the valuation disconnect was emerging government policies that favored the development of electric cars. All the stories, however, said that electric cars wouldn't and couldn't be cost-effective until some clever innovator found a way to increase energy density by six- to seven-fold while reducing battery cost by 75%.

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