To a simple economist, PartyGaming, the online poker company which floated today, looks like a bad investment.
Fund managers reckon the company is worth £4.6bn - as much as William Hill and Whitbread put together. There are three reasons why one might disagree with this opinion.
1. History shows that the long-run performance of newly-floated companies is poor, both in terms of share price and operating (pdf) performance. This is not just the case in the UK; Jay Ritter's research shows it's true around the world.
I suspect investors persistently overlook this because of a combination of the salience heuristic and overconfidence. They overweight prominent information - a new idea, apparently bright prospects - and underweight background data, such as the tendency for IPO firms to disappoint over the long-run. Also, they have too much confidence in their own ability to value companies, and so under-weight the importance of the fact that insiders - those who know the company best - are selling.
2. Innovations don't make big profits. Online gambling is a good idea. But no good idea goes unpunished. This important paper by William Nordhaus has found that:
Only a miniscule fraction of the social returns from technological advances over the 1948-2001 period was captured by producers, indicating that most of the benefits of technological change are passed on to consumers.
Why is this?
3. Good investments require barriers to entry. The key to sustained profits - and hence to a good stock market investment - is not good management or a good business model. It's a barrier to entry. Only this can fend off competition and so maintain profits.
Put it this way. Over 60 per cent of the All-share index consists of businesses that would look familiar to an investor of 100 years ago: oil, mining, brewing, retailing, banking, insurance and utilities. These industries have thrived down the years not so much because of innovation and technical progress, but because they have the power - through high capital requirements or (less so) brand loyalty - to fend off new entrants.
Does PartyGaming really have such a barrier to entry? The best hope, paradoxically, is that its activities are illegal in the "land of the free." Whilst this absurdity remains, at least there'll not be competition from one source.
Nice comment.
You could link this more generally with
http://financeprofessorblog.blogspot.com/2005/06/is-growth-good-for-shareholders.html
which suggests that per capita growth does not provide excess returns.
Posted by: Rob Hayward | June 28, 2005 at 10:18 AM