The Bubble Will Burst and the Frauds Will Be Exposed

I started in the newsletter biz in 1998. The internet was just getting going back then. Good research and due diligence were extremely valuable. To get older Wall Street Journal and Financial Times articles, I’d go to the library, scan microfiche, and print what seemed useful. 

I read books about fiber-optic networks and mobile phone technology. Actually visiting companies and talking to executives was routine. 

It was incredibly exciting and man, you could make a lot of money. Stocks doubled and tripled all the time. Of course, I was too young to realize what a bubble really was…

A lot of people say Cisco was the poster child of the internet bubble. Some will say it was one of the complete BS companies like Etoys.com or FogDog.com. 

For me, no company embodies the internet bubble like Global Crossing. I’ve written about this before, so forgive me if you’ve heard it already.

Global Crossing’s plan was to lay 100,000 miles of high-speed fiber-optic cable across the Atlantic and Pacific oceans. It would eventually connect four continents, 27 countries, and 200 cities.

The founder was an investment banker named Gary Winnick. He had no experience running a company, but what a pitchman. His undersea cable story raised $700 million, and on August 14, 1998, Global Crossing went public at $19 a share. That valued the company at around $3.8 billion.

For more than two years, investors believed that telecoms would flock to lease space on this incredible network. By February 16, 2000, Global Crossing stock hit $61.82, valuing the company at nearly $47 billion.

The billions in revenue never came. Global Crossing spent something like $20 billion on its network and had $14 billion in debt. The stock was trading for a measly six pennies a share when it filed for bankruptcy in February 2002. That $47 billion valuation had fallen to around $70 million.

A Kernel of Truth 

It was pretty clear that Winnick never planned to build a viable company. Winnick sold enough stock that he was worth $4.5 billion less than a year after Global Crossing went public. Anyone that bought his bonds got screwed. 

But here’s the thing: While it failed miserably as an investment, Global Crossing did indeed make a significant contribution to the evolution of the internet. Sure, it was a charitable contribution — the shareholders basically got zero return on billions invested.

The lesson here is that bubbles aren’t flat-out lies. There’s always a kernel of truth at the center. The cable Global Crossing laid is still being used today. 

Bubbles happen when people believe so deeply that they start ignoring fundamentals. And we are seeing instances of fraud crop up these days. 

Take electric/fuel-cell truck company Nikola (Nasdaq: NKLA) for instance. Its story was so convincing that BP (NYSE: BP) planned to partner with it to build refueling stations, and General Motors was ready to dump $2 billion into the company.

Shortly after GM’s announcement, the accusations started. A promotional video from 2016 showed the Nikola One cruising down a road… but it was a fake. The truck had no fuel-cell power source. It had been towed to the top of a hill and rolled down, the camera was tilted to make the road look level.

Both GM and BP canceled their plans with Nikola, but it doesn’t change the fact that they believed. 

Funny thing, after the GM partnership was announced, Nikola said it wanted to use GM’s fuel cells, and GM still didn’t get suspicious.

GM claims it did its due diligence on Nikola. But apparently, nobody thought it was important to actually see one of the fuel cells. 

In a way I get it: We think fraud, and we tend to think some little accounting gimmick lurking on the balance sheet. You don’t tend to think a company will have the huevos to outright lie about a cornerstone aspect of its business.

Imagine Richard Branson saying, “Oh yeah, we go to space all the time. I pretty much live there half the year.” 

Swimming Naked 

Bernie Madoff’s infamous fraud was uncovered in October 2008. We don’t tend to think of Madoff as having anything to do with the financial crisis. But as Warren Buffett has said, you don’t find out who’s swimming naked until the tide goes out. 

Madoff was exposed because of falling stock prices — he couldn’t bring in new investment dollars to pay off redemptions. And the banks were exposed by falling home prices: Rising defaults cast doubt on the value of mortgage bonds that were a huge part of bank assets. 

It’s reasonable to ask what frauds will be uncovered when this market turns lower, as it eventually will. Rest assured there are worse monsters under the bed than phantom fuel cells.

I think accounting is the place to look. Accounting ”rules” allow for a lot of fudgery. Like, when it comes to earnings projections, companies can pretty much say what they want. It’s up to analysts to call them on their BS. 

Take a stock like Peloton (Nasdaq: PTON). It trades at 300 times next year’s earnings — $5 billion in 2021 revenue and the company is worth $40 billion. 

Twenty-six analysts cover the company. You know how many are saying, “It’s been a pretty good run, you should take your profits”? 

That would be zero. Zip. Nada. 

Not one analyst will break from the herd and state the obvious. But we all know that if Peloton misses growth expectations by even one percentage point, the stock will get crushed. 

Jim Chanos is a notable short seller. He’s not one of those shorts like Muddy Waters that release inflammatory press releases to manipulate stock prices (even though Muddy Waters is often right). Shorting stocks is not easy, and Chanos has been around a looong time…

He says his short portfolio is usually 10%–15% focused on accounting issues. Right now, 30% of his fund is allocated to accounting issues.

Don’t forget: All the officers of a company have compensation that’s tied to growth. And when things are going good and scrutiny is low, the envelope gets pushed. Companies can allocate cash to share buybacks, make fanciful EPS estimates a reality, and everybody gets a bonus. Hurray!

Then next year, the envelope gets pushed a little more…

Right now, the surf is up and the water’s warm. I don’t know when, but this tide will go out. And the view will not be pretty.

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.