NEW YORK (
) -- The first thing every securities lawyer learns is that emerging technology is a double-edged sword.
On the leading edge, inexpensive innovations that ramp rapidly over a few years lead to thriving businesses that deliver market-beating returns. On the bleeding edge, costly innovations that can't be implemented at relevant scale for years or decades morph into financial black holes that suck the lifeblood out of portfolios and teach a whole new generation of investors about a predictable and unavoidable market phenomenon that the Gartner Group has dubbed "The Hype Cycle."
For better or worse, private and public financing of technology and resource-development projects can't happen without hype cycles that repeat themselves over and over again. Hype cycles are a force of nature, and as inexorable and predictable as the tides.
The first hype cycle in the life of every technology or resource project begins with a "Eureka moment," when an idea takes form or a resource is identified. At that stage the possibilities are limitless because the inventors and prospectors only have enough data to support a conclusion that additional work is justified. It's the riskiest possible class of investing because the odds are very high that the perceived potential will prove illusory as R&D or exploration follow their natural course.
The most common result is a mini-hype cycle where expectations are highest at the outset, but rapidly fade as technical challenges arise, compromises are made, delays are encountered, costs exceed budgets and the true market potential gets clearer. At the end of the process, the R&D and exploration investors either lick the wounds of a failed project or profit handsomely as a new trigger point arrives and the commercialization hype cycle begins.
In their book
Mastering the Hype Cycle
, the Gartner Group's Jackie Fenn and Mark Raskino explain that the hype cycle
"arises from the interplay of two factors: human nature and the nature of innovation. Human nature drives people's heightened expectations, while the nature of innovation drives how quickly something new develops genuine value. The problem is, these two factors move at such different tempos that they're nearly always out of synch. An innovation rarely delivers on its promise when people are most excited about it. Expectations rise quickly and are easily frustrated, while innovations develop slowly, step by step."
In Gartner's model, the cycle starts with an "Innovation Trigger," where a public demonstration, product launch or other event generates press and industry interest. The innovation may have been in development for years,
"but at this point it reaches a stage where word of its existence and excitement about its possibilities extend beyond its inventors or developers. More and more people hear of its potential, and a wave of buzz builds quickly as everyone passes on the news."
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.
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%.
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.
(AONEQ) have all gone bankrupt. A fourth company,
(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.
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
(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
(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
Car of the Year Award while garnering high marks from
. 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.