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

Lithium-ion batteries were a government-induced hype cycle in search of an Innovation Trigger.

The lithium-ion battery hype cycle reached its Peak of Inflated Expectations in the summer and fall of 2009 when the Department of Energy awarded $1.2 billion of grants to build factories to manufacture batteries that were several generations short of the DOEs stated goals. It was quite literally a case where the DOE said "we'll give you piles of money today to build factories for products that we plan to render obsolete within a few years."

Three years later, the catastrophic outcomes I predicted in late 2009 are clear. Ener1 (HEVVQ), Valence Technologies (VLNCQ) and A123 Systems (AONEQ) have all gone bankrupt. A fourth company, Altair Nanotechnologies (ALTI) sold a controlling interest to a Chinese fund for a small fraction of the stock price I criticized in 2008 and 2009. These companies didn't make bad products, but they were all victims of the hype cycle, and the losses suffered by investors who didn't recognize the underlying dynamic were huge.

Plug-in vehicles. While I was hard on lithium-ion battery manufacturers, I've been brutal in my criticism of electric cars because they represent a government-induced hype cycle in search of an Innovation Trigger in another industry where innovations have been few and far between. The lithium-ion battery sector surged to prominence because its products were essential for the development of cost-effective electric cars. The promised Innovation Triggers in the lithium-ion battery industry have not materialized. So we know for a fact that the cost-effective batteries that will make electric cars economically sensible are years, if not decades, from reality.

Whenever success in one industry is entirely dependent on success in another, the failure of the first condition is a clear indication that the dependent industry is in deep trouble.

To date, the adoption rate for electric vehicles has been dismal. Manufacturers including General Motors (GM) and Nissan (NSANY.PK) missed their first-year sales targets by more than 50% and are on track to miss their revised and reduced sales targets by the same margin. Nobody even pretends that these halo cars are economically or environmentally sensible transportation. As near as I can tell, the biggest reason people buy the cars is to obtain single-passenger access to high-occupancy vehicle (HOV) lanes. The cars themselves may not make economic sense, but the value of time not spent stuck in traffic jams is inestimable, at least until the rules change.

For several months, my favorite whipping boy has been Tesla Motors (TSLA) because I believe it is very close to its Peak of Inflated Expectations. Since its IPO in the summer of 2010 Tesla has captured the market's imagination by ambitious plans to launch the Model S sedan, an expensive car that's particularly well suited to the needs of discriminating customers who are willing to pay a hefty premium for extraordinary performance and HOV-lane access. Its stock has held up well despite the rapidly increasing losses that are all too common in companies on the bleeding edge of technology. After giving effect to a $220 million stock offering in early October, Tesla's shares have a book value of $1.71. The balance of Tesla's $30 stock price represents the alluring promise of how good things are going to be when sales ramp to 20,000 vehicles per year and everybody else jumps on the bandwagon.

The Model S was launched with great fanfare at the end of June. The reviews in the automotive press have been stunning and this month the Model S won Motor Trend's Car of the Year Award while garnering high marks from Consumer Reports. The stock price, however, has been stuck in a narrow trading range as the market grows increasingly cautious about higher-than-expected losses, slower-than-expected production-ramp rates and persistent quality-control issues that had the CEO personally inspecting every car that rolled off the line.

If you pay attention to Gartner's hype cycle graph, it's clear that mass-media hype is the last critical stage before the Peak of Inflated Expectations. As expectations approach their peak, the benefits of incremental hype begin to decline or disappear, which is one of the surest signs that the next stage is a fast freight descent into the Trough of Disillusionment.

In late September, I predicted that Tesla's descent into the Trough of Disillusionment would start in the fourth quarter. While my time estimate is imprecise, my conviction that Tesla is at or very near its Peak of Inflated Expectations grows stronger with each passing day. Customers will buy the Model S and many will be delighted with their purchases. However, the odds that Tesla will be able to live up to the irrationally exuberant expectations I see every day are as close to zero as I can imagine. The winter of Tesla's discontent is coming and it will not be pleasant.

The writer doesn't have an economic interest in Tesla, long or short.

John Petersen, a lawyer and CPA, has specialized in advising companies on corporate finance and business development for more than 30 years. He writes the deathless prose and dire warnings investors read in offering documents and SEC reports. While Petersen has served as a board member or executive officer for a handful of public companies, the bulk of his work is behind the scenes where precision and a passion for detail are essential.

Petersen's investing style is that of "elephant hunter," and nothing grabs his attention like a "multi-bagger" in the rough. His investing time horizon is two to four years. On the long side, Petersen looks for blood in the streets and stock prices that have been beaten down to unconscionably low levels. On the short side, he seeks out high-profile companies that trade at unsustainable levels while hype-intoxicated executives make the same tactical mistakes he's suffered through with clients. Petersen's sector focus is batteries and efficient transportation because he has almost a decade of experience in the industry, including a three-year stint as board chairman of an R&D-stage battery-technology developer. He's convinced these sectors are emerging investment mega-trends.

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