Growth industries offer the potential to create millionaires out of everyday people and launch empires for business entrepreneurs. Yet, the dark underbelly of growth industries is that some of them are bubbles that wreak financial devastation when they burst. Think of the dotcom bubble, the housing bubble or even the beanie baby bubble. Gauging a legitimate growth industry from bubbles that will inevitably burst isn’t always easy, but can play a crucial role in protecting your financial future. There are some indicators that help you spot the difference.
Overvaluation is sometimes easy to spot and sometimes not. In the case of the dotcom bubble, the overvaluation was easy to spot. Companies showing zero revenue were being valued in the billions of dollars during their IPOs. While many startups in a new industry don’t show revenue for the first few years, companies showing zero revenue at the time of their IPO never deserve valuations at that level. Moreover, these exponential increases in valuation will happen over a comparatively short period of time: often in timeframes ranging from a few months to a year or two. A real deal growth industry sees its value rise at a measured pace over a much longer period of time. Companies in the industry will generally be able to show revenue and increases in revenue over time.
Psychological Signs
Bubbles are always accompanied by a kind of group euphoria about the prospects of an industry that often run counter to the available evidence and even common sense. Stories of fortunes made, seemingly overnight, encourage fence-sitters to throw their money into the industry or its stocks. Some of these investors will also make fortunes. Tales of those overnight successes feeds an every growing frenzy about the industry the drives the perceived value of the industry beyond its ability to deliver a return-on-investment over the long haul. Legitimate growth industries generate excitement, but not euphoria, because they deliver a solid return on investment for all of its investors over time, rather than unbelievable ROI for some investors over a short time horizon.
Consistency with Historical Trends
Bubbles that emerge in a new industry often get overlooked because there is no historical data to draw on in making investment decisions. This isn’t true in industries with a historical record of 30 or more years. The housing bubble in the mid-2000s is a clear example of this. Housing prices had risen so far beyond all historical norms that, in hindsight, it was obvious that home values couldn’t continue to increase at that pace. A real growth industry will show some consistency with historical trends. Even groundbreaking new technologies, such as personal computers 20 years ago, will show a growth trajectory similar to other groundbreaking technologies that impacted society as a whole. Consider televisions and personal computers. At first, both were high-priced luxury items that generated big profits on small sales numbers. Eventually, prices dropped, commoditization set in, and you can now find both in most homes.
Avoiding bubble industries and gauging real deal growth industries is art as much as science. Some industries endure despite early bubble indicators and others explode without them. However, by remaining vigilant for overvaluation, remaining wary of over-enthusiasm in other investors and considering industry historical norms, you’ve got a good chance at identifying real growth industries.