Comparisons between cloud computing and the dot-com bubble

We have written previously about the continuity between the dot-com crash of 2000-2002 and the financial panic of 2008-2009, and the belief that "The new economy of the late 1990s was an invention of media and Wall Street [. . .]. By 2000, new economy rhetoric became a frenzy of half-truths, bad history, and wishful thinking" -- a belief that the dot-com crash seemed to vindicate (see this previous post).

The bitterness investors felt towards technology stocks and Wall Street in general after the dot-com crash -- and the mistaken "lessons" of that event -- helped drive more capital into just about everything else, including real estate and securities composed of various flavors of home mortgage. The Fed's over-steering and artificially low borrowing rates added fuel to the fire.

Just as the Great Depression of the 1930s colored the investment perceptions of an entire generation (as well as the investment perceptions of the next generation, in many respects), there is evidence that the dot-com crash continues to color thinking about technology investment, often leading to mistaken conclusions.

For example, this recent article entitled "Storm is brewing for cloud computing stocks" is built around the argument that there is a new tech bubble brewing: "the cloud computing bubble." The article draws directly on the comparison to the dot-com bubble, saying: "the frothy environment is beginning to resemble the tech bubble of the late 1990s."

While it is true that investors must be careful of owning stocks with excessive valuations, we believe that the sell decision is extremely complex and that more weight should be given to business considerations than market action when replacing a core holding (a subject we discussed in greater depth here). As an aside, a distinction could be made here between trimming a position that has run up due to market action and selling a position altogether, but that is another matter.

While agreeing with the author of that article in that respect, we would argue that investors who fall for an easy comparison between today's "cloud computing" companies and the many dot-com companies of the late 1990s that enjoyed explosive IPOs and skyrocketing prices despite having no profits and not much in the way of a business model risk making a serious mistake.

Cloud computing is not primarily about providing free consumer services on the web supported by advertising, as the article implies. Cloud computing is a catch-all term to describe one of the obvious advantages made possible by the enormous increase in the speed at which data can be sent from one computer to another at very low cost, which we have been discussing on this publication for years and which we highlighted in our most recent post.

When ever-larger streams of data can be sent instantly and very inexpensively, individuals and businesses begin to ask themselves, "Why would I want to own software applications and storage on my machine?" Cloud computing companies run the software and the storage on their machines, which their clients can tap into remotely. Because of the massive increase in speed, storing a document or running a program on a remote computer feels the same as running it on your own machine, but with many real and tangible benefits.

For example, enterprises formerly had to buy costly software which had to be installed on possibly hundreds (or thousands) of employee computers, and then pay for costly maintenance and service contracts to keep that software running smoothly and address any glitches, as well as pay for costly upgrades every time the software authors decided to make improvements (or else do without those improvements), as well as paying for their own storage equipment, all the electricity to run all the servers and storage devices and backup power equipment in case of an emergency, and a massive in-house IT staff to keep it all running (as well as for a host of outside consultants and contractors who promised to help make it all run more efficiently).

The cloud computing model creates savings by eliminating much of the hardware, software, consulting, and services required by the traditional model. Instead, the customers can allocate their IT resources towards creating applications to make themselves more efficient using the cloud services, rather than worrying about crashes, upgrades, etc.

This phenomenon is no "dot-com" scheme to sell petfood over the internet: it is a real value-add that can save businesses literally millions of dollars.

We fully understand that the crash of 2000-2002 (to say nothing of the panic of 2008-2009) continues to loom in investors minds, and fill many of them with trepidation about investing in anything to do with technology. However, we would caution against making easy comparisons without fully understanding the actual situation. We have always said that owning well-run, innovative companies can actually be safer than investing in big, established companies such as the ones the author of the cloud computing article suggests to readers at the end of his dot-com analogy.*

We would argue that it is actually a very good thing that most pundits (and many Wall Street firms) still do not completely understand this important topic, and that ill-founded comparisons to 1999 continue to keep many investors out of the companies that are enabling this paradigm shift or positioning themselves to benefit from it.

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At the time of publication, of the stocks mentioned in the referenced article, the principals of Taylor Frigon Capital Management own securities issued by (CRM). At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Open Table (OPEN), Rackspace (RAX), Google (GOOG), Microsoft (MSFT), Yahoo! (YHOO), or the ETFs mentioned (XLK or IYW).